Mark Dampier: A safe harbour if the market recovery has overreached itself
Friday 11 July 2014
We are now five years into a market recovery. This is long in the tooth by historical standards, according to James Harries, co-manager of the Newton Real Return Fund and lead manager of the Newton Global Higher Income Fund. In his view, the upturn has been driven by policy initiatives from central banks across the globe, rather than by any real economic recovery.
Mr Harries argues that an unprecedented amount of quantitative easing (QE) has inflated asset prices to an unsustainable level. This means the stock market has been leading the economy along, but the reverse should be true, and now the gap between the real and the financial economy is extremely wide. Given current valuations, he expects returns from both equities and bonds to be considerably more subdued over the next five years.
Mr Harries' view is that market returns have been "front-loaded" in anticipation that a sustainable recovery will ultimately prevail. We are likely to find out soon whether the recovery is truly sustainable.
The manager's inherently cautious outlook means performance of the Newton Real Return Fund has been muted over the past couple of years. However, it has something in common with the Old Mutual Global Strategic Bond Fund, the focus of last week's column, in that the fund should be considered an insurance policy should things take a turn for the worse.
Newton's views are shared by many, but the problem is one of timing. It is an increasingly common view that this bull market has overrun, yet it seems to me the problem is that so many global strategists missed it in the first place. However, it would be arrogant and complacent not to at least understand the bear picture.
Mr Harries and the team at Newton make five points advocating the position that caution is warranted.
First, persistently loose monetary policy, including excessive amounts of QE, has increased risk in both the real economy and financial markets. Across developed economies significant structural headwinds remain, such as ageing populations and vast amounts of debt. Merely throwing more money at the problem does not solve this.
Second, by targeting financial markets, central banks have pushed up valuations, yet corporate earnings have not kept pace with share prices. One would have to be fairly certain that earnings will grow from here to justify current valuations, though the jury is still out on this point.
Third they point to the VIX index, a measure of implied volatility which has recently fallen to post-crisis lows. Financial assets across the globe have shown considerably less volatility in recent years than historically. That said, before the financial crisis few had heard of the VIX index, so personally I'm not sure whether it genuinely points to a problem.
The next point links to the former in that low volatility tends to go hand in hand with low trading volumes. In essence, it can be easy to buy when markets are calm, but when everybody wants to sell and no one wants to buy, prices can fall very fast. However, I would say that this is true of almost any investment when the majority are looking for the exit.
Finally, a point I made earlier is that this bull market is quite mature compared with history. Only the stock market cycles that began in 1982 and 1994 were longer, where each benefited from a downtrend in interest rates; an option we clearly don't have.
In conclusion, this is a portfolio for those who wish to maintain exposure to bond and equity markets, but with a cautious overlay. The fund also currently holds 25 per cent in cash, which in itself is a pretty aggressive stance, with 67 per cent of that held in sterling and 20 per cent in US dollars.
Time will tell whether Newton's views will be vindicated, though I expect this will be quite soon. In my view, this type of fund is extremely useful in diversifying risk away from pure equity exposure and really comes into its own when things turn sour. Of course private investors, unlike many professionals, can be 100 per cent in cash if they wish. The problem here is the low rates available on deposit, though it could prove opportunistic in a downturn by providing investors the opportunity to buy genuinely cheap assets. However, for me, markets in general are neither cheap nor expensive. Predicting the direction of markets and wider economic issues is extremely difficult at any time, let alone right now.
Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.hl.co.uk
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