Peter Elston: Investment Le er Issue 35: April 2018 This document is intended for professional investors only A Timely Reminder Macro and markets monthly Current fund targets A Timely Reminder As the current global business cycle matures, I thought it might be an opportune moment to revisit one of the basic but counterintuitive laws of stock markets, namely that, broadly speaking, the stronger the economic performance, the worse the stock market performance. Seneca Investment Managers Limited Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. T 0151 906 2450 E info@senecaim.co.uk W senecaim.co.uk Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority FRN 208689. Registered in England. Registered Office: Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. Company Number 4325961.VAT No. 192 7337 83 1
Readers of my letter will know that much of my analytical framework around tactical asset allocation is based upon the empirical findings set out in a 2009 paper by Robeco s Pim van Vliet and David Blitz titled Dynamic Strategic Asset Allocation - Risk and Return across Economic Regimes. I have found this paper particularly useful because the authors employ what seems to me a sensible methodology. The below extract from the paper helps illustrate that. While many other papers use statistical properties of the assets themselves for regime definitions, we propose a more fundamental approach which uses economic data for defining different regimes. An essential feature of our approach is flexibility with regard to the specific set of variables and the model structure that are used. The key difference with the statistical approach is that, instead of providing estimated probabilities of being in a particular regime at any point in time, our approach explicitly identifies the prevailing regime, which enables us to derive transparent regime-based asset allocation strategies. Specifically, we consider a regime model which uses four economic indicators (the credit spread, earnings yield, ISM and the unemployment rate) to identify four phases of the economic cycle (expansion, peak, recession and recovery). Also unlike other studies, we consider a broad opportunity set instead of focusing on the attractiveness of one particular asset class. In addition to equities, bonds and cash we include small caps, value, growth, credits and commodities in our analysis. The other key attribute of the methodology is that the economic indicators used to identify the business cycle regime in question are available on an ex ante basis. This means that it can be used more readily in practice, unlike a framework based on NBER (National Bureau of Economic Research) data that is only available ex post. The NBER is well-known for determining official recessionary periods. NBER data is of little use for real-life dynamic asset allocation purposes though, because the NBER only classifies a period as either expansion or recession after the fact. Because of this hindsight, the NBER data is only suitable for ex post explanatory analyses and not for ex ante decision making. This is also recognized by Gorton and Rouwenhorst (2006), who use the NBER business cycle classification for gaining insight into the risk and return properties of commodities over the cycle. In order to address this concern, we propose an alternative, forward-looking regime indicator. Our indicator uses only information which is actually available ex ante and offers the additional advantage of resulting in a more balanced distribution of observations across regimes. However, while van Vliet and Blitz s paper is useful, it does not offer much explanation as to why certain investment types behave the way they do in each economic regime or phase. For this, there are two papers which I have found useful. These are Donald Keim and Robert Stanbaugh s 1986 paper Predicting Returns in the Stock and Bond Markets and Eugene Fama and Kenneth French s Business Conditions and Expected Returns on Stocks and Bonds, published in 1989. The results of both these papers are consistent with those of van Vliet and Blitz, namely that, roughly speaking, equities do better when economies are weak, and worse when they are stronger. But unlike the latter paper, the two older papers seek to interpret this finding. Fama and French offer two interpretations: consumption smoothing and a risk-based interpretation. The extract below helps to explain the first of these. When income is high in relation to wealth, investors want to smooth consumption into the future by saving more. If the supply of capital-investment opportunities is not also unusually large, higher desired savings lead to lower expected security returns. Conversely, investors want to save less when income is temporarily low. Again, without an offsetting reduction in capital-investment opportunities, lower desired savings tend to push expected returns up. In other words, when times are good, investors want to save more, pushing stock prices up and expected returns down. The reverse happens in bad times. 2
Fama and French use three variables to define the cycle: the dividend yield (D/P), the default rate (DEF), and the term premium (TERM). The aforementioned risk-based interpretation is that these variables are associated with risks that fluctuate over time and that therefore cause returns to fluctuate: Another reasonable hypothesis is that the risks for which D/P [dividend yield], DEF [default rate], and TERM [term premium] are proxies are higher when times are poor and lower when times are good. In other words, high dividend yield, high default rate, and high term premium (essentially, the yield curve) all reflect higher risks in equities and thus the higher returns that are needed to justify these risks. Whatever the explanation, it is useful to remember that strong economies are associated with poor returns from risky assets such as equities and high yield bonds. As central banks tighten monetary conditions in order to rein in strengthening economies, it makes sense to be reducing risk. Review and Outlook If February was remembered for the somewhat inexplicable falls in equity markets there was no obvious trigger March will be remembered for falls that were very much related to one thing the prospect of a global trade war. To the surprise of many, perhaps even those in his inner circle, US president Donald Trump announced that he would be imposing tariffs on a number of imported goods. Given the goods that were being targeted, steel being a key one, it seemed clear that the object of Trump s move was China and the large surplus that it enjoys with the US. Large deficits and surpluses are complicated things and do not necessarily reflect inequity in the way that Trump framed the US deficit with China and others. A deficit in goods and services can simply reflect the fact that there is a surplus on the capital account. China s goods and services may appeal to Americans but to the Chinese, the US s assets may be of interest. In simple terms, what goes in must come out. It might also reflect fundamental attributes of the countries involved. Americans, like the Brits, tend to be happy to live beyond their means whereas the Chinese are frugal people who love to save. Are these things that can be solved with import tariffs? Probably not. That said, the US only has so many assets to sell, so at some point things must change. In other words, the deficit is unsustainable, so action now may not be entirely unjustified. And of course, those Midwestern supporters will be lapping up Trumps words and indeed action. How things progress from here is hard to say. We may end up with the Chinese equivalent of the Plaza Accord, in which China promises more market-oriented policies on the trade front, requiring a commitment to strengthen its currency. Elsewhere on the economic front, we started to note the first signs of economic weakness, following nearly two years in which global growth had been progressively strengthening. One of these was the OECD Leading Indicator which had started to turn down towards the end of 2017. The other was the fact that purchasing manager indices (PMIs) around the world had reached such a high level in a historical context that it was likely that they would soon turn down. Given that unemployment rates are already very low and that trade wars tend to be inflationary not deflationary, it was felt that any growth wobble would not be accompanied by a fall in inflation. Furthermore, we have probably entered the phase of the cycle when growth is as much a potential concern as monetary policy. In other words, we felt there was scope for global growth to disappoint but that central banks would not act because upward inflation pressures remained in place (indeed the US Federal Reserve increased interest rates during the month). Looking at other economic data, core inflation in February rose in the US and Japan, fell from elevated levels in the UK, and stayed steady in Europe. We would expect the trend of inflation on average rising to continue, given that unemployment is now very low which in turn causes upward pressure on wages to increase. 3
Elsewhere in financial markets, bond yields in the developed world fell across the board. This perhaps was as much to do with yields having risen so much over the past year or so as it was a flight to safety associated with Trump s trade manoeuvres. Finally, following months of weakness, the US dollar had a stable month. Table 1: Current fund tactical asset allocation (TAA) target weights as of 29.03.2018 (prior month s targets in brackets) OEICs Investment Trust TAA target Weights (%) (prior month s targets in brackets) LF Seneca Diversified Income Fund LF Seneca Diversified Growth Fund Seneca Global Income & Growth Trust plc Equities Fixed income Specialist assets* UK 19.5 (20.5) 16.0 (17.0) 30.0 (31.0) North America 0.0 (0.0) 1.0 (2.0) 0.0 (0.0) Europe ex UK 6.0 (6.0) 9.0 (9.0) 8.0 (8.0) Japan 1.0 (1.0) 8.0 (8.0) 3.0 (3.0) Asia Pacific ex Japan 5.5 (5.5) 10.5 (10.5) 9.5 (9.5) Emerging Markets 1.0 (1.0) 4.5 (4.5) 3.0 (3.0) Global Funds 2.0 (2.0) 2.0 (2.0) 1.5 (1.5) Equities Subtotal 35.0 (36.0) 51.0 (53.0) 55.0 (56.0) DM Government 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) EM Debt 5.0 (5.0) 2.0 (2.0) 1.9 (1.9) Corporate 27.2 (27.2) 10.0 (10.0) 7.3 (7.3) Fixed income Subtotal 32.2 (32.2) 12.0 (12.0) 9.2 (9.2) Property 7.5 (7.4) 7.5 (7.4) 8.0 (7.9) Private equity 4.1 (4.4) 4.5 (4.8) 5.2 (5.6) Specialist financial 10.4 (10.3) 9.6 (9.5) 11.0 (10.8) Infrastructure 6.6 (6.5) 6.7 (6.6) 7.0 (6.9) Specialist Subtotal 28.6 (28.6) 28.3 (28.3) 31.2 (31.2) Cash 4.2 (3.2) 8.7 (6.7) 4.6 (3.6) Total 100.0 100.0 100.0 Source: Seneca Investment Managers, 29 March 2018 * Target weights for the specialist assets subsectors are the aggregate of holding level targets as top down driven asset allocation targets are not applied to this sector. Increased Decreased 4
March Commentary SIGT, SDIF and SDGF Equity markets around the world were weak in March as fears of a global trade war escalated following US president Trump s targeting of Chinese imports. Despite this, the US Federal Reserve went ahead with an expected increase in interest rates. Bond yields fell in major developed countries as trade tensions triggered a flight to safety. The funds equity targets were lowered mid month, as signs of economic weakness began to appear. Several holdings were reduced, in order to accomodate the TAA reduction to UK equities. We participated in the further equity fundraising of RM Secured Direct Lending by means of a C share offering in the asset backed loan portfolio. High street retail property has an uncertain future, however we like regional retail parks within the Ediston Property Investment Company REIT where we have added on general market weakness. Political uncertainty has created certain infrastructure assets to be oversold. We have added to International Public Partnerships. Strong results from Arrow Global - the capital light asset management business continues to grow as a percentage of group revenues. SIGT and SDIF Added to Insight UK Equity Income Booster Fund, in order to ensure a high level of income is being generated from UK equities, despite having a lower TAA. Added to the Invesco Perpetual European Equity Income Fund, in order to bring to target weight. SIGT and SDGF No transactions across fixed income positions. SDIF Added to fixed income positions in TwentyFour Dynamic Bond Fund and Royal London Sterling Extra Yield Bond Fund, bringing positions to our target weights. SDGF Following the reduction to the tactical asset allocation weight to North America, we reduced the position in the Yacktman US Equity Fund. Somerset Emerging Markets Dividend Growth Fund was exited, in order to fund the new investment in the HMG Global Emerging Markets Equity Fund. Reduction to Samarang Asian Prosperity Fund, in order to bring back in line with target weight. SIGT Magna Emerging Markets Dividend Fund was exited, in order to partially fund the new investment in the HMG Global Emerging Markets Equity Fund. 5
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