Investment Newsletter August 2017
Conflict Management The capital of North Korea is Pyongyang, which literally means “Peaceful Land” in Korean. The irony will be lost on President Donald Trump as he threatens retaliation for any potential “unwise act” by the Koreans, declaring that the US military is “locked and loaded”. By all accounts, North Koreans have been on a war-footing for decades but now tensions have heightened between the two countries.
Neal Foundly
Japan, could be extremely damaging in the short term in terms of loss of life and cost of damage. Longer term, industrial supply chains may be broken and global trade would be significantly affected. In the face of these scenarios, what should we do if the missiles start to fly?
No-one, including ourselves, knows how this will pan out but clearly we wish for a peaceful resolution.
Investment Analyst
This does, however, pose a dilemma for asset markets and in particular for investors. Obviously, the direct and indirect effects of a conflict, especially if it broadens out to include China and
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter August 2017
Nuclear Reaction
The knee-jerk reaction in most markets would be SELL! This is perfectly understandable given the potential scale of financial damage that conflict can bring. By nature, humans are hardwired to be very sensitive to losses, resulting in the fear of losses compelling investors to push the sell button. It’s usually wrong. Unfortunately, trading on instincts, especially fear and greed, is not an investment strategy. As Table 1 (showing the price returns from the S&P 500 Index in the US after major historic events) illustrates, not only does the share price usually bounce back the following day but returns increase following such events:
This does not just apply to war. Take the surprise Brexit outcome in the UK last year when the FTSE 100 Index fell 2.6% on 27 June when the result was announced that the UK had voted to leave. We know of one large UK equity fund that took the view that this was a major risk for the UK economy and decided to sell on the day of the announcement. It was selling stocks like housebuilders which fell by around 40%. Notionally this would seem like reasonable risk management for a portfolio in the face of impending economic disaster but in reality it was locking in losses that seriously impaired returns. One week later the Index was up 10% and housebuilders were 20% higher.
Table 1:
The next day
1 month after
3 months after
World war 2
11.9
13.2
8.8
Vietnam War
0.2
7.3
2.9
Cuban Missile Crisis
0.6
5.6
14.5
JFK Assassination
4.0
6.7
11.5
MLK Assassination
-0.6
5.1
7.5
Iranian Hostage Crisis
-0.7
4.2
11.6
9/11 Terrorist Attacks
-5.5
0.4
4.0
Source: http://blog.simplymoney.net/blog/how-will-the-paris-attacks-affect-the-markets *S&P 500 price returns; data obtained from Bloomberg
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter August 2017
Fear Less
The key reason for this is that asset markets are discounting mechanisms.
the fact that some investors may have anticipated the outcome correctly will reduce the impact.
In other words, markets always have a degree of expectation of events, especially a conflict which is usually preceded by a period of antagonism between the warring parties in which investors, at the margin, can adjust their positions for the different potential scenarios.
After the event, when investors realise that their worst fears have not materialised and more rational thinking takes over, they (rightly) start to use the excessive market weakness as a buying opportunity, usually resulting in the positive returns following the event.
The market may get the eventual outcome wrong, which will result in a large movement on the day, but
Defensive Measures
In the face of this, what is Equilibrium doing? Stepping back from the immediate events in the Korean Peninsula, you may recall from our briefings and newsletters in recent months that we are relatively cautious on the valuations of many of the major asset markets. We have been concerned that many markets in recent years have been buoyed by central bank quantitative easing (QE) programmes which have pumped trillions of pounds into asset markets.
Today, however, they act more to support markets, as Chart 1 from the investment bank Citigroup shows with the level of central bank purchases (dark blue) set against the 3-month rate of change in the global equity index, the MSCI World Index (light blue): Clearly, there is a close correlation. However, as central banks look to unwind their QE programmes this year and going forward, there is a clear danger that this monetary support will serve to reduce support for the high valuations.
Ten years ago, these programmes were introduced to boost flagging economies after the global credit crisis.
Chart 1:
Source: Citi Research, MSCI, Haver Analytic
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter August 2017
Locked and Loaded
As such, Equilibrium portfolios are relatively defensively positioned. This defensiveness is partly reflected in larger holdings in defined returns products and also in greater cash holdings compared to our long term strategic weightings. This puts the portfolios in a relatively good position to not only weather a pull-back in the markets but be quick to respond if good buying opportunities present themselves. So far, equity markets have barely twitched in response to the US/North Korean tensions. Indeed, markets have been unerringly quiet with volatility at historic lows over the last year. In the US, the equity market has not had a pullback of 5% or more in over 280 days, the fourth longest streak since 1960^.
Known and Unknown Unknowns
Most recently in the portfolios we reinvested the proceeds of the Credit Suisse autocall kick out into a fund of autocall products, the Atlantic House Defined Returns fund, to maintain the exposure to these capitalprotected products. In addition, some of the holding in US equities has been reduced and reinvested in a Goldman Sachs India fund which allows us to tap into the exciting investment opportunities in this emerging economy. For more information on these new investments, please see the respective blogs on the Equilibrium website for Atlantic House* and India**.
Will a conflict between the US and Korea be the catalyst to a major market correction? Will the unwinding of QE pull the markets back this year? Will something else blindside investors? Any one or all of these factors may come into play. If they do, we will be in a good position to respond given the positioning of the portfolios and experience of market shocks over many decades. As we have seen, such events can breed excessive fear which can provide good opportunities for nimble investors. However, a key lesson to remember is when there is nothing to do, do nothing, and ultimately patience will be rewarded.
References * https://www.eqllp.co.uk/blog/thinking-outside-thedefined-returns-box/ ** https://www.eqllp.co.uk/blog/ready-steady-goa-4factors-driving-our-new-investment-in-india/ ^https://www.nbc.ca/content/dam/bnc/en/rates-andanalysis/economic-analysis/hot-charts-11aug2017.pdf
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter August 2017
General Economic Overview Recent economic indicators point to a slight slowing of growth in recent weeks. The rising tensions between US and North Korea could exacerbate the situation with a fall in investor and corporate confidence. In the UK, there are signs that consumer spending is slowing as wages fail to keep up with inflation which remains elevated as the weak value of sterling pushes up the price of imported products and services. Many of the central banks with active quantitative easing programmes are expected to begin reversing the loose monetary policy now that growth has become more self-sustained. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Many major equity markets are fully or over-valued. US and European markets in particular do not offer compelling value and in relative terms, our valuation indicators point to better value in markets like Asia including Japan. Our score is unchanged over the month.
-5
Fixed Interest We generally prefer corporate bonds to government bonds and are positioned towards bonds which have low sensitivity to interest rate movements given the potential for higher rates going forward. The score is unchanged over the month.
-4
Commercial Property Returns from commercial property are likely to be mid-single digit percentage. Rental income will be the main component of returns rather than the higher pace of capital growth seen in recent years. Brexit raises particular issues for the London office market and we are avoiding this part of the market.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-4 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and equity, and hold only a small amount of property. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.