Home / Peter Elston’s Investment Letter – Issue 4 August 2015

Peter Elston’s Investment Letter – Issue 4 August 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.


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

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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.

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