View From the Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: after only eleven trading days of 2016 and with global equities off to their worst start in at least 40 years, many investors are inevitably concerned. The risk environment has clearly deteriorated, but imbalances have been building for some time. Our approach is to stay calm, but also to seek tactically to reduce risk exposure. Now is the time to be considering truly uncorrelated asset classes.

When a plane is about to make an emergency landing or a boat is about to sink, the worst thing to do is to panic. Indeed, countless studies show that panicking reduces the chances of survival. Being well-prepared and attempting to act rationally are the optimal courses of action. Why then, should it be any different with regard to investing? The start of this year has in no sense been ‘normal’, but then it is easy to argue that at least the last seven years of financial history have been far from normal either given the unprecedented levels of artificial stimulus and central bank intervention.

The product of such policy action is well-understood: asset-price inflation. Since March 2009, US equities have delivered 15% annualised returns including dividends. Likewise, returns from US High Yield have been 15%. Meanwhile, Investment Grade has returned 7% and even US Treasuries 2.6% over the same period (according to Morgan Stanley). As a consequence, the expectation of double-digit returns (from equities and/or other asset classes) has become the norm, whereas a longer- term perspective shows that such returns constitute the exception rather than the rule. The danger, of course, arises when such returns become expected by investors, although they clearly should not be.

This is the situation in which we clearly find ourselves. It is easy to construct a long list of ‘reasons’ or ‘explanations’ for the price action we have witnessed this year. These encompass (but are not restricted to): Chinese currency devaluation, related US Dollar strength, ongoing energy market dislocation, persistent emerging market stress, weakening global industrial production data and escalating geopolitical concerns. History also suggests to us that once contagion occurs, it will likely continue until proven otherwise. Importantly, what the above indubitably highlights is that (late-cycle) risks are clearly mounting and hence the return profile for risky assets is diminishing. This is therefore not the time to be heroic and attempt to catch the last leg of potential upside in equities at the tail-end of a seven-year bull market in equities. Likewise, it is not a time to panic. Now is the moment to consider appropriate strategies for appropriate times.

What this means is simple: a reduction in exposure to risky assets; and, a consideration of truly diversified and uncorrelated assets. In other words, we find favour in assets such as catastrophic insurance and direct lending vehicles. Alternative managers (such as CTAs, Commodity Trading Advisers) can also prosper. Cash should be considered as a potential asset class. Finally, dislocations do also create opportunities: for the long-term and patient investor, emerging market equities and energy assets look more attractive than they have done for quite some time.

Alexander Gunz, Fund Manager, Heptagon Capital