Read the article in full (5 min read)
Following the post-COVID restart, there would necessarily be an inflationary spike, from base effects alone. Central Banks’ core thesis was that this spike would be “transitory”, rather than “persistent”.
However, the combination of pent-up demand, supply chain disruptions and an energy crisis suggests that inflation could prove more persistent than transitory.
We look at the numbers and how this informs the “big picture triangle” of three key macro factors: growth, inflation and interest rates.
Finally, we outlined potential interventions in portfolio positioning from an asset allocation perspective. Nominal bonds are known to be structurally challenged in an inflationary regime, and propose real asset exposure instead. Within equities, we would propose an income/value bias.
Regiser for our 3q21 Review & Outlook: The Big Squeeze
US inflation at highest level in 13 years running at +5.4%yy for second month, Core inflation (excl energy) +4.3%yy (Jul) from +4.5% (Jun).
With a slight moderation in core inflation, economists are calling this as the inflation "peak".
Whilst this may represent "peak inflation" year over year, overall inflation levels will remain elevated on restart and supply chain constraints
As explored in our recent article on “catch-up” rates, we believe Fed policy will remain accommodative, with interest rates "lower for longer", as it lets inflation run "hotter for longer". This is positive for risk assets that offer inflation protection
In inflationary regime we favour value-bias equities and real assets for diversification.
[3 min read, open as pdf]
The inflation theme is resonating in US earnings calls with company CEOs seeing this "temporary regime" lasting longer into 2022. In terms of prints, June CPI in the US was +5.4% and core CPI +4.5% - the highest print since November 1991.
Markets have been caught between a push-pull between inflation data and interest rate policy response. Concerns that inflation is more persistent than transitory is driving flows to “risk on” assets. Related concerns that the Fed might start tightening policy earlier and sharper has been the “risk off” trade.
Looking at inflation “catch-up” rates suggests that the Fed might let inflation run hotter for longer, pointing to a later lift off in rates from current low interest rates. This would be supportive for risk assets.
What are “catch-up” rates?
In 2020 ahead of the annual Jackson Hole conference the Fed indicated that it would take a more accommodative approach to inflation crossing the 2% target threshold.
Why is this? Part of the answer is the concept of “catch up” rates. Essentially this means that a rate above 2% temporarily is ok if it means we are getting back to a 2% long-term trend-line.
Effectively, letting inflation run hot and overshoot target in the short-term can make up for system slack/undershoots in prior years.
What are the reference points?
We don’t’ know the reference points (basis, trend-lines or catch-up period) the Fed will be using in its Policy decisions.
So to illustrate this concept of “catch up rates”, we created an example with cumulative inflation (left hand scale) and average inflation rates (right hand scale).
We took December 2005 as a base, applied a cumulative 2% target inflation path (in blue), and then plotted cumulative path based on actual inflation rate (in green, averaging (dotted green line) 1.87%p.a. to June 2020 – i.e. below target rate).
The red dashed line is the implied path back to trend-line assuming a “catch-up rate” of 2.65%p.a. (red-dotted line) that it would take for inflation to get back to the original trendline over 3 years.
The catch up rate would be higher if using a shorter time-frame, and lower if using a longer-time frame.
Looking at implied three year “catch-up” rate helpso illustrate the concept and explains why Fed might let inflation run hotter for longer, pointing to a later lift off in rates.
In inflationary regime we favour value-bias equities and real assets for diversification.
Find out more in our quarterly review and outlook.
[10 min read, open as pdf]
In this white paper, we revisit the core principles of inflation
[15 min read, open as pdf]
[3 min read, open as pdf]
Inflation is on the rise: equities provide long-term inflation protection
Inflation risk means greater focus on intrinsic value such as dividends
UK equities with value and/or income bias are attractive
Inflation is on the rise, and whilst it’s broadly accepted that equities can provide a long-term inflation hedge, which kind of equities are best positioned to provide this.
Since the financial crisis, Value investors have been jilted by a market love affair with Momentum. The switch back to Value was already being called on purely a valuation basis since late 2019. But the rekindling of inflation risk in the market is only making companies with a Value-bias and a progressive quality income stream back in the spotlight.
What is quality income?
Quality means persistency, focusing on companies that regularly pay a stable or increasing dividend, whilst mitigating dividend concentration risk.
“One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back many years.”
Indeed, research suggests that Dividends are a key anchor of Total Returns, although this differs from market to market.
Figure 1: Source: S&P Dow Jones Index Research August 2016
Figure 2: Source: JP Morgan, The Search for Income: A Global Dividend Strategy, 2012
How then to screen for companies that can deliver this type of strategy? Is it just about yield? We don’t think so.
High yield is not high quality
Screening for high dividend yield alone can lead to “value-traps” that negatively impact performance.
The poor performance is because those high-yielding companies might be poor businesses with unstable dividends.
Market cap weight or Dividend contribution weight
Traditional equity indices are market-capitalisation weighted. The resulting dividend income for an index is therefore a function of each company’s size. An alternative approach is to weight the holding in each company by its contribution to overall dividends. This way the index is focused on the biggest dividend payers, rather than the biggest companies by size. This creates a direct bias towards Yield, and an indirect bias towards Value, from a factor-exposure perspective.
Forward- or backward-looking
Active equity income managers typically look at forward-looking dividend estimates. Index-based “passive” equity income strategies often look at historic dividend yield for ranking purposes. This is sub-optimal. We believe that index strategies that focus on equity income should use forward-looking estimates, to systematically capture upswings in earnings and dividend estimates.
Equities as an inflation hedge
It’s broadly accepted that equities can provide a long-term inflation hedge. But what kind of equities are likely to perform well in an inflationary regime?
We believe there are three characteristics:
Why the Value focus in inflationary environment?
When the two major styles of investing are compared, i.e., growth and value investing, the latter style rejects the efficient market hypothesis and choses an equity with lower expectations, which is often undervalued and would profit quickly when the market adjusts itself.
During an inflationary environment, economic concepts direct that the ‘time value of money’ has a major role to play. Thus, an equity today, becomes of greater value, when compared to its worth tomorrow. Hence, value investing seems attractive in an inflationary world since the investors are less willing to pay up for future earnings and can regain their money sooner rather than later, when compared to growth investing. (Murphy, 2021)
With a global pandemic, many predicted deflation as a threat; however, with the counter-balancing forces, investors soon realized inflationary threat. (Baron, 2021). Rising inflation is good for value investing for a number of reasons. In general, equity markets are dynamic and display a stronger corelation to inflationary environment, this lays a very strong premise that higher inflation and stronger earnings are co-dependent. Financially speaking, Sectors such as energy, financial are major drivers of the major economic growth. A rise in these value stocks tends to pace up the overall economic growth, thus outperforming others. (Lebovitz,2021)
According to JP Morgan’s chief strategist, the change in investing style, this time around could be a more impactful due to several factors such as the failure of monetary and fiscal policies whilst recovering from a pandemic. (Ossinger, 2021)
Dividends, dividends, dividends: a tried and tested approach
The most fundamental explanation, by John Kingham, a value investor, states that a dividend discount model, attempts to find the true value of the stock, under any market circumstances and focuses on the dividend pay-out factors and the market expected returns.
Historically, the companies with dividend have generated higher returns when compared to companies which either have no dividend or eliminated the dividend. (Park and Chalupnik, 2021) This means that dividends hold value when it comes to the total return of the portfolio.
Moreover, with the market getting more and more inflationary, and equities getting exposed. Adding companies which can provide returns even in a low growth environment can create a sustainable portfolio.
Government bonds have not performed well with rising inflation (Baron,2021) High yielding corporate bonds offered better protection compared to government gilts since these inflations linked bonds add value in-line with RPI Inflation according to Barclays Equity Guilt Study and can protect investors from unexpected inflation, yet they are still not considered as a safe haven like government gilts. (Dillow,2021) Investment manager of Iboss Chris Rush recently told Portfolio Adviser that in order to reduce the inflationary shock the firm had already reduced its positions from treasures and gilts and incorporated strategic bonds They also plan on holding a short duration fixed income. (Cheek, 2021)
Although, it might have not been the fundamental goal, over the past several decades until 2017 dividends reported 42% of the S&P 500 Index’s total return. The global recession and now pandemic have created a lack of stability for the layer of support for future returns, however, analysts have assured there is room for recovery. (Markowicz, 2021)
Whether transitory or persistent, with inflation on the rise, there is a strong rationale for having an allocation to Value from a factor-exposure perspective. Those value-type firms that generate and pay a progressive dividend policy provides a level of inflation protection both in absolute terms and relative to bonds that is more than welcome, and potentially essential.
Henry Cobbe & Aayushi Srivastava
[3 min read, open as pdf]
Inflation is on the rise
Easy central bank money, pent up demand after lockdowns and supply-chain constraints mean inflation is on the rise. Will Central Banks be able to keep the lid on inflation? The risk is that it could persistently overshoot target levels.
It matters more over time
Inflation erodes the real value of money: its “purchasing power”. If inflation was on target (2%), £100,000 in 10 year’s time would be worth only £82,035 in today’s money. But on current expectations, it could be worth a lot less than that.
Real assets can help
A bank note is only as valuable as the value printed on it. This is called its “nominal value”. Remember the days when a £5 note went a long way? When inflation rises, money loses its real value.
By contrast, real assets are things that have a real intrinsic value over time whose value is set by supply, demand and needs: like copper, timber, gold, oil, and wheat.
Real assets can also mean things that produce an regular income which goes up with inflation, like infrastructure companies (pipelines, toll roads, national grid etc) and commercial property with inflation-linked rents.
Rethinking portfolio construction
Including “real assets” into the mix can help diversify a portfolio, and protect it from inflation. Obviously there are no guarantees it will do so perfectly, but it can be done as a measured approach to help mitigate the effects of inflation. The challenge is how to do this without taking on too much risk.
Find out more about our Liquid Real Assets Index
[3 min read, open as pdf]
We look at 1Q21 in review and the outlook ahead.
The economic restart will be sudden, with substantial pent up demand. Corporate and personal balance sheets have been supported which should provide confidence in investment and spending.
From a monetary policy perspective, the focus remains on the delicate balance between bond yield and inflation. Stable, negative real yields are supportive of risk assets. 10 year breakeven rates have climbed further since year-end amplifying demand for inflation-hedges.
With nominal bonds under pressure, there is support for risk-asset. Advisers looking at liquid alternatives to bonds such as property and infrastructure: need to balance the required exposure to inflation-protecting assets with up-risking client portfolios. This balancing act means it’s time to rethink the 60/40 portfolio.
The rebound in risk assets is made even more pronounced, owing to a base effect from last year’s market lows. Timber and Listed Private Equity have been the best performing asset classes in GBP terms on a 12 month view.
For factor-based strategies, World Equity Value factor outperformed all other factors +12.3%, compared to +3.79% for World Equity, for the first three months of 2021.
The breadth and deconcentrating have been rewarded in the first quarter with equal weight US equities returning +11.49%, compared to +6.17% for the traditional cap-weighted S&P500, in USD terms, in the year to March.
Regime indicators point to markets being overbought in the near-term.
For the full update, please view our Webinar
[3 min read, open as pdf]
A “last resort” policy tool
Zero & Negative Interest Rate Policy are Non-Traditional forms of Monetary Policy is a way of Central banks creating a disincentive for banks to hoard capital and get money flowing.
Zero Interest Rate Policy (ZIRP) is when Central Banks set their “policy rate” (a target short-term interest rate such as the Fed Funds rate of the Bank of England Base Rate) at, or close to, zero. ZIRP was initiated by Japan in 1999 to combat deflation and stimulate economic recovery after two decades of weak economic growth.
Negative Interest Rate Policy (NIRP) is when Central Banks set their policy rate below zero. Japan, Euro Area, Denmark, Sweden are currently using a NIRP. US & UK are currently using a ZIRP, and are considering a NIRP.
Fig.1. Advanced economy policy rates
Whilst bond prices may imply negative real yield, or negative nominal yields, a NIRP impacts the rates at which the Central Bank interact with the wholesale banking system and is intended to stimulate economic activity by disincentivising banks to hold cash and get money moving. A NIRP could translate to negative wholesale rates between banks, and negative interest rates on large cash deposits, but not necessarily retail lending rates (e.g. mortgages).
Ready, steady, NIRP
Negative Interest Rates were used in the 1970s by Switzerland as an intervention to dampen currency appreciation. . It was the subject of academic studies and was seen as a last resort Non-Traditional Monetary policy during the Financial Crisis of 2008 and during the COVID crisis of 2020. Sweden adopted NIRP in 2009, Denmark in 2012, and Japan & Eurozone in 2014. The Fed started looking closely at NIRP in 2016.
According Bank of England MPC minutes of 3rd March 2021, wholesale markets are generally prepared for negative interest rates as have already been operating in a negative yield environment. By contrast, retail banks may need more time to prepare for negative interest rates to consider aspect such as variable mortgage rates.
There are arguments for and against NIRP. The main argument for is that NIRP is stimulatory. The main argument against is that NIRP failed to address stagnation and deflation in Japan and can create a “liquidity trap” where corporates hoard capital rather than spend and invest.
The hunt for yield
With negative interest rates, there will be an even greater hunt for yield. We look at the some of the options that advisers might be invited to consider.
Getting the balance right between additional non-negative income yield and additional downside risk will be key for investors and their advisers when preparing for and reacting to a NIRP environment.
[3 min read, pdf version]
Moderate turnover strategies: Monthly Elson Market Indicator
The Monthly EMI ended January 2021 at 62.37 vs 63.12 at end December 2020.
For moderate turnover strategies, equity markets continue to look overbought.
This drives a preference for lower relative position in risk assets.
The Monthly EMI remains above the threshold (60) for a move to a Neutral position in risk assets.
Momentum in the VIX Index increased from 50.9 to 54.4, whilst in absolute terms, the VIX Index closed the month at 33.1, compared to 22.8 at previous month end.
High turnover strategies: Weekly Elston Market Indicator
Over the last 4 weeks, the Weekly EMI declined from 63.87 to 59.35, as at last Friday close, falling below the 60 threshold.
Momentum in the VIX Index increased from 48.56 to 54.35 over the last 4 weeks.
[3 min read, open as pdf]
Growth shock is short and sharp
The medium-term outlook for growth points more to a “short sharp shock” rather than a protracted downturn that followed the Global Financial Crisis. However vigilance around economic growth, and ongoing dependency on vaccine rollout, fiscal and monetary policy support remains key.
Even lower for even longer interest rates
Even lower for even longer interest rates underpins an accommodative strategy to support recovery: but also has created frothiness in some asset classes.
Low nominal and negative real yields is forcing investors into refocusing income exposures, but should not lose sight of quality.
Inflation in a bottle: for now
Inflation caught between growths scare on the downside and supportive policy on the upside. Should inflation outlook increase, nominal bond yields will be under greater pressure and inflation-protective asset class – such as equities, gold infrastructure, and inflation-linked bonds can provide a partial hedge.
Trade deal with EU should reduce GBP/USD volatility
The 11th hour trade deal concluded in December between the UK and the EU should dampen the polarised behaviour of GBP exchange rate, with scope for moderate appreciation, absent a more severe UK growth shock.
Market Indicators: recovery extended
Market indicators suggest equities are heading into overbought territory and whilst supported by low rates and bottled inflation, are looking more vulnerable to any deterioration in outlook. Incorporating risk-based diversification that adapts to changing asset class correlations can provide ballast in this respect.
With respect to 2021 outlook
[2 min read, open as pdf]
A Factor-based approach to investing
Factor-based investing means choosing securities for an inclusion in an index based on what characteristics or factors drive their risk-return behaviour, rather than a particular geography or sector.
Just like food can be categorised simply by ingredients, it can also be analysed more scientifically by nutrients. Factors are like the nutrients in an investment portfolio.
What are the main factors?
There is a realm of academic and empirical study behind the key investment factors, but they can be summarised as follows
The different factors can be summarised as follows:
Which has been the strongest performing factor?
Momentum has been the best performing factor over the last 5 years. Value has been the worst performing factor.
Fig.1. World equity factor performance
Source: Elston research, Bloomberg data
A crowded trade?
Data points to Momentum being a “crowded trade”, because of the number of people oerweighting stocks with momentum characteristics. This level of crowdedness can be an indicator of potential drawdowns to come.
Fig.2. Momentum Factor is looking increasingly crowded
Source: MSCI Factor Crowding Model
The best time to buy into a Momentum strategy has been when it is uncrowded – like in 2001 and 2009, which is also true of markets more generally. MSCI’s research suggests that with crowding scores greater than 1 were historically more likely to experience significant drawdowns in performance over subsequent months than factors with lower crowding scores.
Fig.3. Factors with higher crowding score can be an indicator of greater potential drawdowns, relative to less crowded factors
Source: MSCI Factor Crowding Model
Rotation to Value
The value-based approach to investing has delivered lack lustre performance in recent times, hence strategists’ calls that there may be a potential “rotation” into Value-oriented strategies in coming months as the post-COVID world normalises. But can factors be timed?
Marketing timing, factor timing?
Market timing is notoriously difficult. Factor timing is no different. To get round this, a lot of fund providers have offered multi-factor strategies, which allocate to factors either statically or dynamically. Whilst convenient as a catch-all solution, unless factor exposures are dynamically and actively managed, the exposure to all factors in aggregate will be similar to overall market exposure. This has led to a loss of confidence and conviction in statically weighted multi-factor funds.
Factors help break down and isolate the core drivers of risk and return.
For more on Factor investing, see
A local problem?
In January, when the Coronavirus story broke in China, the global response was that this was a localised issue.
Like other viral outbreaks such as SARS (2003) and H1N1 (2009), the issue look localised to China and Asian Emerging Markets.
In February, as the virus spread aggressively in South Korea and Italy, markets woke up to the fact that this was a global issue. The questions being how far would it spread; how fast would it spread; and how long would it last?
All of these questions were to ascertain how materially the outbreak would impact global growth, as demand falls, businesses' cash flow struggles and supply chains are disrupted.
A false sense of security
What was deceptive is that the time from the first infection in a country to the virus "j-curving" has been quite long 20-30 days. This gave Europeans a false sense of security that the outbreak was containtable.
The chart below shows the J-curve as to how long it has taken for some key countries to reach 1,000 cases. The reality is that once it gets going, containment is difficult without some of the extreme measures introduced quite promptly in Wuhan (wide area quarantines or "lockdowns"), and more recently in Italy.
Tracking the J-curve gives helpful cues as to when the UK government might move through the different phases of its response plan to Contain, Delay, and Mitigate the virus' impact undperpinned by Research.
On this basis, whilst we are still in the Contain stage, we can expect to move into the Delay stage (closing schools, cancelling large scale gatherings, encouraging working from home) in coming weeks.
Economic impact and policy response
The economic impact of self-isolation, travel restrictions and lock-down are in addition to the human cost of the virus. That is why we have seen, and expect to continue to see, a co-ordinated economic policy response that supports business, monetary policy and markets.
Meanwhile, in China, where the outbreak started, case numbers have plateaued suggesting that the drastic measures taken have worked, and that it is in aggregate a 2-3 month disruption.
The next 4-6 weeks will see an acceleration in cases in key European and potentially US markets. So we may not be at "peak panic" yet at a social level, but the key question for markets is will this be a short run (3-6) month impact on otherwise resilient trend growth, or a trigger to a global recession. Our view is the former, but there's more fear to come first.
Conservatives are on track for a winning a clear majority in the UK general election.
The campaign has centred on a core message of Get Brexit Done which has appealed to traditional Tories and disgruntled Labour voters in Leave-oriented constituencies. Furthermore, a distrust of Labour’s leadership under a hard-left Corbyn has led to a significant reduction in Labour seats despite his popularity with youth activists.
A Brexit election
Each party’s position on Brexit has been the key driver for voting intentions, despite efforts by all parties to also focus on domestic policy and leadership personalities.
The Conservatives message was to get Brexit done. The Liberal Democrats was to Revoke Article 50, ignore the Referendum result and remain. Labour’s stance was to hold another referendum. Voters, like markets, wanted clarity over “dither and delay”.
With a clear majority, and an unambiguous mandate to deliver Brexit, some say that ironically, the bigger the majority, the softer the Brexit as Johnson will not be held hostage by hard-Brexit supporting “ultras” from the European Research Group. Meanwhile, Conservative MPs that have become independents or defected to the Liberal Democrats will vanish into obscurity.
Breaking through the “Red Wall”
The changing composition of the Conservative win is radical. Whilst some remain-leaning Conservatives voters (and MPs) have shifted allegiance to the Liberal Democrats, constituencies in Labour’s northern heartlands known as the “Red Wall” because they have not had a Conservative MP since the 1930s or 1950s. As predominantly Leave constituencies, voters have “lent” the Conservatives their vote as more trusted to deliver on Brexit after the shambles of a hung Parliament.
Love him or hate him, the result is a vindication of Johnson’s chief strategist Dominic Cummings who developed Johnson’s core strategy on becoming Prime Minister in July 2019 as “D.U.D.” standing for Deliver Brexit, Unite the Country, Defeat Labour. With the two D’s on track, it will then be for the U and a pivot to a domestic agenda once UK has left the EU on or before 31st January.
The Election in 3 Charts
1. Poll tracker
Based on an analysis of polling data by the BBC, average voting intentions on 11th December, the day before the election, pointed to 43% support for Conservative, 33% for Labour, and 12% for the Liberal Democrats.
Sterling has rallied on exit polls that pointed to a clear Conservative win, with markets encouraged at the prospect at the end of political deadlock, the end of any risk of a hard left Labour government, and the beginning of constructive engagement with the EU to get a comprehensive trade deal in place by December 2020.
On becoming PM, Johnson forewarned that “people are going to lose their shirts” by betting against Brexit, using the language of investment managers. For anyone short sterling over the past few weeks, that’s proven absolutely true.
3. ETF Flows focus on UK Small Caps
In the three weeks in the run up to the UK election, investors have been positioning for a Conservative win, with a record £151m flowing into the iShares MSCI UK Small Cap UCITS ETF (Ticker: CUKS) that focuses on domestically oriented smaller capitalisation companies.
The bottom line is like him or loathe him, Boris Johnson has through force of personality and message discipline won a majority by reaching across tribal party loyalties to secure a clear mandate.
We can expect a break-neck parliamentary agenda to deliver Brexit by 31st January 2020, before pivoting to domestic policy issues.
At last there will be clarity and focus over the next 5 years, and reduced risk of a hard left Labour. This is good news for the markets, but more importantly good news for the country.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) or “LON:” (London Stock Exchange). For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.
There is certainly going to be continued uncertainty in the run up to the Brexit Hallowe’en. We outline three political scenarios.
Hard Brexit: whilst Parliament has successfully passed a law to ensure the Government must apply for an extension if they cannot reach a deal by 31st October, there is still a risk of a Hard Brexit as there is an outside chance that the EU would not win unanimity from the EU27 to agree to grant an extension. 31st October 2019 exit from the EU therefore remains the legal default.
Extension: if there is no deal by 31st October, and the UK Government seeks an extension from the EU and it is granted (for example 31st March 2020), then the can has been kicked down the road further, and there will likely be a General Election that will serve as a bitter and contested rerun of the Referendum campaign. That General Election will either result in one of 1) a “Leave” mandate led by a fractured Conservative/Brexit Party, or 2) a “Remain” mandate from a Remain Alliance led by Lib Dems, or 3) a Labour government and second referendum.
Last-minute deal: there is an outside chance that the Prime Minister secures a Last-minute deal, that would be largely based on the existing Withdrawal Agreement, but with a Northern-Ireland only backstop. Whilst this would be the ultimate in “government by essay crisis”, it would at least provide resolution to this 3½ year saga, tragedy, comedy or farce (depending on theatrical preference).
What about the economy?
To gauge the UK economic outlook, we look at three key indicators: Growth, Inflation and Interest Rates.
Growth: Despite low levels of unemployment, Brexit uncertainty is weighing on the UK economy with GDP contracting -0.2% in the second quarter. Both manufacturing and service sectors have already shown signs of entering a downturn. The uncertainty around Brexit could slow the growth down even more. The GDP growth for 2019 is still projected at 1.2% by the Bank of England.
Inflation: Inflation is close to the Bank of England’s 2% target rate. Although the UK inflation is currently subdued, the expected rate of inflation remained at 3.2% . We estimate expected inflation using the 5 year breakeven rate, the difference between nominal and inflation-linked gilts yields. Put simply, this means that the market is expecting a higher level of inflation over the next five years than at present.
Interest Rates: The UK yield curve continued to be flat at the end of 2q19. The spread between 2Y and 10Y bonds decreased further from 27bps to 21bps when compared with last quarter, the smallest gap since 2008. BoE’s chief Mark Carney’s recent speech warning an intensifying global risks added more concerns of a near-term recession. In our view, there is no change to the “lower for longer” outlook for UK interest rates.
Asset class positioning
In the context of political and economic outlook, what are our views on asset classes?
Equities: Within an equity context, our portfolios do not have a domestic bias and are globally diversified, meaning that Brexit has limited impact on global equity risk compared to the bigger issues of the day, namely US-China trade disputes and US interest rate path. For reference, the UK is only about 6% of global equities (when counting both developed and emerging markets). So for globally diversified equity portfolios, Brexit has limited direct impact.
Equities are long run return drivers and are exposed to a broad range of currencies in terms of the revenues of the global companies that make up each market.
We do not believe that attempting to time the market for short run currency fluctuations, with regards to equity exposure, is worthwhile, and creates additional cost drag.
Key question: to hedge or not to hedge
However, for UK investors, currency positioning is key. In 2016, advisers that allocated to unhedged global equity exposure, and/or focused on large cap UK equities (e.g. the FTSE100) which have a high proportion of dollar revenues protected their clients from sterling devaluation.
Fig.1. World Equity Returns in GBP terms: unhedged vs hedged
Source: Elston research, Bloomberg data, total returns for respective ETFs. YTD 2019 is to 31-Aug-2019. iShares MSCI World (IWRD) and iShares MSCI World GBP Hedged (IGWD). All performance data in GBP terms.
In the event of a no-deal Brexit (legal default), we expect further GBP weakness in which case an unhedged approach continues to make sense.
In the event of an extension or a last-minute agreement, we expect GBP to recover towards 1.30 to 1.40 level respectively, in which case a tactical allocation to GBP-hedged global equity exposures would ensure global equity returns are delivered in sterling terms.
Fig.2. GBP/USD Spot and potential levels under different scenarios
Source: Elston research, Bloomberg data
Bonds: For bonds, most advisers rightly have a bias to domestic bonds for their clients to ensure alignment of client’s income and spending needs, as well as for protection in economic downturns (put simply: typically bond values are higher, when growth and interest rates are lower).
We expect UK interest rates to remain lower for longer under all 3 scenarios, whilst inflation remains contained. If we saw risk of higher UK interest rates, we would look at allocating client assets to shorter duration (e.g. <5 year) UK bonds that are less sensitive to changes in interest rates.
Alternatives: Property: We like property as a real asset that offers inflation protection. However, we see property as a potentially exposed asset class in the event of a no-deal Brexit. We would be concerned by the risk of reduced economic activity, business relocations and higher vacancies. For this reason our preference is for globally diversified funds that invest in shares of property companies, rather than for UK focused funds that invest in direct assets.
Alternatives: Commodities: We like commodities as a diversifier owing to their less correlated relationship with equities and bonds. However as we are late in the cycle, we are cautious commodities. However we see Gold as a traditional defensive asset in uncertain times, and note the risk of sustained upward pressure on oil prices amidst geopolitical tensions in the Middle East.
Positioning for a GBP recovery?
With Brexit doom and gloom mostly priced in, all eyes are on sterling which has become the Brexit barometer. So which way for sterling? Stating the obvious:
In the event of a relief rally in GBP, how can investors position portfolios accordingly?
Recall that the GBP currency impact on portfolios in 2016 was massive. As GBP depreciated, investors whose global equity portfolios were unhedged enjoyed strong performance thanks to the translation effect of foreign earnings. The same applied to FTSE 100 which looked stronger against a weakening GBP.
The reverse would also therefore be true.
Any significant appreciation in GBP would see (foreign) global equity returns offset by GBP strength and would weigh on the FTSE 100. So for those who were lucky enough to be unhedged as sterling fell can’t rely on luck if sterling rises.
Toolkit for GBP recovery
Like everyone else, we have no crystal ball as to how Brexit could play out, but we can identify some of the tools that investors may want to have in their armoury to implement their views, whatever their risk posture, in case of a GBP recovery.
We look a selection of exchange traded products to access currency pairs, ultrashort bonds, shorter duration bond and GBP hedged equities to implement a tactical position for different risk levels.
1. Short-term currency exposure
On the approach to and in the event of any deal, for very short term exposure (<1 month), investors could consider gaining rapid currency exposure by using a currency pair ETC and if seeking additional risk could use a leveraged exposure. Leveraged exposures should be short-term in nature and investors should ensure they understand the risks.
GBPP: ETFS Long GBP Short USD
LGB3: ETFS 3x Long GBP Short USD
2. Volatility dampener
Investors can tactically allocate to ultrashort GBP bonds if they are looking for a cash-like volatility buffer with more yield than cash with a GBP return profile.
Ultrashort duration Bonds
ERNS: iShares GBP Ultrashort Bond ETF
JGST: JP Morgan GBP Ultra-Short Income UCITS ETF
3. Short duration bond exposure
Tactical allocations to short duration GBP bond exposures is available both for UK gilts and GBP corporate bonds for investors seeking GBP bond exposure without being over-exposed to interest rate risk from the longer-duration nature of the main indices.
Short duration Gilts
IGSL: iShares UK Gilts 0-5yr UCITS ETF
GLTS: SPDR® Bloomberg Barclays 0-5 Year Sterling Corporate Bond UCITS ETF
Short duration GBP Corporate Bonds
IS15: iShares £ Corp Bond 0-5yr UCITS ETF
SUKC: SPDR® Bloomberg Barclays 0-5 Year Sterling Corporate Bond UCITS ETF
4. Equities hedged to GBP
To access equities hedged to GBP, rather than running a currency overlay, investors can access GBP hedged versions of mainstream ETFs. At 29-30bp TER, these are slightly more expensive than their conventional versions, but the cost difference represents the cost and convenience of running the currency overlay. Most regional equity ETF exposures offer GBP hedged versions, or investors can use ETFs tracking MSCI World (GBP hedged) as a proxy for risk assets. For example:
Global equities (GBP hedged)
IWDG: iShares Core MSCI World UCITS ETF GBP Hedged
XDWG: Xtrackers MSCI World UCITS ETF 2D – GBP Hedged
Whilst no deal is supposedly ruled out, there is no certainty as to what any deal would look like. Whatever the politics, if you believe there is potential for a recovery in sterling, ETPs provide tactical ways of positioning portfolios accordingly.
The absence of a clearly defined plan for Brexit is creating damaging uncertainty for businesses and the markets.
Leaving the EU, but remaining in the EEA through EFTA would address the concerns of the majority of Referendum voters, whilst also requiring a spirit of compromise from both sides.
Joining EFTA would immediately provide the UK with continued free trade within the EU/EEA, a more valuable set of external Free Trade Agreements, and the added flexibility to negotiate its own free trade deals bilaterally.
Setting a timetable for re-joining EFTA provides a straightforward solution that will give the necessary confidence and direction to businesses and the markets whilst respecting the outcome of the EU Referendum.
This paper, drafted for but not published by the Centre for Policy Studies in July 2016, sets out the rationale for Britain in EFTA or "BREFTA" and calls for greater engagement with the "C10": the largest ten Commonwealth economies.
We certainly live in interesting times. At the time of writing, nobody knows what’s happening with Brexit. Will a deal be reached to prevent a disorderly exit? Either way, what will be the impact on the UK and European economies? And how will markets respond?
In the circumstances, it’s understandable that many investors are considering reducing their exposure to equities until things become clearer. Investing is a hugely personal matter, and nobody should take more risk than they’re comfortable taking.
However, going to cash is not a decision that should be taken lightly, without serious thought or without seeking the opinion of a competent financial adviser. Regardless of Brexit, there’s a very strong case for keeping your portfolio exactly as it is.
So, if you’re thinking of sitting in cash while events unfold in Brussels, here are ten things need you need to bear in mind.
1. Timing the market is notoriously difficult. The evidence shows that it’s almost impossible to do it accurately with any long-term consistency, and the professionals are little better at it than the rest if us. And remember, you have to be right twice; you might get out at the “right” time and then spoilt it all by mis-timing your re-entry.
2. All known information is already incorporated into market prices. Current valuations reflect everything we know about Brexit and the likelihood of all the different outcomes. Do you honestly know something about Brexit that the rest of the market doesn’t?
3. It’s new information that causes prices to rise or fall, and that by its nature, is unknowable. True, government ministers and officials involved in the negotiations may be privy to vital information, but they’re bound by insider trading regulations so can’t act on it anyway.
4. New information is incorporated into prices within seconds, even milliseconds. If there is a significant development over the coming months, it will be absorbed so quickly by the markets that by the time you get to act on it, prices will either have risen or fallen already.
5. Correctly predicting the outcome of the Brexit negotiations won’t, in itself, be of help — unless of course you bet on it. To profit on the financial markets, what you need to do is predict how those markets will respond to the outcome you’re expecting, which is extremely hard to do.
6. Markets often react to big political events in unexpected ways. When an event is widely considered to be negative, markets often wobble initially but then recover and resume the course that they were already on. That’s exactly what happened after the Brexit referendum in 2016 and Donald Trump’s election later that year.
7. Investors typically allow their own political views to influence their investment decisions. Because most of us are prone to confirmation bias and to negativity bias to some extent, our expectations of what will happen if things either go our way or don’t go our way tend to be exaggerated.
8. The idea that there will soon be clarity over Brexit and markets will “return to normal” is unrealistic. It may well be that a deal is reached soon that takes Britain out of the European Union. But, as everyone knows by now, the divorce will be hugely complicated, and it may take many years, decades even, before the lasting effects of Brexit are clear.
9. Important though it is, Brexit isn’t the only show in town. There’s uncertainty everywhere you look, whether it’s the future of President Trump, the prospect of a global trade war or rising tensions between Russia and the West. And those are just the obvious risks. Regardless of whether the UK strikes a win-win deal with the EU that pleases everyone, or there’s a painful, disorderly exit, markets could still fall or rise sharply for a completely different reason.
10. There will always be reasons to bail out of equities. Throughout the long bull run that began in 2009, there’ve been scores of plausible arguments for getting out while the going’s good. If you had heeded any of them, you would have missed out on gains. Will it be Brexit that finally brings the bull market crashing to a halt? The bottom line is that nobody knows.
Again, you have to do what you think is right, and only time will tell what the “right” decision proves to be.
Whatever you do, though, beware of acting on emotions. Assuming that you and your adviser are comfortable with the risk you’re taking, and that your portfolio is thoroughly diversified and has relatively recently been rebalanced, the rational response is to sit tight and watch the political drama unfold.
A well flagged correction
There was near consensus amongst investment managers in their 2018 outlook as regards the risk of a market correction. Equity markets had climbed relentlessly higher in 2017 with little red ink and eerily low volatility.
The fact that equity volatility had converged with bond volatility illustrates the limitations of an asset-based approach to diversified multi-asset investing.
Of course, it was not to last. It was a question of “when, not if” equity volatility mean reverted. And now we at least know when “when” was.
Fig.1 VIX spikes as equity volatility comes back into play.
What was the trigger?
A potential trigger was identified as above-expected inflation trends, leading to increased expectations of monetary tightening. And so it was.
Higher than expected wage growth forced a reassessment of inflation outlook, creating expectations of additional Fed tightening.
What happens next?
A correction enables portfolio managers to consider a fresh look at portfolios.
What is risk-based diversification?
In periods of market stress (when the VIX index spikes), correlations between asset classes tend to increase in the short-run, thereby reducing the diversifying power of a traditional asset-based approach.
A risk-based approach means that allocations to asset classes are not driven by their label but to their realised risk, return and correlation characteristics. This means that genuine diversification can be delivered using a mathematical risk-based approach, rather than relying on labels alone.
Accessing risk-based diversification
US portfolio managers can consider the S&P 500 Managed Risk Index (SPXMR Index), which dynamically allocated between the S&P500 index and cash, whilst maintaining a constant allocation to bonds to deliver a risk parity multi-asset portfolio. This index is tracked by the DeltaShares® S&P 500® Managed Risk ETF (NYSEARCA:DRML).
UK portfolio managers can consider the Elston Minimum Volatility Index (ESBGMV Index), which dynamically allocates across asset class to deliver a minimum variance multi-asset portfolio. This index is tracked by Commerzbank Elston Multi-Asset Minimum Volatility Certificate (Bloomberg: COSP867<Go>, professional investors only)
Fig.2 ESBGMV Index 12 month rolling volatility for index and asset classes
Source: Elston website, ESBGMV index factsheet as at 6/Feb/18
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The Elston Minimum Volatility Index is licensed to Commerzbank for the creation of investable certificates (professional investors only).
Additional disclosure: This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only.