Winter is coming

 

Summer was a welcome opportunity for exhausted investors to turn their backs on the legion threats they face, but they haven’t gone away and the days grow short – we examine four in detail…

 

_{This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.}

 

Markets have been fairly quiet over the summer, with the MSCI ACWI grinding 2% higher since the start of July. This followed a tumultuous first half of the year, with violent rotations between growth and value, large and small cap, and conflicting information and concerns over new variants which could prolong the pandemic. We think many issues stand at something of a junction. As investors return to their desks and (we suspect) critical developments become apparent, new trends could start to become clear. Here are the four key questions we think were left unanswered over the summer – the answers to which are likely to be critical to investor outcomes over the next six to twelve months.

 

Scenario one: Pandemic pandemonium

 

While the UK seems to be moving on from the pandemic, the spectre of the delta variant looms large over other parts of the world, and by association global equity markets. While the rollout of vaccines has hindered the spread of the virus, questions remain over its long-term effectiveness against new variants, as well as the ability to provide sufficient volumes for the rest of the world, and how long nations can hold out against another wave of infections.

The key question for investors is whether the Delta wave (and the associated policy responses) is an issue for local or global markets. Some emerging market countries may have the medical infrastructure to handle a possibly more virulent strain, while the zero-COVID countries like Australia and New Zealand may end up being overwhelmed.

New Zealand was recently forced to enter lockdown over a single case, and the disease has continued to spread. More worrying potentially is Israel, which has seen a spike in hospitalisations despite high vaccine coverage. Recent studies in the country have suggested immunity from the Pfizer vaccine may wane with time: could this be a warning for the world?

In our view there are two corresponding paths investors may wish to take, depending on their outlook. The first, and bullish approach, would be to remain positioned around the value-rally and reopening trades, both of which are direct consequences of the decline in COVID-19 severity and the associated lockdowns.

Value orientated strategies like CC Japan Income and Growth (CCJI) or the more balanced portfolios like Brunner (BUT) are possible ways to tap into the value rotation, with CCJI having returned a NAV total return of 4.5% year to date, compared to the 1.2% to its benchmark, the TOPIX. BUT has similarly outperformed, with a NAV total return of 18.4% compared to the 14.4% of its custom global benchmark.

If hospitalisations remain low through the winter in the key developed world markets, we expect there to be increasingly renewed confidence and economic activity which will be a disproportionate boon for value stocks; though it may in turn spur inflation fears, as we point out in a later section.

One does not have to buy cheap to take advantage of the reopening, there are many strategies without a clear value bias which have proactively added to companies which can capitalise on the global reopening, such as JPMorgan Global Growth and Income, which has purchased companies such as Yum Brands, Wells Fargo, and Volvo, to capitalise on the economic rebound and increased consumer spending.

But what about those who wish to protect themselves from the possible global resurgence of COVID-19? If such a scenario were to play out, we would be tempted to look towards trusts which had performed well during the post COVID-19 recovery; specifically those with strong quality biases. Companies with strong ‘quality’ factors (e.g. robust financial strength, proven management, resilient business models) will be prized, as investors once again look for companies which they can be reassured will be alive once the next wave is over. Such companies are found in strategies like JPMorgan US Smaller Companies and Aberdeen Japan, with the quality factor being the managers’ primary requirement when looking for an individual company.

Technology companies may also be back on investors’ radars, having been amongst the greatest ‘COVID-19 winners’, with Allianz Technology Trust (ATT) being a prime beneficiary of any renewed demand. Though we, like ATT’s managers, are cautious around the high valuations some tech companies now command, as we outline later.

 

Scenario two: Mind the boom

 

Investors best beware, positive economic growth is coming. As paradoxical a statement as it seems, when we consider how successful the ‘long duration’ trade has been, how increasingly comfortable markets have become with growth stocks (just look at the P/E ratios of US mega caps), and how little government bonds yield, then the idea of economic growth begins to become a double-edged sword.

Upwards GDP growth seems almost inevitable in our opinion and, barring an overwhelming surge in severe COVID-19 cases or prolonged supply chain issues, the combination of reopening and record levels of economic stimulus mean that economies are raring to go. The OECD has even revised its 2021 projected global GDP growth from 4.2% to 5.8%, thanks to the vaccine rollout and US stimulus.

While there will certainly be benefits there are also dangers, both from the accompanying inflation and from the significance for valuations. It is our belief that going into Q4 2021 and beyond, investors will need to take stock of how exposed they are to the ‘long duration’ trade. ‘Long duration’ is defined by companies where investors are pricing in earnings which are set to be achieved far into the future, and thus most associated with growth stocks. Tesla is the highest profile example, whereby it was amongst the US’s most valuable companies long before it generated any positive earnings.

Just as with bond yields, rising interest rates (in response to rising inflation expectations) would increase the opportunity cost of holding these investments, when compared to ultra-safe government bonds, as well as increasing the financing costs for new ventures.

While many companies have been prudent enough to lock in long term debt at current rates, future investment projects which are yet to be funded would see their costs rise. Growth investing has already began to suffer as a consequence of this, just see the 18% drawdown of Scottish Mortgage in early Q2 2021, the moment when the markets began to come to terms with inflation.

If investors wish to avoid any future pain it may be time to rotate into less inflation-sensitive strategies, like BlackRock North American Income Trust (BRNA), whose value orientated strategy inherently makes it a ‘shorter duration’. Yet BRNA’s large overweight to financials makes it primed to actually benefit from increasing inflation, as rising interest rates and economic activity are positives for banks’ profitability.

Hardened growth bulls may simply baulk at the idea of economic growth hindering their long-term returns, with some professional managers believing the fear of major interest rate rises is overblown.

Such investors may thus end up seeing any near-term volatility as a rare entry point into a long outperforming style. In fact, sustained upwards growth and improving consumer spending is often a godsend for small cap strategies, which are acutely sensitive to domestic economic growth and consumption. Even today there are some unusual opportunities in growth biased small cap trusts, such as Brown Advisory US Smaller Companies which trades on 8.5% discount (as of 31/08).

We believe that there is one economic outcome which may curb the rise in inflation, and that is increased global taxation, as it would partially curtail the rising consumption driving economic growth.

The huge stimulus packages which were implemented during and post pandemic will need to be funded and, with the freedom from scrutiny that COVID-19 afforded policy makers now dissipating, questions need to be asked about how sustainable the government balance sheets are post-pandemic.

We believe, like many academics, that economic growth is the key to debt sustainability. It should be the consensus that debt serviced by increased revenues due to economic growth is preferred to debt serviced by increased taxation.

The question we believe investors need to ask is, is the post COVID-19 debt burden now so great that increased taxation is now unavoidable? The US has already begun to push other developed nations into harmonising global corporate taxation.

The UK is a prime example of the conundrum investors face here, as we argue in last week’s editorial, whereby our national debt has increased to 97.4%, erasing much of the work done by our austerity policies, but we also have one of the highest predicted growth rates of any G7 nation.

If investors believe that growth will win the day, strategies like Invesco Perpetual UK Smaller Companies, which trades on an 8.7% discount, may seem like an attractive proposition. More bearish investors may instead prefer more fiscally prudent countries, such as China or Germany, whose stronger fiscal positions may allow them to avoid the need for restrictive policies like higher taxes. We believe that trusts such as Henderson European Focus Trust would suit concerned investors, given its large weighting to fiscally responsible European countries.

 

Scenario three: What do bubbles usually do?

 

Wherever you look, there is a new paradigm opening up, offering the prospect of limitless growth. In technology around the globe, we find beneficiaries of business’ move to cloud computing, or consumer platforms such as Google, Facebook, Tencent or Alibaba to name but a few.

Tired of this as a growth theme? Look no further than the opportunities presented by the need to address climate change – either in the form of niche businesses offering solutions to help companies de-carbonise or the providers of materials to achieve this (think miners and the next commodity super-cycle).

Alternatively, one might look to the new era of healthcare which promises to use gene sequencing to provide a wide range of personalised healthcare solutions which will transform the way we look after those in need.

In Minsky’s book Stabilizing an Unstable Economy (1986), he describes five stages of a typical bubble:

First comes displacement, where investors fall in love with a new paradigm, likely helped by low interest rates. As we discuss above, there are plenty of these!

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Second, prices rise with new participants entering the market (such as retail investors).

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Third, euphoria sets in as traditional valuations methods are ignored. Schiller’s CAPE ratio for the S&P500 is now around 38, a level last seen in the dot.com bubble of 2000.

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Fourth, profit taking by ‘smart money’, which is notoriously hard to determine given it presages the peak in markets. It occurs to us that it is probably only possible to tell who the smart money is in retrospect. That said, this article on 26 August from the FT caught our attention: “Wavering US investors cut leverage for first time since start of pandemic”. Perhaps it is starting? It’s unlikely, but we couldn’t rule it out.

Finally, the fifth stage is where panic sets in as investors seek to liquidate at any price. Q1 2020 provided a lesson that previously only seasoned investors had sat in before. The panic stage is all pervasive, and all investing rules go out of the window including liquidity and any semblance of sensible pricing. As we discuss in this article, the reduction of active investors in favour of passive strategies will reduce liquidity in times of crisis, meaning market moves might be even more extreme in the future.

For all the potential doom and gloom outlined above, we actually see many of the structural tailwinds to the growth stories we outline above continuing for a good many years yet. Innovation is happening at a faster and faster pace, and so our central case is that those companies that successfully disrupt incumbents will continue to generate good returns for their investors.

That said, there are signs that things may have got ahead of themselves and, as the punch in the bowl starts to run out, it usually pays to edge closer towards the exit doors. So called ‘meme stocks’, Bitcoin, negative interest rates, SPACs, IPO activity, and the all-pervasive ‘TINA trade’ are all potential warning signs. The problem with TINA is that “there is no alternative” to equities. But what if there is?

Within the investment trust world, finding negatively correlated strategies is hard. In our view BH Macro (BHMG) provides one of the better potential insurance policies against market volatility. BHMG is a feeder into the Brevan Howard Master Fund, a macro hedge fund.

The Master Fund aims to generate capital growth through a combination of global macro and relative value trading strategies. Historically it has generated its highest returns when stock markets have suffered big falls – such as in 2008/09, 2011 and more latterly in 2020. BH Macro has recently merged with BH Global, resulting in a significantly larger and more liquid vehicle.

Other diversifying trusts which could be worth bearing in mind with an objective of de-risking a portfolio include Ruffer Investment Company, Capital Gearing, or Personal Assets all of which we define as ‘protective diversifiers’ in our recent examination of the AIC’s Flexible sector.

Alternatively, real assets and particularly those such as renewable energy infrastructure or traditional infrastructure could also offer respite over the medium term from a correction. Their typically fixed and longer-term leverage, combined with resilient cashflows that sit behind high dividend yields might offer better protection than bond markets. That said, all of the trusts we mention will likely suffer from discounts widening over the short term, as was the case during Q1 2020.

 

Scenario four: Ping Pong

 

Having been the darling of international investors when the pandemic first hit, Chinese equity markets have taken a huge whack back over the net this summer: is this a momentary setback or a change of trend as investors scent a change in direction from China?

It seems investors tend to believe the former, at least judging by the discounts on the China specialist trusts versus their peers. Over the past three months the China specialists are down an average of 13.3% according to JPM Cazenove, yet sit on an average discount of just 3.5%. Indian trusts are up 11.4% yet sit on a 12.5% average discount (all data as of 27/08/2021). The average global emerging markets trust discount is 8.6%. This implies strong confidence in China’s prospects, but is it complacency?

Most of the focus in recent months has been on the technology and ecommerce giants, which have come under increased regulatory pressure. Alibaba, Tencent and Meituan all performed extremely well last year, but have had the Chinese Communist Party take a critical eye in 2021.

The government has clearly taken umbrage at Alibaba’s attempt to force a new business model into the financial system, is worried about the time Chinese youths spend playing Tencent’s video games and believes Meituan and Alibaba have both been deploying anticompetitive practices. However, in discussing these issues, investors often end up arguing about motivations of politicians, which is clearly open to subjectivity, particularly in an authoritarian one-party state like China.

Some investors and commentators have argued there may be a more general shift in policy or attitude underlying the regulatory actions against these individual companies, and against the online education sector. It may be that the Party is concerned to avoid individual business owners gaining too much social, financial and cultural power.

However, we think it unlikely the general trend of policy will change from the overarching purpose of bringing China into the global financial system in order to exploit it. A lot of political and financial capital has been spent on this and, by bringing Chinese markets into the global economy, China gains power over the investors, consumers and business customers that depend on it.

The actions probably should serve as a reminder that China is a centrally commanded economy at its core, and government decisions could see market leadership change. Some managers we speak to think the significance of these moves is that the Chinese government is placing greater emphasis on hard tech rather than soft tech.

This may be for social purposes or reasons of global politics but, in any case, it could be an interesting development which may mean the main consequence for investors would be to switch their Chinese exposure rather than reduce their weight to the country overall.

There are reasons to be more cautious in the short-term though. Sceptics have been warning of China’s debt load for over a decade, but there are some indications that problems in the housing sector are tipping over into the banking sector, which are potentially troubling.

As the Chinese population peaks, demand for housing will potentially fall over the coming years. The government has been pressuring developers to reduce borrowing and limit development. Reuters reports this is starting to be felt in bank’s balance sheets, with Ping An Bank seeing bad debts in the real estate sector triple in the first half.

Evergrande Group, the most indebted developer in the country and the second-largest, issued a profit warning last week. Issues in companies like this would be systemic. The Chinese government seems to have seen this coming, but is not in control. It’s worth remembering that the 2007/08 crisis began in the US real estate sector before spilling over into the banks that had lent against those assets.

In our view, this is a good time to be diversifying emerging market exposure away from China. There are enough clouds around the leading sectors and the economy to think the stunning outperformance of the past few years is unlikely to be repeated in the near future. While we would not sell out of the country, we do think trusts like BlackRock Frontiers, Barings Emerging EMEA Opportunities and BlackRock Latin American look attractive on their wide discount and with their exposure to fast-growing emerging markets which in many cases are looking to develop industries which have been such a great success in China in recent years.