MAY MARKET UPDATE
LONG TERM MACRO OVERVIEW
The period leading up to the financial crisis saw an artificial boost to global productivity as western technology met the excess labour and resources of the developing world. This has now ended. A combination of ageing demographics, and a lack of transformative innovations mean that productivity growth is below historic levels and will remain that way.
Given that, in the long run, productivity growth is the driver of economic growth (nominal GDP) this means that we are not going to be seeing interest rates rising to historic levels. Central bankers will be constrained in raising interest rates as any movement upwards in rates will act to stymie the low levels of GDP growth present. As a result interest rates will remain at ‘zero’ forever with low levels of inflation persisting.
This has important implications for the allocation of capital within the global economy. Interest rates are the pricing mechanism for an economy’s capital stock. Low levels of interest rates keep so called “zombie” companies, which offer negative returns on capital, alive. This prevents the capitalist process of creative destruction that allows capital to be re-allocated to those tasks that generate the highest returns, in turn creating a self-reinforcing cycle of diminished productivity growth.
From the point of view of investors this means we cannot expect future returns to match those witnessed historically, and must remain aware of the increased risk, and opportunities, generated from the market inefficiencies caused by the misallocation of capital.
The model portfolios are currently positioned to hold a lower proportion of risk assets than the strategic (long term) asset allocation. We hold 12%-13% in cash, dependent on the model, and our debt holdings can be characterised as focusing on high quality sovereign debt. In terms of the equity risk, the model portfolios are underweight overseas equity and we have avoided alternatives assets such as private equity or Venture Capital Trusts (VCTs).
Broadly speaking, global equity markets are expensive compared to historic levels. In the US, in particular, recent earnings growth has been driven in large part by companies increasing debt levels to fund equity buybacks. While this has been positive for short term returns, debt acts to makes companies less flexible and amplifies losses in a downturn (you cannot cut interest payments like you can dividends). In a similar vein the low interest rate environment has led to record levels of investor demand for private equity style investments in their search for return, exceeding the level of legitimate investments in the sector.
The models currently have no exposure to emerging markets. The standard investment premise for emerging markets is that economic growth is set to exceed that of the developed world, which will be translated into outsized returns for emerging market investors. This however fails to take into account the poor levels of corporate governance in emerging markets and the often limited access to the companies generating this economic growth. For investors this means being invested into a small number of large companies where risks are poorly understood and the returns do not provide sufficient compensation.
Where we do see the potential for greater shareholder returns is Japan. Japan has spent the last two decades dealing with the debt overhang from the asset price bubble of the late 80s early 90s, but is now beginning to emerge. Corporate governance is being reformed (the number of corporate scandals such as at Toyota and Mitsubishi have been falling) and corporate earnings are on the rise as companies traditionally run to be profitless are forced to take account of shareholders. We do not expect the reforms to be a quick process, but based on the progress seen to date we are comfortable taking a larger allocation to Japanese equity.