Perspectives on China

I like fund managers and economic commentators who are opinionated. They are likely to come up with interesting contrarian thinking and challenge established norms. They stimulate investment ideas and if right the strategies that come out of these ideas are profitable. Recently I came across Michael Godfrey co-manager of M&G’s Asian and Global Emerging Markets funds. I have to admit I have never used M&G for these sectors and Godfrey had not previously come onto my radar as a fund manager to watch. However in an article in Investment Week he made some interesting observations on China. He argued that back in 2007 valuations of Chinese equities were ridiculously expensive at 45x earnings. Now they have shrunk to a more realistic 10x earnings. However he considers State Owned Enterprises to be uninvestable due to poor deployment of capital whilst private sector firms have used resources more wisely. Godfrey is however wary of the domestic consumer story – it is safe but equities in this sector are now very expensive.
Godfrey looks for undervalued companies which will add shareholder value. He likes companies with a good long term strategy and berates investors for looking at short term figures and being obsessed with forecasts. He is particularly scathing on macro metrics, for example supporting an investment case for China based on high GDP growth.* In words reminiscent of Yorkshireman Geoffey Boycott’s forthright views on cricket he says this is utter rubbish! What counts is how companies use and benefit from that growth. To support this he states that Chinese equities have been very volatile and a terrible investment despite high GDP. Finally he contrast this with firms in Mexico, South Africa and Brazil where GDP growth has been lower but equities have performed better due to being shareholder friendly.  
At the same time in another recent article on China, famous US investor Jim Rogers dismissed fears of a hard landing and rounded on Hugh Hendry of Eclectica (he appears occasionally on BBC2’s Newsnight as a studio guest discussing the economy) and Albert Edwards from SocGen who have both been long term bearish on China. Edwards reckons a hard landing will result in a collapse in stock prices. Rogers does not dispute a scenario of share price collapse but is bullish on Chinese equities and sees a sell off as an opportunity to buy back in. There are clear opportunities here as recently the Shanghai Composite index closed 40% down on its August 2009 highs. Rogers is not concerned about slowing growth and sees this as proof the authorities are managing the economy as intended. He compares China with the US which in the 19th century went through 15 depressions before emerging as an economic success in the 20th. Finally he considers China better able to withstand global shocks due to substantial foreign exchange reserves.
 So what’s my view?** I am moderately positive on China. I see it continuing to power ahead with strong economic growth and development of a large affluent middle class and to become the world’s leading economy. However there are substantial risks for investors and I strongly favour an active stockpicking style of fund management over passive index tracking or a top down investment. There is clear value and opportunities to buy in at low prices. Figures from Morningstar show the average IMA China/Greater China fund is down 18% in the year to 27/7/12 and just 1.7% up over three years. To reduce risk China can be accessed via a global emerging markets or Asia Pacific fund. For a pure China fund my old but spurned friend of monthly savings should be considered, not only to reduce risk but to benefit from volatility.  
* Godfrey touches upon a classic distinction between top down and bottom up investment styles. The former seeks to formulate strategies based on macro economic analysis or global trends; the latter focuses instead on company specific issues and stockpicking. Many managers employ a blend of the two styles.  
** Individual independent advice on investing in China should be sought.

Liquidity Squeeze in the Bond Market

Liquidity Squeeze in the Bond Market 

The lead article in a recent edition of Investment Week, a trade paper I subscribe to highlighted significant liquidity issues in the bond market. Liquidity refers to the ability of traders, fund managers and investors to trade stock. It is crucial to ensure a properly functioning market whilst a liquidity crunch can cause difficulty in establishing prices which may collapse with no buyers. It could increase the time or even ability of a fund manager to meet requests for redemptions and could even cause parts of the corporate bond and gilt market to shut down and funds to close. There is a recent history of this during the credit crunch and financial crisis of 2007-2009 where the commercial property market became highly illiquid and effectively shut down. Specialist commercial property funds were forced to cease trading and investors could not sell out. Eventually as the credit crunch eased liquidity improved and these funds re-opened.

The causes of the liquidity issues in the bond market are various. Banks are reluctant to trade as they are forced to raise capital and bond issuance has fallen as companies hold cash on their balance sheets. At the same time demand for corporate bonds from investors has risen due to their perceived lower risk compared to equities and the high income they provide compared to cash. The Investment Management Association (IMA) reported that the Corporate Bond sector has been the best selling sector for 10 out of the last 12 months.

Given these market conditions corporate bond funds may be forced to hold large cash balances as a buffer to help meet redemptions whilst the Bank of England could intervene to help maintain liquidity by acting as a market maker, buying and selling corporate bonds.

So should a liquidity crunch worry investors holding corporate bond funds? Possibly. The most popular funds are mega sized investments which face trading issues in normal circumstances not just during periods of illiquidity. For example the M&G Corporate Bond fund held £6.2 bn at 29/6/12 whilst the Invesco Perpetual Corporate Bond held £5.4 bn (Source: Morningstar). Imagine the practical difficulties if the fund managers want to change the asset allocation of their portfolios and this requires selling £1 bn of bonds. Aside from the difficulty of finding buyers, dumping a large amount of stock onto the market can distort prices. In contrast a smaller fund of say £500 million is much more nimble.  

Whilst I have no knowledge or expectation that “super tanker” sized funds plan to close to new investors, if they do income payments should continue as usual and redemptions may still be possible. However a large number of sellers from funds will drive prices of corporate bonds lower if the unit trust or OEIC manager does not have enough cash and has to sell stock to cover redemptions.* 

If redemptions from corporate bond funds are suspended investors will need to ensure they can access cash elsewhere, highlighting the importance of keeping an emergency fund. It will also mean you will be unable to undertake tactical or strategic investment decisions for example a rotation from corporate bonds to equities. However the real concern is if panic selling drives values of bonds lower. Aside from a liquidity crunch that may cause this, it could be triggered by the bubble in the gilt market bursting.** Prices will fall and this could drag corporate bonds down as well, especially investment grade stock. That said the government and the Bank of England will employ every tactic in the book to keep gilt yields at record low levels.

So what is my advice? For long term income investors corporate bonds are excellent investments, very tax efficient within an ISA and most people would be advised to stick with their holdings. However I prefer high yield to investment grade given the former offer an attractive yield premium for the additional credit risk, low default rates and less sensitivity to interest rates. They provide equity like returns but with lower volatility. For those investing in corporate bonds for low risk growth and sitting on profits it is worth reviewing your holdings and possibly switching to alternative lower risk investments in whole or part. As usual you should seek individual independent advice.

* In contrast to OEICs and unit trusts, closed end funds such as investment trusts, which are legally structured as companies listed on a stock exchange do not have to sell underlying assets when investors sell their shares and this is a distinct advantage over open ended unit trust or OEICs. Selling drives the share price of the investment trust down but not its asset value. More on this at a later stage.

** Not everyone subscribes to the view that there is a bubble in the gilt market. Yields have been driven to historic lows and hence prices to historic highs since 2008. Many professional investors have been surprised that prices continue to defy gravity and have continued to rise. Various factors including government and Bank of England policy are supportive,such as Quantitative Easing (QE). If there is no bubble nor danger of a collapse in prices on the scale of 1994 all one can say is that at best gilts offer poor value.

Tactical Asset Allocation Shift

Following my last post in which I stated I was taking a more active role in asset allocation advice you may be aware that last autumn concerned we were heading for a stockmarket crash from the Eurozone debt crisis I switched my pension fund to cash. This is despite the fact that I am bullish on equities as a long term investment. They remain my favoured asset class. Corporate balance sheets are generally strong with the significant deleveraging that has taken place in recent years and companies hold large cash balances. Valuations are also good both in absolute terms and relative to gilts and corporate bonds. In my view equities have suffered in the last few years from the sins of the bond markets and the profligacy of government debt. This has meant equities have been priced not on fundamentals but “risk off” sentiment and good quality companies have been sold indiscriminately.
The crash has yet to happen and may not, but I have targeted the FTSE 100 index, a proxy for global stockmarkets hitting 4,000 as a trigger for me to rush back into equities. The intended temporary switch to cash was therefore a tactical asset allocation decision. If I get it right I’ll make a significant profit – if I get it wrong and eventually buy back into equities at higher prices than I sold out at I’ll take a hit.
Last week during a review of a client’s portfolio I spotted an excellent buying opportunity that should have been blindingly obvious to me earlier – that commodities and mining and natural resource companies had fallen sharply in the last year. One favourite fund of mine, the JP Morgan Natural Resources with a long track record of excellent performance was down 30.1% to 22/6/12 (Source: Morningstar). The downturn is due to slowing global economic growth especially in China and fears of a Euro break up. Commodities are very economically sensitive and hence prices are highly volatile. However the long term investment case is compelling – with a rising global population, strong economic growth in emerging markets and limited supplies of commodities. It is classic market with favourable long term supply and demand characteristics. Consequently I expect a strong rebound at some stage in commodities and resource companies. So I decided to re-invest 25% of my cash into the JP Morgan fund. I’ll let you know in due course how I get on.
Now I am a high risk investor and there is a real risk that commodity prices may fall signficantly further or stayed depressed for longer, but this was an opportunity that I could not resist. For investors sitting on cash or looking to invest this year’s ISA allowance you could do no better than consider a similar exercise although this is not for the faint hearted. Naturally individual advice would be required and you should not consider the JP Morgan Natural Resources fund as a definite recommendation for you. Finally you should note there are alternative buying opportunities. The average IMA Europe (excluding UK) fund is down 17.5% in the year to 22/6/12, the average IMA China/Greater China fund is 14.9% lower and several India funds have fallen by more than 20%.
Finally to end on something I have banged on about previously – monthly investment. When I switched to cash last year I maintained my regular monthly pension contributions and continued to invest in equity funds. I figured with the downturn in prices following the re-emergence of the Greek financial crisis in August and a possible crash I would pick up units cheaply. A prolonged period of depressed values is highly beneficial when followed by a rally in prices. The risk reducing features and investment opportunities of regular savings is not widely adopted enough by investors who are holding onto cash. I have noticed a significant downturn in new investment since August. In my view risk adverse investors who are not prepared to commit lump sums should seriously consider a flexible regular savings plan instead for example using ISA allowances. These have low minimum contributions, typically £50 p.m. and there is no minimum term unless they are life assurance based. Savings can be suspended at any time and investment trust savings schemes offer a low cost option. 

Episode Investment

Inspiration for my investment blogs and previously my investment e-mails may come from unexpected sources. This one was from a normally dull type of communication that I regularly receive, about changes to a fund range – investment objectives, mergers or fund names. They normally get filed or sent for recycling. The letter and document in question was from M&G about changes to their multi asset funds including the M&G Cautious Multi Asset I have recommended to some clients.
M&G are rebranding their multi asset fund range to include the phrase Episode in their name. It reflects an evolution in their management of this type of investment which they claim is unique. The name reflects an approach that seeks to identify “episodes” where assets are inappropriately priced as a result of investors reacting emotionally to events rather than considering normal investment principles. M&G cite inflation or interest rates here. The episodes could be short or medium term.
This well respected investment company make an excellent point and touch upon a key issue in investment known as behavioural finance; how investors think and behave. When they get it wrong it results in panic selling, indiscriminate selling irrespective of quality, buying high, selling low and burying heads in the sand. This is also true for professional investors who drive markets and asset prices to irrationally low or high prices detached from fundamentals.
M&G do not say what episode investment means in practice but presumably it includes tactical asset allocation, buying underpriced quality assets and contrarian investment, going against the herd. I like active brave fund management. It also reflects my general aversion to inflexible model portfolios, fixed risk assessments of asset classes and closet tracking.
Whilst I have sympathy for a buy and hold investment strategy especially for long term investors for example those saving for retirement, asset allocation has been proven to be the single most important factor in delivering investment returns. For this reason I have taken an increasingly proactive interest in asset allocation advice to my investment portfolio clients – for example my recommendation to consider selling to cash last autumn. At another level I also recommend multi asset funds where I delegate active asset allocation to fund managers I think do it well.   
As previously noted in an earlier blog post  
an environment of low returns and high volatility is expected in the future. In these circumstances I consider episode investment to be a key tool for fund managers in adding value. It would not also surprise me to see this phrase becoming commonly quoted by investment commentators and the concept copied by other fund managers. Logically and perversely if it is widely adopted it should end panic selling and other bad behaviours by causing a return to a focus on fundamentals. Then again pigs might fly or should I say have episodes of aerial movement.

Future Outcome for the Eurozone

I recently read an excellent article on the Eurozone from John Greenwood, Chief Economist of Invesco Ltd. In it he argues that there are now only two possible outcomes to resolve the debt crisis – unilateral default and exit by Greece and possibly other economies or full fiscal union. Prolonged austerity will not work.
The first scenario with a Greek exit runs the risk of contagion. A default on all external debts and a new depreciated drachma would rapidly restore Greece’s competitiveness and growth. This would then become an attractive option for Portugal, Ireland, Spain and Italy. Exit would lead to a run on the banks as depositors including foreign institutional lenders seek to protection funds from conversion to new drachmas, escudos, punts, pesetas or lire. Greenwood also detailed the difficulties in constructing sufficient firewalls and concluded there would be grave consequences for financial markets.
Full fiscal union means a move to central control of Eurozone government revenues and expenditures with a federal government issuing bonds on behalf on all states collectively. Greenwood sets out some examples from history. The one I found most interesting was the monetary union of the United States. The US created a fiscal union before a monetary union, following the War of Independence where the federal government would bail out the indebted states and pay off foreign creditors in exchange for powers to raise revenue in future. Greenwood argues if Brussels took over the debts of Greece etc. the immediate credit crisis would recede and Euro credit could rank alongside US Treasuries.
In the 1830s, following a slump in the rail road boom,  many US states became over indebted again. However the federal goverment which had established a good name in the credit markets did not bail them out to avoid undermining this. Monetary issues were not finally settled until after the Civil War.
Various commentators have argued Euro monetary union was destined to fail as it was flawed from the outset. Greenwood concurs that it is a huge mistake to combine economies with different per capita income, productivity and social systems into a single currency. Booms and busts in the periphery will inevitably lead to debt and banking crises undermining the integrity of monetary union. The Eurozone will need to move to a fiscal union with the powers to tax, borrow and spend in the name of the union. If the federal entity is financially secure it can impose a no bail out policy. There would be no repeat of the Eurozone capitulation to bail outs to date that now threatens the monetary union. Greenwood finishes that we’ll know in a few weeks whether we will see break up or full fiscal union.

Prospects for the US Economy

We are all aware of the importance of the US economy, still the world’s largest albeit with China catching up quickly. The rally in equities in the first quarter of 2012 was in large part been due to clear signs of recovery in the US – corporate earnings are good and cash balances high (some of this is being returned to investors in the form of dividends and share buy backs), unemployment is falling, there are positives in the automotive and service sectors and there is stabilisation and recovery in the housing market. Consumer confidence has risen whilst government policy too has been supportive of growth with less emphasis on austerity than in Europe. In addition US banks are better capitalised and have less toxic assets than their European equivalents. At the same time large scale liquidity injections by the ECB in December and February also reduced risk in Europe and buoyed global equity markets including the US.

Despite the encouraging signs there are however economic headwinds and political factors that the US faces going forward. In an election year with a potential change of government there is uncertainty on two issues – taxation and healthcare reforms. Businesses and individuals will be wary about unknowns costs and this could put a brake on economic growth and investment until there is clarity.

Tensions in the Middle East and a sharp rise in oil prices would also impact negatively. However Mike Turner, Head of Global Strategy and Asset Allocation at Aberdeen Asset Management reckons the price of oil would have to reach $150 per barrel before there was a major effect on economic growth.

Another issue is the debt ceiling crisis in 2011 which prompted Standard & Poors to downgrade the US credit rating from AAA. It is feared it may re-emerge in 2013. However Cormac Weldon head of US equities at Threadneedle Asset Management says that the US has not yet engaged in severe austerity and it is set to start next year. If taxes increases and government spending is reduced it will impact on certain sectors such as healthcare and infrastructure.

So what does this all mean for investors? In two words uncertainty and volatility, especially in the short term, through 2012 and into 2013. That said many commentators are cautiously optimistic on the US and the impact it will have on the global economy. The US does have a highly flexible and productive labour market and a strong corporate culture and this bodes well for the medium to long term.

High Yield – The Search for Income

In an economy of balance sheet deleveraging and low growth a key challenge for investors is the search for income. The impact of the financial crisis in 2008 has led to structural changes in the UK economy with very low interest rates having become the norm. By low interest rates we need to distinguish between those that apply to cash and those that affect UK government bonds i.e. gilts. Often the two are confused. For example Coalition politicians defending the austerity cuts often argue that we have to maintain this economic policy and protect our AAA credit rating in order to ensure mortgage rates remain low. I think there is a bit of spin here. The point is that the UK’s economic credibility impacts on gilt yields and hence the government’s future borrowing costs not mortgage rates. The latter are determined primarily by the Bank of England base rate not gilt yields.

The scenario of low interest rates is unlikely to change in the near future as they are required to stimulate economic growth and reduce unemployment. In this sense central banks have shifted from their traditional remit of inflation targeting. Evidence of this is in the UK where inflation has been well above its 2% CPI* target for a long time yet the Bank of England has kept its base rate at 0.5% p.a. for over three years now. Ordinarily interest rate rises are used to reduce inflation but this monetary policy has been kept under firmly under wraps.

In the current environment low interest rates on cash means this asset class is a very poor investment for income seekers and capital is eroded in real terms by inflation. For those coming up to retirement and buying lifetime incomes from pensions there is a double whammy, low interest rates on gilts, supported by QE** has hammered annuity rates which are priced off of gilts. For those lucky enough to have secured retirement income from generous index linked final salary schemes or who bought annuities in the past when rates were higher you may be in a better financial position than new retirees but you will have seen your annual pension increases trailing inflation busting price rises in food, utilities and petrol in recent years. The “grey” inflation rate focused on life’s essentials not i-pads, flat screen TVs and 3G phones is typically higher than average.

So where do investors find income? In a recent article from M&G they highlighted the importance of high yield corporate bonds. Yields vary but may be as high as 8%-11% from relatively good companies. High yield, as it says on the tin offer real rates of return over and above inflation. M&G also point out high yield bonds have outperformed equities since December 1997 and with low volatility. I must stress the comparison was with equity indices such as the FTSE All Share and the S&P 500 rather than actively managed equity portfolios.

Another attractive feature of high yield corporate bonds is that they are much less interest rate sensitive than gilts or investment grade bonds. An interest rate shock, for example a reversal of the BoE monetary policy could send gilts into a tail spin with capital values falling sharply. The return from high yield is more determined by credit risk of the issuing company rather than interest rates. Finally high yield corporates bonds as with other forms of fixed interest are especially tax efficient when held within an ISA. This is because the plan manager can reclaim the 20% tax in interest. In contrast the 10% tax credit on dividends from equities is not reclaimable.

The choice of fund manager is crucial when it comes to selecting a bond fund. Aside from being a firm believer in active fund management rather than passive index tracking M&G made an interesting point. They compared spread dispersions for different categories of credit ratings in June 2007, before the financial crisis and at the end of 2011 and found they had become much greater. To explain. A spread is the excess return of a corporate bond over and above an equivalent gilt. For example if a gilt yields 2% and a corporate 6% the spread is 4% p.a. It is the extra yield the market demands for the additional risk of buying company credit as opposed to a “risk free” gilt. Further most corporate bonds have their credit ratings assessed and typically these are AAA, AA, A and BBB for investment grade and BB, B, CCC, CC etc. for non investment grade. Typically the lower down the credit scale you go the higher the yield. However within each credit category e.g. BB- or CCC+ the spreads vary much more now than they did in June 2007. This means that there are large differentials of value in high yield and a good fund manager is recommended to seek out these stock selection opportunities.

Finally for the sake of balance I must point out high yield bonds are not the same as cash and capital values can fall. They also carry default risk although pooled investments reduce the impact. In addition high income can also be provided from structured products and equities.

* CPI – Consumer Prices Index             ** QE – Quantitative Easing

Medlee of Comments

I am awaiting something inspiring to write about; nothing has fired my imagination in recent weeks. So in the meantime here are some random thoughts on investment issues.
Markets have been weighed recently by fears over Spain’s economy, after a poor government bond auction and rising bond yields. Spanish stocks also fell on Thursday whilst other markets rallied. Spain has a weak economy, very high unemployment levels and an overhang of a collapsed property boom – unsold homes, falling prices, negative equity, repossessions, failed developers and bad debts sitting on bank balance sheets. Whether Spain needs to be bailed out or could be remains to be seen. It is a much bigger economy than Greece and whether the IMF* can provide a firewall to protect the global economy from contagion is unknown. I conclude recent events will be a pattern for the next year at least, periods of calm and relief rallies, followed by emerging nervousness, crisis and volatility. Sovereign indebtedness is a deep structural problem which will take years to fix.
A new tax year signals a new ISA allowance of £11,280 of which a maximum of £5,640 can be allocated to cash. For those wishing to use stocks and shares ISA allowances but nervous of market volatility, can I remind you of Fidelity’s phased investment facility in which money can be fed into the market over six months, the option of monthly ISA contributions of up to £940 p.m. or the use of Fidelity’s ISA Cash Park, a temporary facility which permits a rapid tactical switch to equities if markets fall sharply.
For those of you receiving income payments from Fidelity I have been advised by one of my clients, that distribution statements are no longer sent out automatically now but have to be individually requested.
Finally a thought on income investing. With yields on UK gilts and other government bonds at record low levels, southern Europe excepted, and interest rates on cash very low, the search for income is a major investment theme. Selected high yield corporate bonds offer high income or equity like total returns but with lower volatility than their own equity. In addition dividend investment is back in vogue with increasing interest in global income. Traditionally UK investors were largely confined to domestic equity income but now a new IMA** sector the Global Income has been launched to accomodate the increasing number of fund offerings and reflect this distinct asset class. The pool of investible companies for dividend income is much bigger outside the UK whilst large cash balances are being returned to shareholders in the form of dividends or share buy backs. This reflects the growing focus on shareholder value not always evident outside the UK.
For lower risk growth investors dividend re-investment is an excellent strategy for long term returns. You will no doubt have seen the data that shows historically a significant amount of return from equities comes from dividend re-investment.
* IMF – International Monetary Fund
** IMA – Investment Management Association.
Mike Grant

Expectation of Future Investment Returns

In the same week I have seen polar opposite opinions on expectations for future returns from equities. According to Citigroup the FTSE 100 index will double in value in the next 10 years. That takes some faith given the index is still trading at around 1,000 below its December 1999 peak of 6,930. The drivers will be earnings growth, strong balance sheets, high cash balances, mergers and acquisitions and a focus on shareholder benefits. This argument has some legs; it is clear the corporate sector is in rude financial health and sits on a large cash mountain.

Against this conclusion is the house view of Newton fund managers, part of BNY Mellon who wrote an excellent and thoughtful analysis on expected investment returns from developed economies. Their thesis is that since the banking and credit crisis in 2008 it is clear we are in a very different world to that which prevailed in the previous 30 years. Here they cited the great bull market from the early 1980s to the early 2000s driven by falling global inflation, lower bond yields (these lower discount rates on future cashflows and hence supported higher prices for financial assets), loose monetary policy, globalisation, deregulation and financial innovation. It was also a period of relatively muted volatility compared to the 1960s and 1970s. According to Newton* we had super normal total returns of 17.2% p.a. from UK equities over a 20 year period from 3/12/80 to 31/12/00.

Newton argue we are now in a radically different world with an extended period of deleveraging (debt repayment) which will not progress smoothly. Western authorities are in a trap, unable to save or grow their way out of debt and will focus on treating its symptoms rather than the root causes. They are struggling to maintain bubble era levels of activity and asset prices to support unprecedented levels of debt. In this environment debt will be a significant drag on economic growth.

Newton also argue “risk free” interest rates on government bonds are artificially low and their risk is mispriced. The banks have changed from being agents in the economy to being principals, they are too leveraged, still too big to fail and carry systemic risk. The global financial system is comprised of a web of carry trades** whilst financial innovations such complex derivatives, high frequency trading, hedge funds and structured products (with their attendant counterparty risk) which account for much day to day market trading has created heightened volatility.

This analysis predicts low investment returns and high volatility in an environment of structural rather than cyclical over indebtedness and unsustainable sovereign finances.

The shift of realities is a game changer when it comes to investment returns. During the great bull run, risk was being out of the market, not owning financial assets such as equities, bonds and property. This was the era that passive or index investing was born and thrived with many active fund managers struggling to outperform trend returns which were on a upward trajectory. In the new paradigm capital protection, losing less in the more frequent periods of asset falls may be more profitable than chasing returns. A focus on not losing money means absolute return strategies are required whilst index based returns and benchmarking to “risk free” government bonds will be unfavoured.

Active flexible asset allocation and management will be required, traditional asset correlations may prove unstable, certain hedging strategies may fall foul of regulatory authorities and a focus on volatility as the major risk may be dangerous. Two examples were given. Firstly in the late 1990s during the technology boom equity volatility was at low levels but this proved to be a poor measure of risk as the subsequent bursting of the bubble proved. Similarly in March 2009 at the nadir of equity markets, volatility was very high and risk reduction suggested. In reality selling rather than buying equities would have been a poor decision as the subsequent rally proved.

Newton also emphasised the prime importance to total returns of the compounding of re-invested income. Robust and sustainable income streams are likely to matter more and prove less volatile. Unconstrained forms of investing should also be favoured.

In conclusion Newton said if they are correct then we are in the early stages of a major transition in attitudes; if wrong we are in the foothills of another structural bull market. Time will tell who is right Newton or Citigroup. Newton’s analysis feels right to me but their thesis is focused on developed economies of the West. As emerging markets continue their inexorable economic growth decoupling can be expected and this may drive a global bull market. You will be aware for example that significant earnings from FTSE 100 companies arise from emerging markets. Consequently Newton’s view may be too cautious.

What is clear to me that there is evidence of Newton’s thesis playing out in the last decade, with indices moving sideways, high volatility and active fund management being favoured. Interesting times lie ahead.

* Source: Thomson Reuters Datastream; total return of FTSE All Share Index.

** Carry trades are strategies where investors borrow money at a low interest rate to invest in an asset that is likely to provide a higher return. It includes currency investments.

Mike Grant


When is a default not a default?

When it is a Greek debt restructuring deal! This is the largest bond swap in history with the majority of private investors such as banks and pension “voluntarily” accepting up to 74% haircuts worth around £90 billion in total. This slashes the Greek debt burden and triggers a further £110 billion in loans from the so called Troika (IMF, EU and ECB). The question is is this a default? The D word is feared by the markets, central bankers and politicians alike due to upstream losses and fears of contagion.
The answer lies with the controversial “Collective Action Clauses,” that the Greek government can impose on the miscreant bondholders who do not want to accept the write downs. Ratings agencies say if these are invoked Greece will be in default. Further ISDA, the International Swaps and Derivatives Association is due to decide if the credit event will trigger Credit Default Swap (CDS) payouts? You will recall these are insurances taken out by bondholders to cover default risk. By definition a claim on CDSs means default and losses for the CDS issuers and could trigger further sell offs in the bond markets although some argue these events are already priced into markets.
If successful this deal could be a key step in stabilising the EuroZone and the financial crisis in government debt together with the second tranche of easy money from the ECB. The focus may then shift to the fundamentals of the global economy. My feelings are that the debt crisis is not over yet and interesting times are ahead.
This post is not recent and some information is out of date