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Peter Elston’s Investment Letter – Issue 10 February 2016

8 February 2016

It is possible that we are now in an environment in which the falls in markets since last summer, particularly those in early December and throughout most of January, begin to have an impact on aggregate demand (which anyway was already somewhat insipid what with on the one hand the US nearer the end than the beginning of its business cycle and on the other hand China slowing structurally). If people or companies feel more uncertain as a result of market declines, they may reduce their spending or investment patterns which could cause a recession.

How one judges whether this will happen and thus whether a protracted bear market looms is an almost impossible task. The global economy is an example of what is known as a non-linear complex adaptive system. Or to put it another way, it’s unpredictable. Fear can spread like wildfire, feeding on itself. And fear can be rational, as in bumping into a tiger, or it can be irrational, where one is fearful for no reason other than that others are fearful. Whether the crowd’s fear is itself rational is neither here nor there. Why wait to find out? It is human nature to run first and ask questions later. This reminds me of the conversation in Joseph Heller’s classic novel Catch 22 between Yossarian and Major Danby: “But, Yossarian, suppose everyone felt that way?” to which Yossarian replied, “Then I’d certainly be a damned fool to feel any other way.” You cannot argue with the logic.

You may think me barmy but below is my favourite chart (Chart 1). It depicts book values over the last 15 years of portfolios invested on 31 Dec 2000 in various MSCI indices, rebased to 1. In other words, no account is taken of subsequent movements in equity markets, only of dividends received. The series are calculated by simply dividing the total return indices by the respective capital only indices. Think of them as the accumulated value of dividends received (if you look carefully you can just about discern a slight flattening of the lines in 2009 when dividends fell, meaning that the rate at which dividends accumulated fell slightly).

Chart 1: Dividend indices – accumulated value of dividends derived by dividing total return indices by capital only indices

Source: Bloomberg Dec 2015

The point of the chart if you haven’t realised it is this: if dividends are so stable, why are markets so volatile? (I keep a copy of this chart pinned up on the wall near my desk to remind me to keep wondering about this question). The fact is that dividends in aggregate rarely fall and when they do they recover quickly. Why do markets sometimes behave as if dividends are going to dry up for good when the likelihood of this happening is so remote? Furthermore, why worry about this possibility when the circumstances that would cause it such as a nuclear holocaust or an asteroid hit would almost certainly cause you to worry about things other than the value of your portfolio. The answer to both of course is: human nature. Humans run first and ask questions later.

What this means of course is that if you step back and behave rationally, you can take advantage of the irrational behaviour of the crowd.

In 1981 Yale’s Bob Shiller wrote a paper titled “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?”

In the paper, Shiller noted that it had “often been claimed in popular discussions that stock price indexes seem too “volatile,” that is, that the movements in stock price indexes could not realistically be attributed to any objective new information [about dividends], since movements in the price indexes seem to be “too big” relative to actual subsequent events.”

To illustrate the point graphically, he plotted (see Chart 2 below) the S&P Composite index, P, against the present discounted value of the actual subsequent real dividends, P* (both series were de-trended so one could more clearly see the variations around the trend). What is clear from the chart is that the answer to the title of Shiller’s paper is ‘yes’, stock prices do indeed move too much to be justified by subsequent changes in dividends.

Chart 2: Actual S&P composite index and theoretical value based on discounted future dividends (both de-trended)

Source: Robert Shiller, 1981

Shiller’s paper dispels the notion that stock markets are efficient. Markets are simply too volatile to be justified by big changes in discount rates (real interest rates) or by people being rightly fearful of collapses in future dividends. Given that dividends haven’t collapsed in the past and that the sample size is large, it is highly unlikely that they will in the future. Companies have the ability to adapt to prevailing conditions. In the face of lower earnings, they can cut payout ratios in order to maintain dividends. They can cut capex, costs or prices. In the face of higher inflation, they can raise prices. All this means that companies in aggregate have a remarkable propensity to deal with and recover from recessions.

Shiller’s key conclusion is that markets are not efficient. If markets were efficient, they would track much more closely the present value of future dividends, something that can be reasonably estimated and which is very stable. Thus when markets veer a long way from the present value of dividends as they have a tendency to do, they will naturally be drawn back towards it, also known as mean reversion. This means it is possible for tactical asset allocation to add value.

To illustrate further this tendency for markets to recover, I have investigated how the US equity market has behaved following instances when it has fallen by various amounts in relation to its all-time high. Specifically, I have calculated how long it has taken the S&P 500 index to recover its all-time high once it falls certain percentages from said all-time high and what the annualised return has been during these periods. As of 20 January 2016, the S&P 500 was 12.7% below its all-time high attained on 21 May last year. Thus, I have considered all other periods since 1955 when it has fallen by the same amount, as well as by 20%, 30% and 40%. The results are shown in Table 1 below.

Table 1: Evidence of mean reversion in US equities

Source: Bloomberg, 20 Jan 2015

On the 13 occasions since 1955 when the S&P 500 has fallen by 12.7% from its all-time high, it has taken an average of 581 days (roughly 2 years) to regain its high, during which time the annualised return has been 6.3%. This is in fact slightly lower than the long-term average of 6.6%. However, when the index falls by more than 20%, the annualised returns to get it back to its all-time high have been well above 6.3%.

What this means is that judging by the history of the last 60 years a decline in the order of what we have seen over the last 8 months should not prompt one to increase equity weightings. However, if the market falls further, one should begin to get excited. And one should continue to get more excited the further the market falls. Gamblers call this a Martingale strategy and it works when applied in markets where there is mean reversion as is the case in equity markets.

Although it is certainly possible that we have entered a protracted bear market in equities, I don’t believe this to be the case. Economies around the world still in general have scope to grow, as evidenced by negative output gaps, low inflation, and unemployment rates that can fall further. Monetary policy can remain supportive (as we go to print Japan has introduced negative interest rates). And there is also scope to boost fiscal policy if necessary, though this would more likely be a response to a recession rather than slower growth. As for equity valuations, dividend yields are well above historic averages, which in the absence of a nuclear holocaust or asteroid hit represent good value. Thus, I don’t think markets will continue to fall for much longer but if they do we will be ready.

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

 

Table 2: Inflation data releases over past month

There are very tentative signs of improvement in inflation numbers around the world (improvement could mean it either rising if it is too low or falling if it is too high). Numbers in Japan and the UK, while still below desired levels, were higher than both prior month and survey. Among the BRICS countries, China and India saw a similar pattern, though inflation rates in Brazil, Russia and South Africa were still high and rising.

I remain of the view that although monetary policy is not a cure for all ills, it can certainly help to get inflation back to desired levels in the medium term. For further reading, I would recommend former Fed governor Ben Bernanke’s 2002 speech Deflation: Making Sure “It” Doesn’t Happen Here. Below is an extract:

By increasing the number of U.S. Dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in Dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

I do not believe as some do that QE has failed. Frankly, what choice did central banks have once short term rates hit the zero bound? To get out the white flag and give up? Although headline inflation rates across the developed world are very low and in some cases negative, this is largely the result of falling commodities prices, in particular the oil price. Taking out food and energy, inflation is not so worryingly low. Yes, it will likely be a long haul, but central banks have come a long way from the policy errors of the Great Depression. And even Germany now understands that in combination with sensible fiscal policy, QE does not have to lead to hyperinflation.

 

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Table 3: Employment data releases over past month

Source: Bloomberg

On the whole, labour markets in key global economies continued to improve. Brazil’s unemployment rate unexpectedly fell in December, though it is hard to conclude at this point that this is definitively good news in light of rising inflation and the nasty recession that Brazil is experiencing currently.

 


Specialist investments

We have decided to stop using the term ‘alternative investments’ to describe our investments that are neither equities nor bonds, and instead will use ‘specialist investments’. We have found that the term ‘alternatives’ tends to be associated with potentially high risk vehicles such as structured products, hedge funds, art, wine, coins, and stamps, none of which as a matter of policy we would invest in. What we are looking for in this area are investments that genuinely offer something of value in relation to equities or bonds. For us, this means income streams that are more stable than those of equities and more real (index-linked) than those of bonds. It also means yields that are generally higher than equity market yields. And finally, most of our specialist investments are listed on the London Stock Exchange.

We have four sub asset classes within the broad ‘specialist investments’ segment: REITs, private equity, specialist financial and infrastructure. While we considered using the term ‘real assets’ which others are using, we felt that this term too was misleading, suggesting as it does investment in the aforementioned non-yielding art, wine, stamps etc. What links all four sub asset classes is that they are ‘specialist’ in some way or another. So, we have decided to use the term ‘specialist investments’.

Table 4 below provides data on seven of our ‘specialist’ investments. The message is a simple one: our specialist investments have been great ‘diversifiers’. The seven in question have all outperformed and been less volatile than the broader equity market since listing, and have all been lowly or in some cases negatively correlated with the broader equity market.

Table 4: What do our specialist investments bring to our portfolios?

Source: Bloomberg

On a related matter, we have now aligned the strategic asset allocation within CF Seneca Diversified Growth Fund’s specialist investment segment with those of our other two public funds. Previously, the growth fund had a small allocation to commodities and a lower allocation to REITs. We felt that in the case of commodities, since physical commodities do not yield anything they are hard to value and thus should not be part of our strategic asset allocation. As for REITs, we felt there was no good reason why the growth fund should be any different to the other two funds. REITs may not be as ‘growthy’ as equities, but they can provide a good alternative to bonds (in the credit space rather than safe haven space).

Table 5 below sets out the strategic asset allocation weights within our ‘specialist investments’ segment, showing that all three funds now have the same weightings in this area.

Table 5: Strategic asset allocation within ‘specialist investments’, as percentage of total (previous in brackets)

Source: Bloomberg

 

 


Current fund targets (as of 22 January 2016, end Nov ‘15 targets in brackets)

The targets in Table 6 below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example. Note that since we did not include the below table in the January letter which was dedicated to the 2016 outlook, we are using end November targets for comparison.

Table 6: Current and previous target weights of our three public funds

Source: Seneca Investment Managers, Dec 2015

 

  • We increased equities target across the funds in early to mid-January from 2 percentage point overweight to 4 percentage point overweight, funded out of a combination of cash, fixed income, and specialist investments
  • This increase was driven more by bottom up factors and was all in UK where our UK equity specialist was keen to introduce two names, Victrex and Royal Dutch Shell
  • Victrex is the world’s largest producer of polyether ether ketone, a high performance polymer for which new uses and users are continually being found by the company; 3.2% dividend yield to Sep 2016 which we think is attractive given growth prospects and balance sheet with net cash; special dividends also likely over next two years
  • As for oil major Royal Dutch Shell, this was very much a contrarian investment idea; the shares had fallen materially over 2014 and 2015 and we felt the 10% dividend yield was extremely attractive even if the dividend were to be halved as seems very likely
  • The notable holding level target reduction was in specialist investment Assura plc, the niche healthcare property vehicle; it had performed extremely well in 2015 and the yield had fallen to 4%, a level we considered unattractive in comparison with our other REITs
  • It is encouraging to note that the timing of our addition of Halfords to the target portfolios at the very end of November was very opportune; the stock is now trading above our average purchase price which given the performance of equity markets is an excellent result; early days yet of course but it is always nice to get the timing as well as the long term right

 


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Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.01.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
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Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
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Peter Elston’s Investment Letter – Issue 9 January 2016

5 January 2016

Executive summary:
  • We believe on balance that the world will continue to grow in 2016, that equity market valuations by and large are low enough to make positive returns likely, and that western government bonds remain overvalued.
  • The US and China contributed 82% of global nominal growth over 2014 – 2015, and so our review for 2016 starts with these two major economies:
  • Economic data coming out of China, following the prolonged period of excessive bank lending to capital projects (money supply is off the scale), is contradictory. This said, there are signs of progress in the services sector, in the anti-corruption drive and in reforms to the welfare system. Overall, our view is that China as a command economy is advantaged in the shift it is trying to make to more services/consumption driven growth.
  • The tapering of QE implies that real US rates have already risen substantially. With the process of modest rate rises now underway and likely to continue, albeit haltingly and only to what will remain historically low levels, the future shape of the economic cycle has become more difficult to determine. This said, the US yield curve is not suggesting recession whilst the fall in unemployment has been flattered by those who have temporarily (?) left the labour market. We don’t believe the cycle is at an end yet.
  • Elsewhere in Asia, Japan continues to face massive demographic headwinds, however the ‘three arrow’ reforms are providing opportunities for some companies to move ahead of their competitors, and there is plenty of scope for bottom up stock selection.
  • In mainland Europe, QE has a long way to go which is likely to be supportive of growth and this is our largest overweight position in equity markets. Meanwhile, in the UK, inflationary pressure remains benign, and the yield curve supports the view that growth can be maintained for now.
  • In terms of valuations, whilst our zero position in developed sovereign bonds is not helping us substantially yet, at some stage, we believe yields will rise significantly and government bonds will bite the hand that bought them. We see no value.
  • High yield bond spreads have moved out, which given our expectation of future growth means this is an attractive area for us, though we continue to avoid the oil and gas industry, which is suffering from the Saudi squeeze on margins.
  • With regard to equities, these appear reasonably valued especially on price to book and yield metrics, and the apparent lack of any imminent end to the global cycle from yield curves and labour markets.
  • Within the equity arena, in addition to Europe, we particularly highlight the value in UK mid-caps, where we expect continued good performance, and which are free from the excessive dividend concentration and low dividend covers so apparent in the large cap universe.

 


2016 investment outlook

This investment outlook is particularly hard to write. The world’s two largest economies, the US and China, are at critical junctures. While, the US is arguably much closer to the end of its business cycle than the beginning, as evidenced by unemployment that has been falling for six years and that has just recently hit 5%, China is undergoing a pronounced and persistent structural slowdown, as evidenced by plummeting industrial metals, iron ore and bulk shipping prices. Throw in the conundrum of low or negative real long-term interest rates, bloated central bank balance sheets, widespread wealth and income inequality, the impact on growth and inflation of the internet, the shift away from fossil fuels, aging populations, financial sectors in the developed world that remain huge and complex, and over-indebted private sectors, and you have an investment strategist’s nightmare – how on earth to make sense of everything?

My framework for thinking about markets and asset classes has a medium-term element and a long-term element. The former is based around the business cycle while the latter attempts to assess the aforementioned structural trends in order to form an opinion as to whether the world economy will grow or stagnate over the longer term (I think it will grow).

With respect to the business cycle I try to keep things simple, looking ostensibly at the unemployment rate in a particular country. This works better in developed countries where cyclical rather than structural forces dominate. In the US, for example, the unemployment rate has exhibited significant regularity over the last fifty or so years (chart 1).

Chart 1: US unemployment rate

Chart 1 - US unemployment rate

Source: Bloomberg

 

The yield curve also tends to be a good leading indicator of growth – all five recessions in the US since 1975 were preceded by an inverted yield curve and not once did an inverted yield curve not lead to a recession (chart 2).

Chart 2: US: yields curve versus Conference Board coincident index

Source: Bloomberg

 

Table 1: Annualised returns

* 6 month moving average of 10 years minus 2 years. Source: Bloomberg.

 

Correctly predicting recessions can help add substantial value to the performance of multi-asset funds from time to time (at business cycle extremes) given the strong link between recessions and inflation and thus bond market performance on the one hand and between recessions and corporate profits and thus equity market performance on the other. This is what our tactical
asset allocation framework at Seneca seeks to do.

 


 

One third of the global economy on a purchasing power parity basis is accounted for by the US and China. Furthermore, between them, they accounted for 82% of global nominal growth over 2014-5.

As far as the overall world economy is concerned, it still appears to be operating below capacity, as can be seen in chart 3. Although the IMF output gap for advanced economies has risen since the crisis as should be expected, it is still -2%. This suggests there remains considerable scope for the global economy to recover and we are thus some way off from the point at which central banks will need to consider restraining growth rather than supporting it.

Chart 3: IMF output gap

Chart 3 - IMF output gap

Source: Bloomberg

 


United States

Employment in the US has been rising now for the best part of six years. The previous three expansions saw employment rise on average for 6 years, so on the face of it, it appears we should be nearing the end of the current expansion. The unemployment rate has fallen to 5%, which compares to trough rates during the last three cycles of 5%, 4% and 4.5%. Surely the current expansion is running out of steam?

Perhaps not.

If one looks in more detail at the employment data, one can reach a different conclusion. The number of employed as a percentage of the working age population has indeed been rising but not by much. During the global financial crisis, the percentage fell from 63.0% in June 2007 to 58.3% in December 2009. In the years since, it has retraced just 21% of the previous decline, and currently stands at 59.3%. And yet the unemployment rate has fallen all the way back to 5%, retracing 90% of its previous increase.

The explanation lies in the fact that the workforce as a percentage of the working age population (known as the participation rate) has been declining sharply (see chart 4). Some of this decline is due to demographic factors such as the aging population but not all of it. Many left the workforce because they gave up looking for work. What this means is that the economy in the US can continue to improve without putting upward pressure on wages, as supply of labour is boosted by people rejoining the workforce. This means that inflationary pressures should remain benign for some time, allowing the Fed to maintain an accommodative monetary policy – interest rates may rise but they will almost certainly remain low.

Chart 4: As percentage civilian non-institutional working age population

Chart 4 - Percentage civilian non-inst working age population US

Source: Bloomberg

 

That said, there is no doubt that some parts of the US economy are struggling at the moment. The strong dollar has put pressure on manufacturers while the sharp decline in the oil price has led to a contraction in the oil and gas sector. The question is whether weakness in these areas of the economy will cause weakness more broadly.

I think not.

America’s economy is big enough, deep enough and strong enough to absorb the pain. It should be remembered that services account for 80% of the US economy. If anything, contractions in manufacturing and energy sectors should be considered part of the process of creative destruction, with freed up labour getting employed in other, higher value-added areas of the economy.

This optimism, at least as far as the economy is concerned, is supported by yield curve data. As can be seen in chart 2, although the yield curve has fallen over the last 5 years, it is still well above zero, standing currently at 1.2% (recall that the yield curve falling below zero tends to indicate that a recession is not far off). During the last two cycles, it took 6 years and 2 years respectively for the yield curve to fall from 1.2% to below zero, suggesting that the next recession is some way off.

Of course there are other factors that complicate the picture. It is possible that with interest rates close to or at the zero bound, the yield curve is less useful as a recession predictor. Furthermore, the tapering of asset purchases by the Fed constituted a de facto tightening of monetary policy, so while we have only just seen the first increase of the Fed Funds rate, this hides the fact that monetary conditions have been on a tightening path for some time. This is illustrated in the chart below, which shows the actual Fed Funds rates along with what is known as Krippner’s shadow rate. Leo Krippner is a member of the research team at the Reserve Bank of New Zealand and he devised a method using:

“bond option pricing techniques to formally model the value of the option for investors to hold physical currency at the ZLB (zero lower bound). That enables an estimated “ZLB/currency option effect” to be removed from the observed yield curve data, leaving the “shadow yield curve”; i.e. a hypothetical yield curve that would exist if physical currency was not available.”

I don’t understand it either, but conceptually one should be able to grasp the idea that it must be possible to measure the effect of quantitative easing in terms of an effective interest rate below zero. Looking at chart 5, one can see that the effect of QE from 2008 to 2012 was to take the effective short term interest rate from zero to around -6% (note that this is a rate that cannot be observed, only felt). The tapering of asset purchases that was announced in the middle of 2013 has seen the shadow rate rise back to close to zero, and it is thus entirely logical that this is the point at which the Fed would raise the actual Fed Funds target rate.

The point is that if one uses the shadow rate rather than the actual rate, we have already seen a rise in short term rates similar to that seen from 2004 to 2006 that arguably precipitated the fall in the housing market and in turn the GFC.

As it happens, I don’t think we are very close to the end of the tightening cycle, for the reasons mentioned earlier with respect to the labour market, but I would imagine the end of QE makes things less predictable than would otherwise be the case.

Chart 5: As percentage civilian non-institutional working age population

Chart 5 - Krippner's shadow rate vs actual Fed funds rate

Source: Bloomberg, Reserve Bank of New Zealand
(http://www.rbnz.gov.nz/research_and_publications/research_programme/additional_research/monthly-update-dec-2015.xls)

 


China

While it is pretty clear that the fall in the oil price has been supply driven, with the Saudis playing a high stakes game of trying to drive out higher cost producers by turning on the taps, it seems the fall in industrial metals and iron ore prices is demand driven, with China principally to blame.

It is now well understood that China is in a transition phase, as its one dimensional growth model based around building stuff financed with bank credit reaches its limits. What it transitions to and how smoothly it does it are still unclear, but the shift has certainly caused a lot of pain in commodity producing countries such as Australia, South Africa and Canada.

The strengthening of the US dollar has not helped matters, given the renminbi’s link to the greenback, and while headline GDP growth is still a very respectable 6.9%, there are suggestions that things could be much worse – how I wonder can electricity consumption be growing only at 0.6% year on year if the economy is growing at close to 7%? The fact is that it is very hard to get a good understanding of what is going on in China. For a country with GDP per capita of just over $8,000, China’s money supply is off the scale (see chart 6).

Chart 6: Money supply as percentage of GDP versus GDP/capita

Chart 6 - Money supply as percentage of GDP versus GDP-capita China

Source: Bloomberg

 

View from the Bund, early 1990’s               View from the Bund, 2010

The Bund, early 1990's & 2010

Source: Skyscrapercity.com

 

Although China’s shift away from manufacturing is evident in manufacturing PMIs that have been hovering around 50 for some time – a level that indicates neither expansion nor contraction, services PMIs have remained well above 50, though admittedly have been on the decline (chart 7).

Chart 7: China purchasing manager indices (PMIs)

Chart 7 - China purchasing manager indices (PMIs)

Source: Bloomberg

 

Aside from the shift away from steel and concrete towards services and consumption, there are other important changes afoot in China. The collapse of Macau casino revenues is an indication that president Xi’s anti-corruption drive is biting, while reforms of China’s welfare system are ongoing, a good example of which is allowing migrant workers access to education and healthcare. While it remains to be seen whether China can make this transition smoothly, I suspect such change is more easily achieved in a command economy like China’s.

 


Europe and Japan

The two developed countries and regions where growth has been most elusive are Europe and Japan. As can be seen in chart 8, growth in Japan and Europe has been noticeably lower than in the US and UK. In Japan’s case this is because of severe demographic headwinds. The government forecasts that the country’s population will fall from around 128 million currently to 86.7 million in 2060 (figure 1). Furthermore, the number of people aged 20-64 is expected to fall from 75 million to 41 million over the same period. With market shrinkage on this scale it is no wonder than Japanese corporate investment is so weak. Indeed this severe structural headwind is what is behind (or in front of!) prime minister Shinzo Abe’s so-called ‘three arrow’ reforms. Indeed, while the long-term outlook for Japan’s growth is not so good, the reforms are providing opportunities for the more innovative and nimble companies to get ahead of the more sleepy incumbents. Japan may not be interesting from a top-down perspective but that does not mean there are not interesting bottom-up opportunities.

Chart 8: Economic growth (incl. forecasts) in key developed countries and regions

Source: Bloomberg

 

Figure 1: Japan’s population

Figure 1 - Japan's population

Source: http://www.ipss.go.jp/s-info/e/ssj2014/images/001_01.jpg

 

Europe’s problems have also been structural but not demographic. Growth prospects have been weighed down by politics and the lack of reform with respect to the region’s banks, as well as high interest rates in Europe’s periphery. Nevertheless, recovery is now firmly in place, if some way behind the likes of the US and the UK. 10 year yields in the periphery on average are now close to 3% (chart 9) while employment conditions across the region are steadily improving (chart 10). Though the unemployment rate has fallen from just over 12% in 2013 to 10.7% currently, it is still high and still far above the pre-crisis low of 7.2%. This means one thing: monetary policy will remain very loose for some time to come.

Chart 9: Europe 10 year government bond yields

Source: Bloomberg

 

Chart 10: Unemployment rates in Europe and US

Source: Bloomberg

 


United Kingdom

As can be seen in chart 8, the UK’s economic performance has almost been on a par with that in the US. Growth since 2010 has averaged 2.1%. While this is lower than pre crisis growth of around 3%, it is nonetheless better than growth across the channel or in Japan. Bank of England governor Carney has conceded defeat to his adversary (or is it colleague?) across the pond in the race to be the first to raise interest rates, and it now seems that a rate rise in early 2016 is off the table. Inflationary pressures remain benign: although core inflation has been rising, at 1.2% year on year it is still well below the central bank’s 2% target.

As for the yield curve, it has fallen from the 3% post crisis level but is still steep at just over 1%, suggesting that growth momentum can be maintained for the foreseeable future (chart 11).

Chart 11: UK: yield curve versus coincident index

Source: Bloomberg

 


Asset class and market views
Government bonds

There is very little if any long-term value in developed government long bonds, with real yields either very low or negative (chart 12). However, this does not mean that in the short term they cannot perform well, before the long-awaited bond bear market finally begins. The trigger for good performance over the next year or two would be widespread global recession that would cause inflation to fall and real yields to fall even further. However, I do not think this scenario likely, given that monetary policy across the developed world remains very stimulative. While the plunging oil price is no doubt causing a great deal of pain among higher cost producing companies and countries, on balance I think it is a net positive for the global economy. With inflation, real yields and credit risk all at very low levels, and governments and their central banks providing a great deal of support, the risks would appear to be on the upside (for yields).

Chart 12: Inflation linked bond yields

Source: Bloomberg

 

In sum, we continue to steer clear of developed sovereign bonds, though accept it may be a little while yet before this position really starts to work for us. That said, one can clearly see that there has already been a change in trend with respect to the performance of government bonds (chart 13). Pre-crisis, the DB Global Government GBP Hedged bond index in real terms was generating trend returns of around 4% per annum. Since 2009 however, this trend rate has fallen to 0.8% per annum. The drag of an underweight position is falling considerably.

Chart 13: Global government bonds

Source: Bloomberg

 


High yield bonds

As can be seen in chart 14, high yield bond spreads had been nudging up since the first half of 2014, before rising sharply in recent weeks. Most of the pain has been felt in the US energy sector as a result of the strain being put on shale producers by the falling oil price. However, there has been some spillover, with yields in other sectors as well as in Europe also affected.

Given my view that the global economy will continue to grow this year, these higher spreads represent good buying opportunities, though we would continue to avoid the energy sector in view of the fact that the Saudis are unlikely to capitulate with respect to oil supply.

Chart 14: High yield spreads

Source: Bloomberg

 


Equities

On the face of it, there appears to be a rather worrying decline in corporate profitability as measured by return on equity (chart 15). However, dig a little further and one finds the decline is concentrated largely in one sector: energy. Over the last four years the return on equity of the MSCI World Energy sector index has fallen from 17% to -3% (this helps explains why the oil and mining heavy FTSE 100 index has been such a poor performer this year). As can be seen in chart 16, the profitability of the consumer staple sector has been pretty stable in the 17-20% range.

Chart 15: Global corporate profitability

Source: Bloomberg

 

Chart 16: Corporate profitability by sector

Source: Bloomberg

 

As for global equity valuations, they remain very reasonable, and indeed have become even more reasonable in recent weeks. On both a price-to-book and dividend yield basis, the MSCI World index is on the cheap side relative to history. Sure, valuations are well above where they were at the depths of the crisis, but they are still below historic averages (chart 17).

Chart 17: Global equity valuations

Source: Bloomberg

 

As far as dividend streams are concerned, there are no obvious signs that they are overstretched. In the US, dividends per share have been growing at a decent pace since 2010, and indeed as can be seen in chart 18 have been keeping pace with the index (or is it the other way round?!) It should also be noted that over the last 50 or so years, dividends in the US fell only during the more recent bear market, and even then the falls were concentrated in one sector: financials.

Chart 18: US equities and dividend distributions

Source: Bloomberg

 

As for the UK, dividends have also been growing at a reasonable pace since 2010 and if anything, as can be seen in chart 19, have been outpacing the advances in the market (dividend yields have risen).

Chart 19: UK equities and dividend ditributions

Source: Bloomberg

 

Perhaps the starkest illustration of the decent value that is now offered by UK equities, at least in relative terms, is how the equity dividend yield compares with the real long bond yield. While the equity market’s dividend yield has undulated in the 3-5% range over the last 20 or so years, the real long bond yield has fallen from 4% to -1% (chart 20). For those who argue that one should subtract the inflation rate from the dividend yield, recall that Gordon growth says that the future market nominal return is equal to the dividend yield plus nominal dividend growth. The future real return is the dividend yield plus real dividend growth. In other words, inflation gets subtracted from the growth part not the yield part.

Chart 20: UK equity and bond yields

Source: Bloomberg

 

Finally, a mention of UK mid-caps (the UK equity portions of our multi-asset funds have a strong midcap bias). As can be seen in chart 21, midcaps in the UK have performed extremely well in relation to their large cap peers over the last two decades (the margin is around 4% per annum). Given the prospects of continued accommodative monetary policy and an economy that continues to improve, the prospects for midcaps remain decent. Indeed we think that our funds’ exposure to midcaps is one of our key differentiating factors. Not only would we expect midcaps to continue to outperform large caps over the longer term, but the subsector also provides better stock picking opportunities, given the thinner research coverage.

Chart 21: UK mid cap performance (relative to UK large caps)

Source: Bloomberg

 

Wishing everyone all the very best for the year ahead!

 

 


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Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.11.2015 unless otherwise stated.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/170.

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Peter Elston’s Investment Letter – Issue 8 December 2015

15 December 2015

As we approach Christmas, this month’s letter will be a little shorter and thus I hope easier to digest, at least than the average Christmas feast! Furthermore, since January’s letter will include my market outlook for 2016, I thought that this issue should look back at 2015, particularly with respect to how our three public funds have performed. Of course the year is not over yet and anything (or nothing!) can still happen in the weeks remaining, but at least as far as our peer group standings are concerned there should not be much change between now and the end of the month.

A review of 2015

In what was a fairly trendless and thus tricky year for markets, our three funds performed well in both absolute terms and relative to their respective peer groups in the calendar year to 4 December. Given our strategic asset allocations, our expected long term real returns for each asset class, our fund costs and the value added we expect to generate from tactical asset allocation, stock selection and fund selection, we would hope over the longer term to achieve a real return of around 5% per annum for the CF Seneca Diversified Income Fund and 6% for both the CF Seneca Diversified Growth Fund and Seneca Global Income & Growth Trust.

In the 49 weeks so far, we have achieved, in nominal terms, 4.9%, 5.6% and 7.2% for the income fund, the growth fund and the trust respectively. Given that the UK consumer price index rose just 0.2% in the ten months to October, this means that the performance of our funds in real terms has either been very close to or exceeded our long-term return expectations.
Furthermore, the three funds have performed considerably better than their respective peer group average (see table 1 over the page).

It should be noted that in the case of the investment trust and its peer group, the performance and volatility numbers are based on total shareholder return, a measure of net asset value including dividends rather than share price including dividends. Also, the volatility number is the volatility of daily total returns which is then annualised. Finally, I have also included for comparison purposes four other IA sectors that may include multi-asset funds and thus which should be considered relevant.

Table 1: Total return and volatility statistics

Table 1 - Total return and volatility statistics

Source: Bloomberg

What is also pleasing is that our funds’ volatility has been considerably lower than that of the respective peer group.

The primary reason for our good performance has been our exposure to UK mid-caps. All our funds invest directly in the UK, which not only helps to keep our costs down but by focussing on the mid-cap space exposes us to better idiosyncratic and systematic returns than would be the case with large-caps. Research coverage is thinner among mid-caps so the opportunities to find under-valued situations are more prevalent. Furthermore, we would expect mid-caps to continue to outperform large caps over time – since March 1995, mid-caps have outperformed large-caps by 131% (4.1% per annum) and have outperformed in 72% of rolling 12 month periods.

Within overseas equities our biggest tactical position is a 5 percentage point overweight (in all three funds) in Europe ex UK which was worked largely because the majority of the exposure has been in currency hedged funds. At the end of 2014 we felt that the likely direction of monetary policy would be positive for equity markets but negative for the Euro which indeed has been the case.
As for fixed interest, we maintained our zero position in G7 government bonds. This position detracted in 2014 but has started to work in 2015. The DB Global Government Hedged GBP index has returned 1.4% this year and although this is still the right side of zero, it is less than previous years and also less than other areas of the fixed interest market we have been exposed to such as high yield.

Our fourth asset class is what we call ‘specialists’ where we invest in specialist funds such as renewable energy, asset leasing, REITs, private equity, loans and reinsurance (note that we do not invest in hedge funds, structured products or tangible assets such as precious metals, art, coins and stamps). Our REITs have performed particularly well this year, with Assura, GCP Student Living, LondonMetric and Tritax Big Box all posting double digit returns. We think ‘specialists’, which is well represented in all our funds’ strategic asset allocations, is an area that will continue to enhance both the return and risk characteristics of our funds.

Finally, as a result of the good performance in 2015, our 3 and 5-year quartile rankings have improved. These are of course the periods on which we should ultimately be judged (see table 2 below).

Table 2: Annualised returns

Table 2 - Annualised returns

Source: Morningstar

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

Inflation data releases over past month

Inflation data releases over past month

Source: Bloomberg

What is particularly notable about the table above is that inflation almost everywhere is lower than desired. The only place where inflation is close to where the central bank would like it is the US, where CPI ex Food & Energy is running at 1.9%. Even so, other measures in the US are weak. For example, the PPI ex Food and Energy index at the end of October was only 0.1% higher than a year earlier.

It is also notable that in general, inflation data around the world are still coming in lower than expected and also lower than the previous month. In such an environment one would have thought that despite the talk to the contrary there is still a decent chance that the Fed will hold off raising rates at its December meeting.

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Employment data releases over past month

Employment data releases over past month

Source: Bloomberg

Unemployment continued to fall across the developed world but in all cases remains about what should be considered full employment. I am reassured by these trends. If we started to see unemployment rising across the globe, this would be indicative of economic growth stalling and perhaps the proverbial ‘canary in the coalmine’ with respect to a looming global recession. Employment conditions continuing to improve with inflation pressures remaining benign or weak should be conducive for equity markets.

 


Captain Murphy’s diary

Murphy’s Law says that what can go wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

 

I’ve always enjoyed reading Financial Times columnist Martin Wolf’s articles. His approach to economics often focusses on the balance between savings and investment and how that balance helps explain such things as growth and the level of interest rates. If there are more companies and individuals who want to save than want to invest then it follows that real interest rates must fall to a level that encourages more investment and less saving.

Wolf’s latest piece (Corporate surpluses are contributing to the savings glut, November 17th) is about the excess of savings in corporate sectors around the world – particularly those in developed countries – and how this is impacting interest rates and growth. Wolf points out that the imbalance is as much about a lack of investment as it is about too much saving. Is this imbalance temporary or is it structural and thus perhaps something to be more deeply concerned about?

Oscar Wilde said that “people who live within their means lack imagination”. I doubt that he meant it in relation to economic systems but nevertheless its relevance in this regard is rather neat. The fact is that if everyone on the planet wanted to live within their means the global economy would collapse. Economic growth relies on people or businesses who are prepared to take risks and spend more than they earn. If you want to live within your means – meaning that you want to spend less than you earn – there needs to be someone else doing the opposite. It is a mathematical identity or truism that in aggregate spending must equal income, savings must equal investment. Those who live beyond their means (borrowing to fund ideas and dreams) should be applauded; it is their risk taking that drives growth.

As to why corporate investment is weak, Wolf puts forward three reasons. First, demographics; if societies are aging and population growth falling, there is less need for corporate investment to grow capacity. Second, globalisation has meant relocation of investment from high-income developed countries to lower-income developing countries. And third, technological innovation. As Wolf points out, “much innovation seems to reduce the need for capital: consider the substitution of warehouses for retail stores”.

I wonder if the internet isn’t almost single-handedly to blame. True, computers changed our lives, but for me it is the internet that has transformed them. It has been a hugely deflationary force, with high street shops being replaced with online shops and people now able to organise things themselves rather than having to engage and thus pay an intermediary, travel being a good example.

Will the global economy find ways to employ the excess capital and labour that now exists? Almost certainly. It has for the last several thousand years without too much trouble. It’s just it’s never had to do it this quickly.

 


Current fund targets as at 7th Dec (previous month’s targets in brackets)

The targets in the table below are where our funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Current fund targets 7th Dec 2015

 

  • Very little change to tactical asset allocation in November.
  • SIGT’s total equity target was increased to 62% to bring the trust in line with the two OEICs i.e. 2 percentage point overweight.
  • This was effected through an increase in UK equity target from 28% to 30% which also brings the trust more in line with the two OEICs in terms of the position relative to strategic asset allocation.
  • At a holding level in the UK we added Senior plc to both the growth fund and SIGT. The company is a “build-to-print” manufacturer of high technology components and systems for original equipment producers, principally in aerospace, defence, land vehicles and energy markets. The stock offers a 2.8% dividend yield for CY2015 which is 3.1 times covered. Return on equity is a respectable 18%.
  • In Japan we added the Coupland Cardiff Japan Income & Growth Trust to all three funds – this is an IPO and a closed ended version of Coupland Cardiff’s successful open ended version. We like the value oriented approach of the manager and the fact that the trust is hoping to achieve a 3% yield, unusual for a Japanese equity fund.
  • In the growth fund we reduced the holding in iShares Gold Producers ETF. This followed it being reclassified from ‘specialists’ to ‘overseas equities’ as well as a more general move away from passives on our part.
  • In ‘specialists’ we reduced the target weight in Tritax Big Box. The distribution and logistics property specialist has performed extremely well and as a result its yield has fallen to the point where better opportunities exist elsewhere in the REITs sector.
  • As far as broad asset class views are concerned there has been little if any change.
  • Equity market yields generally remain above their historical averages and thus offer reasonable value.
  • Within fixed interest, developed market sovereigns remain overvalued, with real yields that are either low or negative.
  • Both the above views are predicated on the belief that monetary and fiscal policies in large or developed countries will continue to prevent economies from slipping into recession. Recession on a global scale would of course be negative for equities and positive for save haven bonds.

 


Download this investment letter as a PDF


 

Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.11.2015 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/161.

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Peter Elston’s Investment Letter – Issue 7 November 2015

9 November 2015

We may yet be proved wrong but it is starting to look as if our call that we were not heading into a more pronounced period of equity market weakness was a decent one. In a yourmoney.com article on 2 October, I was quoted as saying that most bear markets begin when economies are strong or overheating. As evidence, I pointed to the IMF world output gap having been 2% in both 2000 and 2007 when the last two bear markets began, whereas the gap currently is -2%. I also noted, though it wasn’t used in the article, that bear markets also normally begin when markets are overvalued, again pointing to high valuations in 2000 and 2007, and current valuations that are certainly not stretched (in fact dividend yields pretty much everywhere are above their longer term averages).

I stand by these assertions.

There is no doubt that it is very hard being an investor at the moment, let alone being an asset allocator. Negative real interest rates, bloated central bank balance sheets, a slowdown in China, weak investment across the developed world all serve to cause consternation that another 2008 is just around the corner. My view is that ultra-loose monetary policy and scope to boost fiscal policy if required will prevent growth from slipping into recession. Furthermore, the prevailing weakness will keep a lid on inflation. This is a ‘Goldilocks’ environment that equities tend to thrive on.

Contrarian opportunities

Thanks to Canaccord’s Alan Brierley for his slides highlighting some interesting contrarian opportunities. The four he presented were MSCI World Value (having underperformed MSCI World Growth), MSCI World ex US (versus S&P Composite), MSCI Emerging Markets (versus MSCI World) and Euromoney Global Mining (versus MSCI AC World). The four had underperformed their respective comparator by 19, 39, 43 and 73% respectively in recent years.

What do we think about these opportunities?

As multi-asset value investors, we’d certainly support the assertion that value will do well, though it is hard to know when it will start outperforming growth. Since inception of the indices in November 1975, the MSCI World Value index has returned 7.4% per annum versus Growth’s 6.8%. This may not sound like much until one realises that over the 40 years, Value’s total excess return equates to a very decent 22%.

As for the MSCI World ex US in relation the S&P Composite, we’d also agree that the US will start to underperform (in our Income Fund we have zero exposure to US equities given paucity of yield). The US market is starting to look obviously expensive versus the rest of the world: the price to book ratio of the MSCI US index is 2.8 times versus 1.6 times for the World ex US index. While US companies may be more dynamic than those elsewhere, we think the valuation gap is too big. Furthermore, it is clear that the US is closer to its business cycle peak that other developed countries, notably Japan and many in Europe, so monetary policy tightening is also closer.

The emerging markets versus developed markets question is a particularly intriguing one. I have for a long time held the view that emerging markets are horrible places to invest. The ‘region’ is stuffed full of corrupt countries and poorly-governed companies, and as a result the stronger economic growth achieved has not filtered down to shareholders. Since inception of the index in 1987, the MSCI Emerging Markets index has returned 7.7% per annum. This compares with 7.8% for the MSCI US index, pretty poor when you consider the difference in economic growth. Furthermore, when you take volatility into account, you’d wonder why anyone would invest in emerging markets: 29% versus 17% for the US. Having said all that, the current price to book ratio of the MSCI EM index of 1.4 times is getting close to the 1.2 times it reached at depths of the global financial crisis. We’re still underweight emerging market equities but are starting to think there is value emerging.

Finally, what about global miners? Well, in August we made a move into Blackrock World Mining Trust, feeling that the 10% yield that was on offer was good value even if dividends were halved. So we’d agree with Alan on that one too.

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

The table below lists price data releases over the last month in various key countries and how they compare with the survey consensus, the previous month, and where central banks would like the rate to be (the last of these requires a bit of judgment). It also derives an average of the comparisons by taking the net number of up and down arrows and dividing by the number of data releases.

Inflation Watch Table

Source: Bloomberg

Overall, inflation pressures in the developed world and in key emerging markets remain very weak. This means that monetary policy will remain loose for some time to come which should be positive for equity markets and other so-called ‘risky assets’.

Overall, inflation data is coming in slightly below expectations but slightly above prior periods. The big discrepancy is between current rates of inflation and desirable rates of inflation – in most countries other than the US, inflation is much lower than central banks would like.

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Employment Watch Table

Source: Bloomberg

Unsurprisingly, given the weak inflation pressures, unemployment rates around the world are still in general above the level that central banks would consider full employment. Furthermore, while the rate in the US may be getting quite close to the NAIRU (non-accelerating inflation rate of unemployment), it should be remembered that many have left the workforce over the last few years. A better job market may tempt them back in the coming months and years, thus keeping wage pressures lower than would otherwise be the case.

 


Captain Murphy’s diary

Murphy’s Law says that what can go wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

Question: is China a slow motion train wreck or has the Communist Party found the secret to generating high and stable growth?

China has the potential to cause global markets serious problems. Its economy is huge and has been growing at a relentless pace for a number of years. Furthermore, its growth has been one-dimensional, based on building and making ‘stuff’ using bank credit. This is evident from the below two charts.

The first chart illustrates the extent to which China has consumed vastly more cement per person per year than any other country on the planet, particularly when GDP/capita is taken into account. Even Bill Gates was moved to tweet a few months ago about what he thought was the most mind-blowing fact he had learned in 2014, namely that China used more cement in the three years from 2011 to 2013 than the US used in the entire 20th century (6.6 gigatons versus 4.5 gigatons).

The second chart shows the extent to which China’s use of bank credit is also off the scale in relation to its GDP/capita. Given the best fit line, China’s money supply as a % of GDP should be 125% given its GDP per capita of $8,280. In fact, it’s 208%.

Cement consumption per capita vs. 2012 GDP per capita

Cement Graph 1

Source: Deutsche Bank (2014)

Money supply as % GDP vs. GDP/Capita

Cement Graph 2

Source: Deutsche Bank (2014)

What these observations mean for China’s future growth prospects is very hard to say. China has far too much cement capacity and the same goes for other commodities too, steel being a good example. Shutting much of the capacity (an inevitability) would be deeply painful for banks and employees alike, but perhaps not terminal. Laid off employees would eventually be rehired in more value added activities and the banks would be recapitalised as they have been in the past. The problem is that the numbers are so far off the scale that there is no precedent, and no precedent means a lack of predictability.

Another measure on which China scores highly is average GDP growth adjusted for the volatility of GDP growth (think of it like a Sharpe Ratio for economies, the higher the better). As can be seen in the table below, China has achieved high and stable growth. The only country that comes close is India, with an “Economic Sharpe” of 3.1 times versus China’s 4.6. Perhaps it has been learning a few tricks from its bigger emerging cousin. Whether these are accounting tricks or some sort of growth miracle is of course the big question.

Captain Murphy Table

Source: Bloomberg

 


Current fund targets as at 2nd Nov (previous month’s targets in brackets)

The targets in the table below are where our funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Current fund targets

  • We increased the equities weighting in the OEICs by 1 percentage point each in October, taking them to 2 percentage points overweights relative to the respective strategic asset allocation
  • We did this predominantly because we felt markets were looking slightly cheap, with dividend yields generally above long-term averages
  • We also think that monetary policy will remain on the whole loose, with inflation pressures still muted in many countries
  • We did not increase the equity weight for the investment trust, which because of its closed-end structure has a higher weighting in less liquid specialists
  • The aforementioned 1 percentage point increases in equities targets came out of fixed interest in the Income Fund (reduction in corporate bonds target) and specialists in the Growth Fund (Exit from Woodford Patient Capital which was only held in the Growth Fund)
  • We continue to avoid developed market government bonds which we still think are very overvalued
  • Within fixed interest, we have a focus on global high yield; this segment of the fixed interest market was hurt along with equities during the August sell off but we held firm in the belief that while spreads were lower than they were five or so years ago, they were still well above historic lows and thus offered good value
  • We retain exposure to emerging market local currency debt in the OEICs but have not increased it; frankly, we had not expected the selloff that we have seen this year in emerging market currencies
  • Our specialists exposure seeks to target investments that offer something interesting in relation to equities and bonds; in the case of equities this is more stable income streams and in the case of bonds it is income streams that are index-linked
  • Our private equity exposure in each of the three funds is largely in AJ Bell, a private company in which we are one of three outside shareholders
  • Elsewhere in specialists, we like non-core REITs, asset leasing and renewable energy

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you should read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/138.

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Peter Elston’s Investment Letter – Issue 6 October 2015

6 October 2015

It has been another eventful month. The Federal Reserve decided not to raise interest rates while Norway and Taiwan cut theirs and India cut more than expected. It would appear that growth generally is still too weak rather than too strong. This month’s letter is largely dedicated to considering the risk that central banks fail to prevent their economies from slipping into deflation.

Captain Murphy’s Diary

Murphy’s Law says that what can go wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

Let’s face it, being Chairman of the Federal Reserve is a pretty thankless task. Janet Yellen came in for a huge amount of stick last month following the FOMC’s decision to not raise interest rates, and Bernanke before her was often slated in the press.

Much of the criticism is from people who are either unqualified to comment or who do not have access to the same data that the Fed does. Furthermore, the fact that the entire world was fretting over an increase in one country’s interest rate from virtually zero to practically zero – or is it the other way round? – suggests that we have become over-dependent on our central bankers. If the likes of Janet Yellen and Mark Carney are now our only saviours, what happens if they fail? Although a difficult risk to assess, it is the one considered in this month’s Captain Murphy’s Diary.

To ask ‘what happens if they fail?’ requires one to understand what they are trying to do in the first place. On the face of it this seems clear: the job of most if not all central banks is to maintain price stability and promote full employment. The problem comes when deflationary forces in an economy are so strong that interest rates hit zero and can’t go any lower. When this happens, central banks are forced to use the unconventional monetary policy known as quantitative easing which involves central banks buying assets such as government bonds.

This bond buying has the effect of reducing real interest rates which increases private demand for credit which in turn props up inflation, stopping real interest rates from rising, and thus further stimulating private demand for credit. In other words, it is supposed to create a virtuous circle in which central bank stimulus causes credit demand to return to normal.

The problem is it has not returned to normal. As the chart below shows, broad (M4) money supply growth in the UK is close to zero, far below levels seen in the decades leading up to the financial crisis. In fact, the total M4 money supply is lower now than it was in April 2010, over five years ago! While the Bank of England has succeeded, just, in keeping inflation above zero, it has certainly failed in getting private credit demand back to normal.


UK M4 Money Supply (YoY%)

 

Money-Supply

Why is private demand for credit so weak?

One answer would be that the price of credit – the borrowing rate – is too high. And yet borrowing rates are as low as they can get. Or at least they are in nominal terms. In real terms they can get a lot lower if inflation rises. They can also rise if inflation falls, which is why central banks are so desperate to stop that happening, or at least should be.

Another answer might be that banks are not able to lend because they’re restricted by reserve requirements or by low capital adequacy ratios. In fact, as a direct consequence of QE, commercial banks’ actual reserves held with their central bank are way above required reserves (in the case of the US 30 times higher!) so that isn’t a restraint. And capital adequacy ratios are generally ok too. Not great, but ok.

The FT’s Martin Wolf suggested that the weak global demand (for which read weak private demand for credit) reflects a slowdown in potential growth, due to “some combination of demographic changes, slowing rises in productivity and weak investment”.

It is certainly the case that workforce as well as broad population growth in many countries are not the drivers of economic growth they once were. Companies may not want to invest in new capacity if their markets are shrinking or at best not expanding. As for productivity growth, the latest Bank of England inflation report notes that it “has been subdued since the financial crisis but appears to have picked up recently: in the four quarters to 2015 Q1, productivity growth was 0.8% and is expected to have been 1.5% in the four quarters to Q2.”

The report notes that productivity growth may until now have been held back by the abundance of labour – if labour is abundant and thus cheap there is less need to increase productivity – as well as by forbearance and low interest rates that may have “allowed businesses that face persistently lower demand to remain operational, impairing the reallocation of resources to new or more dynamic companies with the potential to achieve higher productivity.”

Putting my somewhat rough and untrained slant on things, it seems that there is a Catch 22 situation with respect to labour productivity. Namely, that there is so much scope in today’s world to replace humans with machines and computers that in the absence of legislation to limit hours worked per person, there is increasingly a structural surplus of labour that economies cannot put to work. This surplus will keep wages, and thus inflation, low, perhaps even negative, presenting a problem for central banks seeking to maintain price stability.

In fact, this is nothing new. Since the invention of the plough the human race has been freeing up labour for use in superfluous activities such as pyramid building, commercial dog walking and proprietary trading. As a result, we have generally always been able to find ways of making things or providing services more cheaply as time goes by. Indeed, from 1209 to 1913 – excluding the war- and disease-ravaged years from the middle of the 16th to the middle of the 17th century – inflation in the UK was just 0.2% per annum. It is interesting that this period of low and essentially stable inflation ended at the same time the world’s greatest money printing machine – aka the Federal Reserve – was established but that is a topic for another time.

Coming back to the topic at hand, namely the risk of central banks failing to prop up inflation, it seems to me that as unemployment rates fall, particularly in the US and UK where they have already come down a long way, upward pressure on labour costs will rise. In turn, this should increase the incentive for companies to boost labour productivity through increased investment. Increased investment feeds directly into stronger economic growth which should boost inflationary pressures.

Milton Friedman said that inflation is “always and everywhere a monetary phenomenon.” I have sympathy with this view, in that if everyone all of a sudden had ten times the amount of money, sellers of goods and services would quickly jack up their prices by the same multiple. But it of course is more complicated than that, otherwise the job of maintaining price stability would be an easy one which it clearly isn’t.

Former Fed Chair Ben Bernanke wrote in 2002 that “under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.”

On balance, I am optimistic that sensible government (fiscal and monetary) policy in combination with sustained if not accelerating scientific and technological progress should allow economies to continue to heal and for private demand for credit to recover. I just wish Ms Yellen and Mr Carney did not seem so keen to raise interest rates and jeopardise what is still a fragile recovery.


Current Fund Targets (as at 22 Sept)

The targets in the table below are where our funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Fund-Targets

  • During the month we added Blackrock World Mining Trust (categorised under “Global funds” in the earlier table) to the funds in the belief that its 8% yield was very attractive and left room for material dividend cuts among underlying holdings
  • We also reduced our fixed income target slightly in the OEICs via reductions in the AXA US Short Duration High Yield Bond Fund and the Legg Mason Income Optimiser Fund, principally to fund the increase in the Blackrock World Mining Trust target mentioned earlier
  • Our broad equity target weights are in line with or close to being in line with our strategic asset allocation – a neutral position – reflecting the view that while dividend yields are not low, nor are they particularly high
  • Within equities, we are lightly positioned in North America and Japan, where we think valuations are too high
  • Our big equity overweight is in Europe ex UK, which we think is at a much earlier stage of economic expansion than other developed economies, as evidenced by unemployment rates now falling but still being well above historic averages
  • We have zero targets in developed market government bonds, reflecting the view that real long-term yields that are below 1% and in many cases negative are not good value
  • There is still good value in corporate bonds where although spreads are not particularly high in relation to history, default rates should remain low
  • Our specialists exposure seeks to target investments that offer something interesting in relation to equities and bonds; in the case of equities this is more stable income streams and in the case of bonds it is income streams that are index-linked
  • Our private equity exposure in each of the three funds is largely in AJ Bell, a private company in which we are one of three external shareholders
  • Elsewhere in specialists, we like non-core REITs, asset leasing and renewable energy

Download this investment letter as a PDF


 

Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you should read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/121.

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Peter Elston’s Investment Letter – Issue 5 September 2015

1 September 2015

Recent Market Volatility: Are We Entering a Bear Market?

What do the sharp falls in equity markets across the world portend? Were they simply the inevitable result of prices that had gone up too much in recent months or do they reflect significantly overvalued markets in combination with some sort of material deterioration in the underlying fundamentals? Of course there is also a third option to consider: that economic fundamentals will deteriorate as a direct result of the recent sharp falls in equity markets, the so-called negative wealth effect.

Looking first at valuations and underlying economic fundamentals, there is nothing on the face of it to be particularly alarmed about. Even before the recent market declines, equity market dividend yields across the spectrum were generally above historic averages. This is encouraging and supportive of a view that markets will soon bounce back: the 2000-2002 and 2007-2009 bear markets began when yields were low in relation to their history. Price to book values too are not stretched. Depending on which market you look at, they are now anywhere between 8 and 30% below historic averages. Valuations will not tell you how far markets will fall in the near term – that will be determined by when the panic stops – but they should provide a guide as to what to expect in the way of returns over the medium term.

As for economic fundamentals, it is certainly true that China has been slowing down and will continue to do so. That there was a material slowdown underway was abundantly clear in declining commodities prices, Chinese electricity consumption and Chinese exports, if not in China’s GDP growth numbers which have declined only slightly from 8% a couple of years ago to 7% currently. China needs to shift away from its one-dimensional investment driven economic growth model to something more balanced. This will certainly be challenging but I suspect will be easier for a command economy like China to engineer than would be the case for a more market-oriented one.

In the developed world, final aggregate demand is still weak, but this should if anything be a cause for optimism. Equity bear markets often coincide with declines in the business cycle which themselves occur when economies are operating above capacity i.e. when aggregate demand is strong. Inflationary pressures are also still very subdued which bodes well for central bank policy remaining supportive. Although Yellen and Carney have both talked about raising interest rates soon, I suspect the likelihood of this happening has declined sharply as a result of the China growth concerns and equity market declines. Furthermore, although unemployment rates have fallen, they remain above (or well above in the case of Europe) levels at which inflation generally starts to rise and central banks tend to act.

So that leaves the two other options: markets falling because they’d gone up too much or a positive feedback loop in which the market falls precipitate an economic slowdown.

As to the former, it is certainly true that the global equity bull market that began in early 2009 was well advanced. Furthermore, and more importantly, equity market volatility had noticeably declined.

The VIX index, a measure of equity market volatility had until the last few days averaged 15 since the beginning of 2013 compared with 22 from 2010-2012. Low volatility is analogous to a volcano that has been dormant for a while. The lack of activity is not a sign that the likelihood of an eruption has decreased but that pressure is building up underneath. Furthermore, the longer the period of inactivity the bigger the eruption when it eventually happens.

As for the third option – that turmoil in equity markets causes an economic slowdown – this is much harder to predict. The global economy is a complex system which can often behave non-linearly. Although there will be positive feedback loops that cause household and business confidence to be impacted by the recent equity market falls, there are also negative feedback loops that can cause equity markets to bounce back. Examples of this would be government or central bank stimulus measures or people buying because prices are cheaper.

In summary, it is impossible to say with certainty that we are not about to enter a bear market but from a business cycle and valuation perspective, economies and markets are to varying degrees some way from the point at which bear markets generally begin.


Strategic Asset Allocation

As is the case with many things in the financial world, there is no one clear definition of the term ‘strategic asset allocation’. While this may not have been the case when the term was first used in or around the 1970s, in the decades since its meaning has become increasingly ambiguous.

The term ‘Strategic Asset Allocation’ (SAA) was essentially a product of Modern Portfolio Theory and the idea that a client’s asset allocation with respect to equities, bonds and cash should be determined by real long-term expected returns from each, as well as volatilities and correlations. Since long-term expected returns would by definition not change, the SAA for a particular client would not change (volatilities and correlations measured over the longer terms are also very stable).

‘Tactical asset allocation’ (TAA) quickly became associated with SAA and referred to the process by which actual asset class weights would deviate from the SAA to take account of expectations that returns from one or more asset classes would in the shorter term be different to the aforementioned long-term expected returns. In practice, TAA deviations from SAA were never more than a few percentage points. Thus the value added from TAA has been generally either low (if the manager’s views were correct) or negative (if they weren’t).

At Seneca, we like the use of the terms SAA and TAA but we have a very different view of what they mean and how they should be applied with respect to management of investors’ portfolios.

For starters, real long-term expected returns from asset classes should not be considered stable and indeed can vary substantially from decade to decade – or even from generation to generation.

Take bonds.

Using the US as an example – it has the best data history – the table below shows annualised real returns from long bonds over certain periods.

Annualised Real Returns for Bonds Table

These periods or phases can be seen in the following chart, which depicts the actual real long bond index.

Long Bond Real Index

Source: Credit Suisse

The point that I would make is that it would be foolish to have a high strategic allocation to bonds during multi-decade periods in which they produce substantially and consistently negative real returns.

Interestingly, equities in the US haven’t exhibited the same long-term cycles as bonds. While bond bull and bear markets average 30 years, the average for equities is 6 years. The reason for this is that bonds follow inflation cycles which are long while equities are more synchronised with business cycles which are much shorter. In other words, equity market bull and bear markets can occur within long-term bond bear and bull markets. For example, the last two equity bear markets (2000-2002 and 2007-2009) both occurred within the bond bull market that began in the early 80s. Conversely, the two equity bull markets of the 1970s happened during a period of poor real bond returns. Go back further and you’ll find other examples.

To demonstrate how these findings can be used to build a more effective SAA (i.e. one that is not static but at the same time one that does not change frequently) I apply some very simple rules as follows:

  • SAA starting point is 50% equities/50% bonds
  • Move the equities allocation to 75% if the real equities index falls to 40% below its all-time high
  • Move the equities allocation to 100% if the real equities index falls to 75% below its all-time high (very rare!)
  • Move the equities allocation back to 50% five years after previous increase
  • Move the bonds allocation to 0% if the real bonds index falls to 60% above its 30 year moving average
  • Move the bonds allocation back to 50% if the real bonds index rises to 40% below its 30 year moving average
  • The cash weighting is the residual of the above changes and cannot be negative.

The impact these rules would have had on the SAA can be seen in the chart below.

Rules-based Strategic Asset Allocation

Source: Seneca Investment Managers

The main point to note is that very few changes are made. There are 14 triggers to change the equity allocation, which equates to one every ten or so years. As for bonds, there are even fewer triggers to reduce or increase its weighting: four to be precise, or once every 34 or so years (it should be noted that the bond allocation may get reduced because equities are increased, but such reductions are not ‘active’ ones). In total, therefore, there are 18 active decisions to change the SAA over the 135 or so years under consideration, equating to one every 7.5 years.
The big question of course is what impact these changes would have had on the performance of the rules-based SAA in relation to the static 50/50 SAA.

The answer is that they would have added 1 percentage point per annum (remember, this relates only to SAA and thus takes no account of value that can be added from TAA or security selection). Furthermore, there were only two months (out of 1260) when the rolling 30 year annualised return was lower for the rules-based SAA than for the static version. These findings can be seen in the chart below.

Value Added from Rules-based SAA in Relation to Static SAA (annualised over 30 year rolling periods)

Source: Credit Suisse

While the value added varied between 0% and 3% per annum, it is important to note that it was never negative (other than in the case of the aforementioned two months which indeed were only very slightly negative.)

To be clear, the rules-based SAA outlined above is for demonstration purposes only. The message I am seeking to communicate is that fixed SAA weights are a bad idea and that with a small number of simple rules, a substantial amount of value can be added. Furthermore, those SAA frameworks that are more flexible with respect to weighting changes tend to reduce equities at the wrong time. This is because optimisation models incorporate volatility as an input. When equity markets fall, volatility generally rises and as a result recommended SAA weights get reduced. This is in stark contrast to the rules-based SAA outlined above in which when equity markets fall, the SAA recommended weight is increased not decreased. In fact, the rules-based SAA never seeks to anticipate equity bear markets, only to respond sensibly when they happen by raising targets. Indeed this approach is endorsed by investment adviser William Bengen in his 1994 paper, Determining Withdrawal Rates Using Historical Data. In it, he wrote:

“Admittedly, increasing stock allocation to 100 percent after a long period of miserable returns requires unusual foresight and fortitude on the part of the advisor, as well as the client. If you can convince your client just to maintain the 75-percent allocation under such conditions, you have won a major battle. However, the client is still faced with a shorter than-average portfolio longevity, and with much less wealth to pass on to heirs than originally hoped for.”

Bengen’s point was that although severe bear markets will always damage portfolios, the damage will be even worse if you do not take advantage of them, or, heaven forbid, reduce positions during them.


Our Response to FT Adviser Article

My attention was drawn during the month to an article in FT Adviser, Multi-asset pledge ‘should set off alarm bells“Investors should be wary of multi-asset funds promising 5 per cent income that could be taking a “gamble” with capital”, experts warn” says the piece. Sensationalist tosh in my humble opinion. Any fund that is investing outside of risk free assets could be said to be taking a gamble with capital, not just those targeting a high yield. What matters is whether any loss of capital that will always occur when investing in risky assets is temporary (tolerable) or permanent (not tolerable).

I can’t speak for all funds seeking to deliver a 5% yield but I can speak for ours. We have done extensive modelling on our CF Seneca Diversified Income Fund and we believe we can deliver this yield without putting real capital at risk over the longer term (I would agree that one cannot seek to protect capital over the short term, markets don’t work that way).

In order to achieve our investment performance objective, we need to deliver a gross total real return of just shy of 7% per annum over the longer term. After costs, this would come down to closer to 5%, which would be split between income of 5% and real capital of 0%.

So, the question then becomes, how do we deliver a gross total real return of 7%? The answer is that it comes from a combination of strategic asset allocation plus value added from tactical asset allocation and security/fund selection.

We think we will get around 4.5% from strategic asset allocation without taking undue risk. Our strategic asset allocation to equities is fairly low at 40% (our fund sits in the IA 20-60% Shares sector) and we think equities will deliver us around 6% real, in line with long-term historic averages.

Adding in bonds and specialists, which we think will provide 2% and 5% real over the long term, and you get to a total of around 4.5% (our strategic asset allocations to bonds and specialists are 35% and 25% respectively).

As for value added, we are looking to add 2.5 percentage points per annum from tactical asset allocation and security/fund selection. Whether we can do this depends on two things.

First, is the ex ante tracking error of our fund in relation to its strategic asset allocation giving it the potential to produce 2.5 percentage points of value added? Our risk models tell us that the answer to this question is ‘yes’.

Second, do we have an investment process that is able to deliver this potential? Again, the work we have done tells us that the answer to this question too is ‘yes’. Our tactical asset allocation process draws on well-regarded academic work that finds strong links between yields of equities and bonds and future returns.

Within UK equities, where we invest directly, we focus on mid-caps where there are higher systematic returns as well as greater stock picking opportunities that exist because of thinner broker research coverage. We also think that we’re able to spot third party managers of overseas equities funds who have strong, value oriented approaches that produce good returns over time.

So, while we would agree there may be funds out there promising 5% that don’t know what they’re doing, ours does.


Inflation Watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

The 10 year US Treasury yield has fallen from 2.5% on 27 June to 2.1% currently (as at 25.08.2015), a very substantial change. Normally, changes in nominal yields are due to changes in the expected inflation rate over the life of a bond as well as changes in the real yield (in the corporate bond sector yields are also a function of credit spreads). However, it is interesting to note that the recent fall is due entirely to a fall in the expected rate of inflation. The 10 year breakeven inflation rate, as it is known, has fallen from 1.9% to 1.5% over the period in question, while the real yield has stayed around +0.5%.

Real Yield and Inflation: The Two Determinants of Nominal Yields

Source: Credit Suisse

My point is that I find it hard to understand how the Federal Reserve could now justify a rise in interest rates any time soon. As I wrote on our blog recently:

“I’m angry with Fed chair Janet Yellen and Bank of England Governor Mark Carney. Why did they have to be so eager to raise interest rates, talking them up in the way they did? Yellen’s trigger happiness has caused the Dollar to rise, oil prices to fall, China to devalue its currency, other emerging markets to devalue theirs, inflation pressures (to the extent there were any) to subside and, guess what, the case for raising rates to be booted into touch.

Actually, it’s worse than that. By calling for rates to be raised too soon, Yellen has lost a lot of credibility. Central banks have been virtually single-handedly propping up the global financial system, so their credibility is paramount. I remember five years ago wondering which would come first; a global economy returning to “normal” or loss of faith in central banks. The last few days and weeks have seen me shifting my views firmly in favour of the latter.

My main bone of contention is that the end of QE in both the UK and the US constituted an effective tightening of monetary policy. As I noted in my last investment letter, it is estimated that the tapering of asset purchases in the US was the equivalent of an interest rate rise of 4 percentage points. This is the same as the entire tightening cycle of 2003 to 2006, which saw the Fed Funds rate go from 1% to 5%, and which arguably triggered the financial crisis. Why oh why couldn’t Yellen or Carney communicate the message that having had a substantial effective tightening, they would leave interest rates where they were for at least 2 years in order to gauge its effects? It’s not as if we were coming out of a normal recession in which inflation pressures were going to rebound quickly. Far from it. Inflation still needs propping up not suppressing.

I’m not an economist – thankfully! – but it seems to me that the world is prone to deflation not inflation. We humans seem to be able to find cheaper ways each year of making something or providing a service. Furthermore, while credit creation is inflationary, the reverse is deflationary. Throw in other sources of deflation like the internet or China and you have a world in need of central bankers not competing to be the first out of the blocks.”


Captain Murphy’s Diary

Murphy’s Law says that what can go wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

Emerging markets are proving yet again that they can be a horrible place to invest. Currencies across the emerging world have been falling of late and even the strongest emerging currency of them all, the Chinese yuan, has succumbed to weakness, albeit government-induced. Is it possible that another Asian financial crisis or Russian debt crisis is lurking in the wings?

It is very hard to say where or when a similar crisis might start, but countries that have borrowed dollars and export oil must be hurting right now. One such country is Kazakhstan and as I write its currency has just plummeted 23% against the Dollar, having previously been pegged to it. The likes of Russia, Nigeria and Venezuela must also be under severe pressure.

One issue that gets misunderstood is the difference between the nominal value of currencies and their real value which takes relative inflation rates into account. Even renowned publications like the FT get it wrong. A recent article in the paper was titled “Emerging currencies hit 15-year lows”. In it, the authors cite the JPMorgan Emerging Market Currency index as having fallen to its “lowest level since it was created in 1999”. Unfortunately the index in question consists of nominal exchange rates against the US dollar, not real ones. This means that it does not take account of the fact that consumer prices across the emerging world have risen much more than in the US, so emerging market currencies are not (yet) as competitive as the FT suggests.

Barclays Capital runs a series of real effective exchange rate (REER) indices. Their emerging markets REER index rose by 50% from lows in early 2004 to a recent high attained earlier this year. True, much of this was attributable to the strength of the Chinese yuan but this in itself is instructive: the yuan could have much further to fall.


Current Fund Targets

The table below sets out our funds target weights. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades, for example.

Current Fund Targets Table

  • Our broad equity target weights are in line with our strategic asset allocation – a neutral position – reflecting the view that while dividend yields are not low, nor are they high
  • Within equities, we are lightly positioned in North America and Japan, where we think valuations are somewhat high
  • Our big equity overweight is in Europe ex UK, a region which we think is at a much earlier stage of economic expansion than other developed economies, as evidenced by unemployment rates now falling but still being well above historic averages
  • We have zero targets in developed market government bonds, reflecting the view that real long-term yields that are below 1% and in many cases negative are not good value
  • There is still good value in corporate bonds where although spreads are not particularly high in relation to history, default rates should remain low
  • Our specialists exposure seeks to target investments that offer something interesting in relation to equities and bonds; in the case of equities this is more stable income streams and in the case of bonds it is income streams that are index-linked
  • Our private equity exposure in each of the three funds is largely in AJ Bell, a private company in which we are one of three outside shareholders
  • Elsewhere in specialists, we like non-core REITs, asset leasing and renewable energy
  • Commodities we think generally add volatility but not much in the way of return

Macro and Market Data

Macro and Market Data Table


Download this investment letter as a PDF


Important information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of this investment you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you should read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment.

The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/108.

 

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Peter Elston’s Investment Letter – Issue 4 August 2015

31 July 2015

We have introduced an explicit value-oriented approach to our investment process. We think multi-asset value investing is both new and original (a search of the term and variants of it on Google yields zero results). Value investing traditionally is associated with investing in equities, but we have applied it to the management of multi-asset portfolios and their associated components, namely tactical asset allocation, equities selection, fixed income selection and specialists selection. After all, the principle of value investing is to buy things cheaply, something that can be applied to anything, whether tactical asset allocation or grocery shopping. In practice, we apply a value approach by looking at current yields of various instruments (debt, equity, funds) and asset classes and asking the simple question, “are they materially higher than they should be?” in the context of various other factors such as future income growth, leverage, inflation and monetary policy. If the answer is “yes”, we will invest. (In the case of things that don’t yield anything such as commodities, we would look at valuation based on inflation-adjusted prices, but they’d have to be well below historic averages for us to be interested). We think this approach is one that is both simple and effective.

It is also an approach in which risk management is deeply embedded. We think the most important investment-related risk is the risk of permanent loss of capital, not price volatility. Important risk is thus much more closely related to solvency risk, something that can be more effectively avoided by assessing intrinsic value. Market risk on the other hand is something that much of the time we seek to be actively exposed to as a source of return. Unlike success, risk is about the destination not the journey. One should be able to tolerate and recover from the odd bit of bumpy road. It’s driving off a cliff one should avoid.


Commodities

When will commodities prices recover?

Unlike equities, bonds or property, commodities cannot be valued on the basis of the income they generate. This makes it hard to feel comfortable investing in them, as without yield it is hard to predict future returns. In fact, when you invest in commodities, one way or another you have to pay for storage, which makes them even less attractive as investments. For this reason, our core allocation to commodities is zero for all our funds other than our Growth Fund where it is a low 2.5%, and this more for their diversification benefits than their return characteristics.

The only reasonable method I can think of to value commodities is to consider their inflation-adjusted prices then compare them with their long-term price trends. But this throws up another problem – what should the trend real price appreciation of a particular commodity be? Should the real price of a commodity be rising, falling or staying the same over the long term? Should nominal prices be rising in line with inflation, in which case trend growth is zero? Or falling, in which case trend growth is negative?

This question brings to mind an article written by the great Isaac Asimov. The piece in question was entitled The Dismal Science, and it somewhat obscurely constituted the editorial in his 1991 science fiction magazine (Asimov was a polymath and would write on any number of subjects).

Asimov began his editorial by saying that he could not understand economics. “People may say they understand it and economists even win Nobel Prizes, but I think it’s all a fake”, he wrote.

He then went on to note a New York Times article in which the story is told of a bet made by two economists, one who thought the prices of certain industrial metals would rise – because of rising populations – and one who thought they would fall – because of advancing technology. Asimov was staggered to learn that the pessimist had lost the bet.

If we look at a broad index of commodities over the last 15 years, we capture in that period the great bull market of the noughties. This means that trend growth over that period was substantially positive, +8.9% real in fact, and thus that current prices look very cheap relative to trend (see chart).

Real Price of Commodities*

*UBS Bloomberg CMCI Composite divided by US consumer price index
Source: Bloomberg as at 29/05/2015

Look further back however and you get a different picture. In the case of gold, oil, copper and lead, longer term trend growth in real prices has been 2-3% per annum (see charts below). In other words, Asimov was right! Trend growth over the longer time frames is nowhere near the 8% per cent or so registered in the last decade and a half, but it is nonetheless positive. I would guess that the explanation for the 2-3% growth lies in real prices tracking growth in real incomes (GDP) and thus the fact that the world can afford to pay a bit more each year for these raw materials in real terms.

Real Price of Gold*

*Gold Spot Price per Troy Ounce vs CPI Index

Real Price of Oil*

*Crude Oil Price vs CPI Index

Real Price of Copper*

*London Metals Exchange 3 month Copper Price vs CPI Index

Real Price of Lead*

*London Metals Exchange 3 month Lead Price vs CPI Index

Source for all graphs: Bloomberg as at 29/05/2015

Nevertheless, 2-3% real is still not particularly attractive given that commodities prices are very volatile and that as an investor in commodities you will a) be paying for a storage and b) not be using the commodities to manufacture things and make a profit. Looking at the charts, it would appear that a sensible approach to commodities investing would be to buy them when real prices are well below trend and to have a long-term – 5-10 years – investment time horizon, selling when real prices are well above trend.
So, where are prices currently in relation to their trends? While the oil price is still well below its trend, 26% in fact, the others are either close to it (copper and lead) or above it (gold), making them in my view unattractive.

Is it time to buy oil? I’d say not. In 2001, prices fell to 53% below trend, and in 1970, 54% below (that these are so similar is instructive!) In other words, prices can fall much further if history is any guide which it often is. True, there are forces that might drive the price up (a prolonged period of heightened political risk or the fact that the world is using up its fixed reserves) but there are also forces that might drive it down further (the shift to renewables and lowered political risk, the recent Iran deal being a good example of the latter). At $30 I might be interested.


Scientific Advance

I don’t know whether it’s me noticing them more, the media picking up on them to a greater extent, or the fact that there are more of them, but I have been captivated by the scientific advances I have read about recently, many on the Business Insider website.

I have always been intrigued by the stagnation versus growth debate and have tended to side with the latter. My recent reading has reinforced this position.

While our closest relatives would struggle to launch a banana more than 10 feet off the ground, we, the human race, have just done a flyby of the furthest planet from Earth in the solar system, at the same time sending back photos. And we just shrug as if it’s no big deal! The scientific advances that must have been required to do this must surely somehow be useful in helping make the world a better place.

I forget all of bits and pieces I came across relating to other scientific advances – there were simply too many – but here are two I do remember.

The first was Boeing having just had a patent application for a new jet engine design approved by the US Patent and Trademark Office. The proposed engine uses lasers and nuclear reactions to create vast amounts of energy that is projected out the back of the engine in the form of thrust. Wow! Substituting oil and its derivatives in relation to land transportation and electricity production is already well underway but I’ve often wondered how jet fuel would be replaced. Perhaps this is it.

The second related to biotechnology and what the MIT Technology Review described as “the biggest biotech discovery of the century.” Jennifer Doudna and Emmanuelle Charpentier have found a way to use bacteria to cut out particular sections of DNA and replace them with other sections. Double wow! If anyone was wondering how we would likely find cures for cancer and other diseases such as HIV, they need wonder no longer.

I don’t understand Boeing’s jet or the DNA cutting bacteria. I wish I did. But what I’m pretty sure of is that such scientific advances, along with the countless others, are likely to have a huge impact on economic growth and the quality of human life.


Tactical Asset Allocation Change

At the end of June we increased our European Equity exposure to a 4 percentage point overweight position relative to our core allocations. We had felt that there had been a reasonable correction over the prior two months, with the Euro Stoxx 50 index falling by around 10% from its April highs.

Furthermore, we remain optimistic that an economic recovery is underway in Europe but that it is still in its early stages. Unlike in the US, where unemployment started to fall more than five years ago, in the Eurozone the employment situation only began to improve in mid-2013. Thus while the unemployment rate has fallen, it is still high at 11.2%, meaning that monetary policy will remain likely very loose for at least the next couple of years.

We feel that this, combined with profit margins that provide scope for improvement and dividend yields that are reasonable, bodes well for European Equities.

It was the uncertainty in relation to the Greece situation that gave us the opportunity to increase our European equity exposure at lower levels. Now that there is more clarity with respect to whether or not Greece remains in the Euro, we would expect investors to refocus on Europe’s better fundamentals.


Inflation Watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

My core belief about the first interest rate rises here in the UK but also across the pond is that they’ll happen much later than many think. True, Mark Carney and Janet Yellen would dearly love to normalise monetary policy, but the reality is it’ll be a while before they’re able to and I think they know it. The reason they talk about it I believe is because it is the only tool they have to stop asset prices, whether financial or real, from rising too much and causing problems down the road. Their main job is promote stability in the price of goods and services and right now these need supporting not supressing (core inflation in the UK has fallen from 2% a year ago to 0.8% currently).

Furthermore, I think both Carney and Yellen are well aware of what happened when the Fed raised rates slightly in late 1936 following a few years of moderate growth: a severe economic contraction and a halving of the stock market. Rates were quickly reduced and did not rise above 1% until the late 40s, a good ten years later.

Mark Carney’s comments to the Treasury Select Committee last month were strong on rhetoric but light on substance, saying only that “The point at which interest rates may begin to rise is moving closer”. That doesn’t really commit him to very much.

The final point to note, and this is specifically about the Fed Funds rate, is that it may be hard, as a result of QE, to induce an increase in rates. The Fed Funds rate is the rate depositary institutions lend excess reserves to each other. When actual reserves are close to required reserves, this rate matters. However, actual reserves are currently 30 times required reserves, the result of quantitative easing, so banks do not need to borrow. If they don’t need to borrow, raising the Fed Funds rate won’t have any effect.

Talking of the Fed, Janet Yellen was also on parade last month, this time in front of Congress. In relation to inflation, she said that factors that had been holding it back such as higher joblessness would subside. She was a bit more specific than Carney on the timing of the first rate rise, saying that “economic conditions would make it appropriate at some point this year to raise the federal funds rate target.” My question to her would be, if the banks don’t need to borrow because you’ve stuffed them with reserves, what good would a rate rise do? Seems to me she’s trying to talk down asset prices.

STOP PRESS: Following Yellen’s remarks about the likelihood of a rate rise this year, Carney came out and hinted during a speech at Lincoln Cathedral that the Bank of England may raise the base rate around the turn of the year. “The decision as to when to start such a process of adjustment will probably come into sharper relief around the turn of this year”, he said. This was more precise than his remarks two days earlier to the Treasury Select Committee, and suggests that he is taking a cue from Yellen. In some respects this is to be expected. If the Fed chair suggests the US economy is stronger than previously thought, that would indeed have implications for the global economy and thus the UK economy. But for him to change his tune so quickly, and for him not to have consulted colleagues, seems a tad brusque.


Captain Murphy’s Diary

Murphy’s Law says that what can wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

The risk that I consider this month is the risk of growth in the US slowing significantly as a result of the ending of QE3. Although all the talk is of interest rates rising, it is possible that the tapering of asset purchases by the Federal Reserve that began in January 2014 constituted a significant tightening of monetary conditions, the impact of which is yet to be felt.

When interest rates hit the zero bound, central banks have only one option if they want to loosen policy further: QE. But can one measure the impact of QE in terms an equivalent level of short term interest rate? The answer is ‘yes’. In a paper entitled “A model for interest rates near the zero bound”, Leo Krippner of the Reserve Bank of New Zealand lays out a method for converting central bank asset purchases into an effective short-term interest rate, what he calls the “shadow rate”. The maths is complex but to put it as simply as possible, Krippner uses bond option pricing techniques to determine what the short term interest rate would be if physical currency did not exist (central banks cannot in reality lower interest rates below zero because people would instead hold physical currency).

The chart below shows the actual Fed Funds rate versus Krippner’s shadow rate. It is interesting to note that since 2012 the shadow rate has increased by nearly 5 percentage points. This is similar in size to the increase in the actual Fed Funds rate between 2003 and 2006, arguably the cause of the fall in property prices that precipitated the global financial crisis.

While it is by no means clear that the impact of a 1 percentage point rise in the shadow rate is equivalent to the impact of a 1 percentage point rise in the actual rate, one would be wise to note that interest rate increases tend to impact economic growth with a considerable time lag. Knowing about Krippner’s work should help keep one more wary about the outlook for growth and perhaps to better interpret any unexpected weakness.

Krippner’s Shadow Rate Versus Actual Fed Funds Rate


Source: A model for interest rates near the zero lower bound by Leo Krippner & Bloomberg as at 29/05/2015


Download this investment letter as a PDF


Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/99.

 

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Peter Elston’s Investment Letter – Issue 3 July 2015

2 July 2015

For the Love of Charts…

I like charts.

This month I take a look at MSCI’s major global sectors and see if there is anything that can be learned from what has been going on the last 20 years with respect to accounts items and ratios relating to profitability, leverage and valuation.

I get all this from Bloomberg, which aggregates the data for MSCI’s sector indices: Energy, Materials, Health Care, Information Technology, Financials, Consumer Discretionary, Utilities, Consumer Staples, Industrials and Telecom Services.

I’ve also made comparisons between the sector index data and the data for the overall MSCI World Index. It should be noted that these indices are for developed markets only and thus exclude companies in emerging markets.

I’ve tried to focus in on data where a particular ratio is at or near its extreme, or where there is a strong trend that may or may not be turning.

Here goes!

Revenue per Share

The sector that has exhibited both the strongest and the most stable growth in revenues is Health Care. Since 1994, revenues per share have grown nearly six times, compared with just short of a doubling for the World index. Furthermore, growth has not only been strong but also stable. While revenues for the World index fell materially both following the tech burst and the GFC, Health Care companies’ revenues continued to rise. This is perhaps the best example of a secular trend which has been extremely clear and also shows no sign of ending. Indeed, given the ageing of the world’s population and the continued scientific breakthroughs, one would expect this trend to continue.

Revenue per Share

Chart 1


Operating Income per Share

With respect to operating income, it is interesting to note just how extraordinary the energy boom was in the years leading up to the GFC. Indexed to 1 in January 1995, operating income per share for the Energy sector rose by over ten times before collapsing in 2009. The driver of operating income of course has been the oil price but one should note that despite the decline over the last 12 months, the Energy sector’s operating income has still risen more than any other sector over the entire 20 year period.

As for Health Care, operating income has flattened out the last three or so years, despite revenues that have continued to rise. It is not clear why this is the case but it is certainly something to keep an eye on.

The IT sector’s operating income has been more volatile than that of the Health Care sector but it is now slightly ahead over the 20 years.

As for Utilities, cash flows are supposed to be very stable but the reality is that in recent years this has not been the case – 2011-2012 saw significant declines in profit.

Finally, a word on Financials which was the worst hit sector in 2009. Operating income for the sector has recovered and continues to recover but is still half what it was pre-GFC.

Operating Income per Share

Chart 2


Capital Expenditure

There are a couple of interesting things to note about the capital expenditure data.

The first relates to the Energy sector and how despite the sharp falls in operating income to 2005 levels, capital expenditures have hardly fallen. If the oil price does not rise from current levels, I think there is a strong possibility that capital expenditures could fall a lot further.

As for capital expenditures for the World index as a whole, it is noticeable that they have been flat for three years now. This must be of concern for central banks who via negative real interest rates are hoping to encourage companies to increase capex.

The Bank of Japan’s governor, Haruhiko Kuroda has been getting particularly exasperated with his country’s hoarding of cash by corporates, telling them last November that such behaviour would be costly for them.

Perhaps increasing capital stock does not make sense in a country where demographic headwinds are so strong. Indeed, the falling global population growth may explain the weak capex in other developed countries.

Capital Expenditure

Chart 3


Dividends per Share

I have picked out five of the eight sectors in relation to dividends per share.

Although it may be related to one company or a small number of companies in the sector, the dividends that the IT sector has been distributing have been growing at a remarkable pace. Along with Health Care, the IT sector is one where there is a strong secular trend in place, albeit one which includes the odd collapse in profits. The dividend performance of Consumer Staples and Health are are closely related, which is understandable: Health Care is after all in many ways a consumer staple. Dividends in the Energy sector have not yet fallen but if operating profits in the sector are anything to go by, cuts may be just around the corner.

Dividends per Share

Chart 4


Total Assets per Share

It is interesting to contrast the fortunes of the Financial sector which continues to de-leverage (as measured by total assets) with those of Health Care which goes from strength to strength.

Total assets of the Financial sector fell sharply in 2008 and 2009 but have since continued to fall, driven by tighter capital requirements and weak loan demand.

Total Assets per Share

Chart 5


Gross Profit Margin

Gross profit margins can vary from industry to industry (the highest are to be found in the Telecom service and Utilities sector where asset turnover is very low).

However, changes over time can be instructive and in this regard it is interesting to note that while gross margins for Health Care have been declining, those for IT have been on the up.

Indeed, in 2013, the IT sector’s gross profit margin surpassed that of the Health Care sector.

Gross Profit Margin

Chart 6


Return on Equity

It is remarkable just how stable return on equity has been for Health Care companies. While this measure of profitability has been very volatile for other sectors, with return on equity for the World index anywhere between 2% and 17% over the last 20 years, the Health Care sector has posted numbers consistently in the 15-20% range.

The chart below also illustrates well the extent to which profitability in the Energy sector has been cratering, with it now sitting close to 20 year lows.

Return on Equity

Chart 7


Net Debt per Share and Net Debt to EBITDA

One sector stood out with respect to net debt, namely Information Technology.

This is a sector which over the last 20 years has seen a progressive strengthening of balance sheets. While much of this strength can be attributed to Apple inc, the sector is well placed to move quickly in the event of scientific progress being made in areas such as quantum computing or artificial intelligence.

Net Debt per Share

Chart 8

Net Debt to EBITDA

Chart 9


Price to Book Ratio

Four sectors to pick up on with respect to price-to-book ratios as well as the World Index as a whole.

First, although Health Care and IT valuations have been on the rise, they are still far below the levels they reached in the late 90s. Price to book ratios of consumer staples on the other hand have risen in line with the aforementioned two sectors but are now quite close to 20 year highs attained back in 1998. One might expect a bit divergence from here, similar to what happened in the late 90s.

As for the Energy sector, valuations at 1.6 times book are now close to historic lows, suggesting that much of the challenge being faced currently by the sector may be discounted in share prices.

As for aggregate World Index valuations, they have risen from 1.3 times book at the depths of the GFC to around 2.2 times currently. This is well below the 4 times book reached in the late 90s so arguably still represents good value.

Price to Book Ratio

Chart 10


Dividend Yield

Finally, the most important number of all: dividend yield. Viewing nine lines in one chart would have been difficult so I have split them between the following two charts, with the first of them including the yield for the World Index.

Starting with latter, the dividend yield for the World index is currently 2.2%. This is bang in line with the 20 year average so not overstretched by any means. Indeed, in the context of real long term interest rates that are much lower than 20 year averages, the current 2.4% is arguably attractive. Furthermore, the lowest levels that yields reached in the 20 year period under review was 1.2%, in the late 90s, so there is still scope for yields to fall further.

As for sectors, it is interesting to note that IT has converged with Health Care. Which of these deserves to be the higher rated is up for debate but on the basis of past volatility it should be the latter. Energy’s yield of 3.6% may well reflect fear of dividend cuts, but even factoring material declines is still attractive. Elsewhere, given past performance, the fact that the yield of Consumer Discretionary is a lot lower than Consumer Staples appears anomalous.

Dividend Yield

Chart 11

Dividend Yield

Chart 12


Download this investment letter as a PDF


Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/86.

 

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Peter Elston’s Investment Letter – Issue 2 June 2015

3 June 2015

Fear of Equities:

Every now and again I feel the need to wonder why people are so scared of equities, in light of how stable dividend distributions are over time. I’m not the first to wonder this. Thousands before me have written about the so-called “equity risk premium puzzle”, a reference to equities returning so much more than they should have, given their risk. Six years into a bull market in equities is perhaps a good time to revisit the question, particularly because I’ve been meeting a lot of customers recently who have been and continue to be nervous about investing in equities.

The chart below shows the rolling 12 month dividend per share for the S&P 500.
Question: what would you pay for that income stream? (I have used the S&P 500 because data goes back further but you’d see similar patterns in the UK.)

Here are the facts. First, dividend per share growth since 1970 has been 6.0% per annum. Second, volatility of dividend growth has been 6.7% per annum, meaning that two thirds of the time dividend growth has been between -0.7% per annum and 12.7% per annum.

I don’t know about you, but I wouldn’t demand more than a 7% return from that income stream. Over 30 years, that’s 527 percentage points more than you’ll get from the 30 year Treasury, which more than compensates you for the higher volatility of the income stream, yes? I think I am being extremely reasonable, although, perhaps a tad greedy..

Rolling 12 Month Dividend Per Share of S&P 500

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

Using the Gordon dividend discount model, a 7% return would suggest a current fair value for the S&P 500 index of 4,151. You’ll note of course that I have reversed engineered this result. But I have done so to make a point, namely that even if the S&P 500 index reached 4,151, your return would still be a respectable 7% per annum!

The next chart overlays the dividends per share (left hand scale) with the S&P 500 index itself (right hand scale). It also bands the seven equity bear markets we have had in the last 45 years. The only bear market that was remotely justified on the basis of what happened to dividends was the most recent one in 2008-9. All the others saw no corresponding decline in dividends. Indeed during the first five dividends continued to rise.

Rolling 12 Month Dividend Per Share of S&P 500 vs. S&P 500 Index

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

But the main point to note is how much more volatile the index is in relation to the underlying dividends. The volatility of the S&P 500 index is 16.7% per annum, 2.5 times that of dividends.

There is an illogical circularity here. Equity investors demand a high return because of equity market volatility, but it is their own behaviour, not that of the underlying dividends, that causes the volatility!

The point of all this of course is twofold. First, one should not be nearly as fearful of equities as is generally the case. Second, bear markets should be welcomed with open arms; they represent
opportunities to buy a fabulous income stream super-cheap.

These conclusions have widespread academic support, but a paper written in 1994 by William P. Bengen, Determining withdrawal rates using historical data, is particularly interesting. Bengen’s study considered historical returns from equities – and bonds – over the long term to determine optimal equity-bond asset allocation as well as the maximum one could withdraw from one’s fund every year – expressed as a percentage of the starting value – without running out of money within 30 years. This maximum percentage he calls Safemax.

Although conventional wisdom is that in retirement one should shift to a more defensive asset allocation strategy, Bengen’s study found the opposite was true. He writes, “An asset allocation as high as 75% in stocks during retirement seems to fly in the face of conventional wisdom…But the charts do not lie – they tell their story very plainly.” The charts he refers to are ones that clearly show portfolios with higher allocations to equities lasting a lot longer than those with lower allocations. He then goes on to consider how one should react to periods of poor equity market performance, concluding that increasing the equity weight to 100% is the optimal strategy. “This [increasing allocation to stocks following periods of poor performance] is a testament”, he says, “to the enormous recovery power of the stock market – and the need to avoid emotion when investing. The best time to invest is likely to be right after the worst time to invest! Admittedly, increasing stock allocation to 100% after a long period of miserable returns requires unusual foresight and fortitude on the part of the adviser, as well as the client. If you can convince your client just to maintain the 75% allocation under such conditions, you have won a major battle. However, the client is still faced with a shorter-than-average portfolio longevity, and with much less wealth to pass on to heirs than originally hoped for.”

I would add two points to Bengen’s study. First it was written when long-term real interest rates in the US were 4%. This represented good value so an allocation to them made sense. Nowadays, long-term real interest rates are now either close to zero or negative, depending on the country, which makes allocating anything to government bonds an absurd idea. Second, longevity has risen over the last 20 years so one has to make one’s portfolio last even longer than was previously the case.

Six years into a bull market it is very hard to move from a defensive to a moderately aggressive stance (if you’ve been decently weighted in equities the last six years, well done and stick with it!) Bull markets only tend to last eight years, I hear you say, so surely the next bear market is just round the corner. It is possible that the next bear market is indeed about to begin, but it is also possible, probable even, that this is not the case. The current bull market is to a large extent a function of the bear market that preceded it. Since the last one was so damaging, the recovery may well be longer. This suggestion is supported by dividend yields that are, on the whole, still above historic averages so have further to fall. Furthermore, bear markets don’t tend to begin until unemployment rates start rising (as this is when central banks start to tighten monetary conditions). Since we’re still some way off from this happening, the likelihood is that the bull market has further to run.

But there is a chance that I’m wrong, or that some shock causes markets to fall, so if you are persuaded – as I hope you will be – to increase your equity exposure at these levels, you must also be ready to increase it even further. Contingency plans are after all an important part of any strategy.


Asset Allocation and Unemployment

I am a big believer in keeping tactical asset allocation simple. The more complicated you make it – either by considering too many factors or time frames that are too short – the less effective it tends to be. To support this view I cite work done in 1979 by Richards J. Heuer Jr. involving a study of horse handicappers. The study found that as one increased the number of pieces of information available to the handicappers from one to five, accuracy of predictions increased. However, beyond five pieces, accuracy decreased. Furthermore, while accuracy levelled off beyond five pieces of information, handicappers’ confidence in their predictions continued to increase!

My approach to tactical asset allocation focuses, simply, on the business cycle and how different asset classes perform at certain times. This means having a longer term time horizon, because business cycles average around six years.

To gauge the business cycle I use one indicator: the unemployment rate. There is nothing more fundamental to an economy than the percentage of the workforce that it is not, for whatever reason, able to put to work. Employment is closely linked with economic activity, a major determinant of bond and equity markets, hence my use of it in tactical asset allocation. This of course makes complete sense. Why? Because the unemployment rate is a good measure of inflation pressures and inflation pressures are a good leading indicator of monetary policy, the key driver of financial asset prices.

Of course if one is using the unemployment rate to predict the future path of asset prices, one must first establish that the unemployment rate is itself predictable. A simple way to do this is to determine if there is a sufficiently high correlation between the change in the unemployment rate over one period and the change over the next period. If there were no correlation, this would indicate that the unemployment rate follows a random walk and is thus unpredictable.

It turns out that, at least in the case of the US, changes over four months have the greatest predictive ability (three and five months changes are less correlated than four months). The correlation coefficient between four month changes and subsequent four month changes is 0.54, which indicates a fairly high degree of correlation. If I’ve lost you, just look at the chart below showing the unemployment rate in the US over the last 70 years and ask yourself whether it looks random or whether it contains some sort of pattern.

US Unemployment Rate

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

The relationship between the unemployment rate and long-term interest rates is a simple one: inflation. If the unemployment rate is above a certain level, inflation pressures will be low or falling and thus bond prices rising. Similarly, if the labour market is tight, inflation pressures will tend to be high or rising, a not-so-good environment for bonds.

Equities tend to perfom poorly when unemployment is rising, as rising unemployment is a feature of recessions and thus weak corporate profits.

Thus, much of the time, equity and bond markets will be out of sync (negatively correlated). Safe haven bond markets like rising unemployment. Equities do not.

Unemployment Rate, The Yield Curve & The Stock Market

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

So, what are unemployment rates around the world at the moment saying about the outlook for bonds and equities?

In the case of developed markets, unemployment has fallen pretty much everywhere, the reason for the good performance of equities generally. However, rates remain above levels that would be considered inflationary, so bonds have also been performing well. Looking ahead, the US and the UK are closer to the point at which inflation will start to rise than is the case in Europe and Japan, where unemployment rates remain closer to their peaks than their troughs. So, although equity markets in all four still look well supported, they look best supported in Europe and Japan.

As for bonds, there appears to be very little value in developed sovereign markets, but since inflation pressures are likely to remain most subdued in Europe and Japan, their bonds would be the relatively more attractive, if unappealing in absolute terms.

Of course there will always be noise that causes short-term volatility, but one would be advised to ignore this and look for the pattern. Simple.


Download this investment letter as a PDF


Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/67.

 

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Peter Elston’s Investment Letter – Issue 1 May 2015

1 May 2015

Introduction:

A warm welcome to this, my first monthly investment letter. The intention is for it to be thought-provoking. Simple as that.

At Seneca, we are value investors. I hate to give him even more publicity than he already has, but Woodford Patient Capital Trust’s Neil Woodford puts it well: “Valuation”, he says, “is the best form of capital protection.” I wholeheartedly agree.

Important risk, is the risk of permanent loss of capital, not volatility which measures temporary losses (and gains) of capital. In markets, what goes down more often than not goes up again: volatility should be thought of as the cost of good long term performance, not a risk to be concerned about (mine, not Woodford’s).

What is important to me, to my colleagues, to our customers, is to avoid investing in things that go down, but not up again. In other words, permanent loss of capital. How does one do this? By buying things well below their intrinsic value. In other words, by value investing. Indeed, put like that it’s difficult to understand why anyone would be anything other than a value investor!

In fact, it’s not difficult to understand: being a value investor is hard. It requires you to be contrarian, which human beings are not built for (we like to conform, to be part of a crowd). It requires you to be very analytical and objective, assessing numbers and facts rather than listening to the mass emanation of nonsense. It requires you to accept periods of underperformance: there can be periods of up to 2-3 years when the expensive outperforms. It requires you to be a bit dull – talking about discount to intrinsic value is, let’s face it, not as sexy as talking about the latest fad. But the hard work is all worth it. Funds managed by value investors generally have very good long-term track records.

Now, value investing is most commonly associated with equity investing. At Seneca we’re applying it to multi-asset investing.

Take government bonds as an example. Right now, the yield of the 30 year inflation-linked Gilt is -0.9% which means that buying and holding it to maturity will lose you 24% of your real capital. If you measure risk in terms of volatility, be my guest and invest – these things ‘look’ really safe. If you measure risk in terms of potential for permanent loss of capital, step away from the table, leaving the crumbs that may be left on it for someone else.

So, at Seneca, we apply a value investing ethos to everything we do: tactical asset allocation (the above case of government bonds being a good example), stock selection (where Graham and Dodd began), fund selection (we like managers who themselves have a value investing ethos), and sector/trend research (the value investing articulated by Graham and Dodd was as much about looking for quality and reliability, similar to that which can be found in some long-term trends, as it was about valuation measures).


The Big Picture

Looking back, the biggest events over the last 18 months have been the substantial falls in G7 bond yields and the oil price as well as the sharp rise of the US Dollar.

To be clear, what has been happening in bond markets is almost without precedent. Bond markets are thus a source of uncertainty and potential instability. Excellent real returns since the early 1980s have been driven by three things: the high level of the yield itself in real terms, falling inflation, and falling real interest rates. We are now at a point where neither inflation nor real interest rates can fall much further, so predicting poor returns from bonds has never been easier surely. But then that’s what most were doing – us included – at the back end of 2013 and look where that got them. 2014 saw US and European sovereign long bonds return 24.9% and 12.8% respectively, hardly poor.

Although one can be absolutely sure that the bond bull market will end, timing it is hard. Bond yields in the US stayed low throughout the 1930s, 40s and 50s, only rising sustainably above 4% in the mid-60s (see chart) though real returns would have been negative for some of this time as a result of high inflation during the war years.

In a debt soaked world it is very hard to get growth going. Classical economics text books ignore debt as a factor of growth, arguing that on a net basis it sums to zero. Instead, they present economic growth as a function of workforce growth plus productivity growth. I’m not trained as an economist – a good thing, I keep telling myself – but it seems to me that an underleveraged economy has the potential to grow faster as credit spreads throughout an economy (imagine how much more activity can place if a product can be exchanged for a promise rather than another product!) This is a good thing – credit, what is essentially an IOU, is one of man’s greatest inventions – but it does mean that the same must from time to time happen in reverse. The deleveraging of Japan’s private sector over the last twenty or so years stands as testament to this.

In June 2013, then Fed governor Bernanke commented that US growth forecasts were being revised up and that the Fed would soon begin tapering its bond buying program, causing bond yields to rise sharply. After hitting 3% at the end of 2013, the ten year yield has since slipped back to below 2%, defying pretty much everyone’s expectations. Despite the Fed’s optimism, it gradually became apparent that the economy would not be strong enough to absorb the ending of QE. The falling oil price only served to increase the downward pressure on inflation and thus bond yields.

It seems extraordinary that six years after the crisis we are none the wiser as to how economies will be weaned off “unconventional monetary policy”. One thing that is clear however is that central bank money printing has not led to the runaway inflation that many feared. Indeed, the opposite is the case: inflation is running below central banks’ targets for much of the developed world, and in fact is now negative in Europe. How can this be, given all the stimulus?

Economists such as Larry Summers and Robert Gordon argue that global growth is stagnating as a result of weak demographic trends and the absence of some game changing technology such as the steam engine, internal combustion engine or the silicon chip. It is also possible that workers have so much competition nowadays from robots, other labour-substituting technology as well as workers elsewhere in the world that a rise in real wages quickly results in a shift to specialists, particularly when the cost of capital is so low.

It seems therefore that one can view currently low bond yields in two ways. The pessimist would argue that they reflect a flight to safety and fears of yet-to-surface instabilities within economies and financial systems. The optimistic view would be that they reflect low inflation which is a good thing, as well as the aforementioned structural issue surrounding labour costs. In such a world, the owners of capital are the winners. You don’t get rewarded for investing in government bonds because there is no or little risk with respect to credit or interest rates.

I tend to side with the optimists, though that doesn’t mean I think bonds are a good investment. Although there may not be a new game changing technology about to burst onto the scene in the way that the steam engine and the internet did, there is certainly technological progress that does not get celebrated widely in the media. As economists Brian Wesbury and Robert Stein of First Trust Advisors note, “tablets and phones that cost a few hundred Dollars today have capabilities that cost millions just 20 years ago. Shale oil drillers are successful on most of the wells they drill versus much lower percentages of success in the days of wildcatters. 3-D printing reduces prices, while increasing flexibility in production. Low cost apps, websites, and the cloud undermine the need for brick and mortar investment.” Furthermore, although technological progress may often be linear, its effects can most certainly be non-linear. For example, photovoltaic cell efficiency may well be closing in on a tipping point at which usage takes off.

US Experience Graph Image2


Oil

Despite some proclaiming that the price fall was a sign of a weakening global economy, I suspect that increased supply has been mostly to blame. Since 2009, global supply of crude oil has increased from around 84 million barrels per day to around 94 million bpd. At the same time there has been a huge increase in the supply of energy from renewable sources. True, renewable energy still only accounts for a small percentage of total, but it is at the margin where its effects are felt.

The changing supply/demand dynamics in the energy industry represent a paradigm shift, something that the Saudis appear to have recognised. They know that the global economy can tolerate a price of $100 per barrel – after all, one barrel contains the energy equivalent of roughly twelve years of human work (based on 40hrs per week, 48 week working year) which would be valued much more highly – but also feel that they alone should not bear the responsibility for keeping it there, particularly in a world that is being weaned off the substance.

So, OPEC – for which read ‘the Saudis’ – has decided that if no one else is going to cut production, it won’t either. The resulting price fall has been forcing production cuts on the less efficient producers, rather than them being offered voluntarily. This is ultimately how a well-functioning market should operate, and demonstrates that the process of creative destruction is alive and well.

What perhaps is slightly unusual is that, unlike in most other industries, in the case of energy it is likely to be the most recent entrants – shale oil and renewable energy suppliers – who will get weeded out first, rather than the veteran incumbents in the Middle East. This is a shame, at least in the case of renewable energy, but should ultimately be seen as a good thing; the lower oil price will boost aggregate demand as well as increase pressure on renewable energy companies to improve efficiency further.

That said, I cannot see the oil price falling much below $50, despite Saudi oil minister Naimi’s unusually blunt comment that OPEC will not cut production even if the oil price falls to $20. This is game theory at its purest, with OPEC apparently attempting to engineer swift production cuts by higher cost operators so that the market can return to a more balanced state and prices back to normal, even if this is still well below $100.

The falling oil price was one of the factors behind the strength in the US Dollar but by no means the only one. Changes in expectations with respect to monetary policy are, as usual, the key factors. The reality is that by ending its bond buying program the Fed has been tightening policy. Furthermore, expectations are that the Fed will raise interest rates within the next year or so. In Europe and Japan on the other hand, expectations are for policy either to remain loose or to be loosened further. The rise in the Dollar has been exacerbated because of its status as a funding currency; as it starts to rise, many who have borrowed in US Dollars seek to pay them back, thereby adding to the strength.


Looking Ahead

The critical question I think has to be whether or not the global economy is at risk of sliding into recession. If the risk of this is low or negligible, as I think is the case given that central banks and governments generally remain very supportive, then the outlook for stocks should still be reasonable – after all, dividend yields are still decent while profitability of companies as measured by return on equity is not stretched.

In this regard, I think we still need to watch very closely for signs that the rise in the Dollar or the fall in the oil price is impacting growth in the US, the latter through closures of shale oil developments which have provided a boost to the economy is recent years. As of now, the yield curve is still steep, albeit it less so than a year ago, suggesting that a recession is not looming.

Yield Curve Graph Image

Coincident Index: shows the current state of economic activity within a particular area. Compiled using employment, real earnings, average weekly hours worked in manufacturing and the unemployment rate.

Indicators can be classified into three groups based on the time period that is being measured. Lagging indicators change after the economy as a whole changes, coincident indicators show the current state of the economy and leading indicators show where the economy is going. Coincident indicators are often used in conjunction with leading and trailing indicators to get a full view of where the economy has been and how it is expected to change in the future.


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Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/50.

 

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