Strategy & economics
Strategy & economics
Mary-Anne Daly, Head of UK Wealth Management, Cazenove Capital
At last year’s seminar, we warned that with valuations no longer compelling and US interest rates likely to rise, returns would be both more muted and more volatile; this is indeed what markets delivered. Going forward, two theories currently prevail on the fate of the world economy; the more gloomy predicts a global recession with the strong dollar forcing US producers to drop their prices to compete with imports. This will spill into the consumer sector where corporate margins will be squeezed between lack of pricing power and rising wage costs, causing a downward spiral on unemployment and wages.
The less gloomy theory and the one to which we currently subscribe, accepts that global growth will be slower due to known secular global trends such as ageing populations, ongoing de-leveraging and slower world trade as China rebalances its economy, but believes that the scale of the recent market declines were disproportionate based on the current economic data. We believe the risks surrounding China are increasingly priced into valuations and that today’s economic data is not overly concerning. Nevertheless, the greater uncertainty is to what extent the US can remain the engine of world growth, so we reserve the right to change our mind should we see indications of corporate stress and a stalling of employment growth which has driven anglo-saxon economic growth in recent years.
Richard Jeffrey, Chief Investment Officer, Cazenove Capital
The world is no more uncertain than it was, but it is possible to be overwhelmed by the deafening noise of statistics. Newspapers love volatility and encourage investors to feel nervous, but the best explanations are usually the simplest. Prior to the last recession, unsustainable, credit-fuelled excess demand from advanced economies created rapid growth in manufacturing output in emerging economies, which, in turn, led to increased demand for raw materials and energy. The current disruption is the unwinding of that trend.
A new pattern of growth has emerged from the last financial crisis and the world has become a lot more competitive. Aggregate growth is lower and the global export environment has seen a significant shift with the West now being a net saver. In this environment, commodity prices were only likely to weaken. Nevertheless, there are good signs coming through: intraeurozone trade is increasing, indicating a gentle recovery within the single currency area, and meanwhile the environment in the US is better, as demonstrated by increasing UK exports there.
The China problem
China’s economy is in a fragile state with an overall growth rate more likely to be 5% rather than the 7% reported by the authorities. Industrial sectors of the Chinese economy are in recession in the absence of the previously high level of demand for Chinese manufactured goods from the West. Chinese policymakers know what they need to do, which is to transform their economy into one that is more services orientated, but it is not easy to achieve this overnight. While we don’t believe the gloomiest prognoses, China is not going to be the engine of world growth from here, and it is not surprising to see the yuan weakening somewhat in these circumstances.
For commodity producers and those with strong trading links, the implications of the current environment are dire. However, for the UK, the eurozone and the US, the drop in import prices is effectively a tax cut for households. It is no coincidence that there was a 0.25-0.5% boost in consumer spending in the UK during 2015.
Labour markets are very tight in the UK and US, with record job vacancies and openings. This could create higher wage inflation. However, this is a concern: headline inflation has been very low, while core inflation shows a different picture. If food and energy prices are excluded, inflation is trending upwards. Central banks need to think clearly about this and inflation may catch people by surprise. If, as a result the US Federal Reserve (the Fed) tightens, it will put pressure on the Bank of England to do likewise. It wouldn’t surprise me if we hadn’t seen the first UK rate hike by the end of the year.
Francis Brooke, Investment Director, Troy Asset Management
Dividends make an overwhelmingly important contribution to overall equity returns. Of the 4.8% annualised real return from the UK equity market since 1970, 4% is attributable to dividend yield. Dividends have also proved a robust way to protect against inflation and have tended to be less variable than earnings.
However, it is not simply the size of those returns, but also the risk and volatility associated with those returns. The maximum drawdown from peak to trough associated with UK equities since 1989 is over 50%, yet quality, income-paying equities only have a maximum drawdown of just over 30%. These businesses are profitable and self-financing and have growth in their underlying businesses. They may not always be in fashion, but in the longer term, they deliver the strongest returns and expose investors to the least volatility.
Equally, equities are the only asset class that yield the same as they did in the 1980s. All other asset classes have seen the income available slide – dramatically so in the case of cash and sovereign bonds. Historically, a UK stock market yield of 5% has been a good buying opportunity, while a yield of 3% has been a strong sell signal. The market currently has an average yield of just under 4%, suggesting equities are neither outrageously expensive, nor outrageously cheap.
Reliable dividend growth
For the Trojan Income Fund, we like higher quality companies with good franchises. Sky, for example, has grown its dividend at 17% per annum since it paid its first dividend in 2004. We also hold Royal Mail Group, a much older company than Sky, but newly released back into the private sector with a high yield of about 5% which is implementing cost-cutting and efficiency savings while it builds its parcel business. It has delivered good predictable income, and has the scope to increase its pay-out ratio. Paying dividends is an excellent discipline for companies. It is an important way to reward shareholders for providing capital to support their businesses. As investors, we believe that if we look after the income line, the capital value will look after itself.
Matthew Dobbs, Fund Manager, Schroder Investment Management
China has a significant credit bubble to be unwound with debt-to-GDP approaching 300%. Over-capacity is having a global impact, contributing to falling prices and is weighing on growth. There are plenty of levers for the Chinese to pull to help them through, but adjustments following a credit bubble do not tend to happen smoothly. More generally, increasing corporate debt has flattered returns in recent years. While the return on equity (earnings per share) has been fine, companies’ underlying return on invested capital has been falling, leading to a de-rating of Asian equities when compared to markets such as the US where there is perceived to be a higher degree of creativity and less reliance on debt.
The positive track for China is to readjust away from manufacturing to services – to coin a phrase “fluff ” not “stuff ”. In China, services are now around 50% of GDP, up from 40% in 2000. We are not expecting them to go to US levels any time soon, but if they moved up to the levels of, say, Taiwan and Korea, both at around 65%, it would generate significant further growth, and allow average Chinese people to enjoy the aspects of life enjoyed by the rest of the world – leisure activities such as cinemas, tourism and ecommerce. These areas are indeed seeing huge expansion. More excess credit growth, however, is not a long-term answer.
Benign economies: better stock markets
In aggregate, the economic outlook in Asia is relatively benign: the ‘taper tantrum’ forced improved credit discipline in emerging ASEAN, while Asian economies are also benefiting from the lower oil price. There is scope for policy flexibility with interest rates still relatively high and the region’s central banks have not resorted to quantitative easing in the manner of the Bank of Japan or the European Central Bank.
Although a minority, more prudently managed companies are not investing heavily because they are not yet seeing prospect of sufficient returns. Consequently, they have been paying down debt and pushing dividends higher, which is good news for investors. Moreover, valuations are a lot better than they were two years ago and are at levels that have historically led to good prospective returns.
Perhaps most importantly, Asia is no stranger to tough times as the crisis of the late 1990s demonstrates. As Asia enters a period of dynamic change, we consider the small and mid-cap area to be the centre of the action and where real innovation is taking place. We are finding the best opportunities in information technology, consumer and healthcare sectors. However, whatever the industry, prudent and focused corporate management remains key.
John Paulson, President, Paulson & Co.
I founded the firm in 1994 with just US$2 million of capital. Risk arbitrage has been our speciality since inception. It is a strategy that has been around for several decades and is not correlated to the broad markets. It starts with a corporate event – a merger or a bankruptcy reorganisation. In a merger, what typically happens is that company A offers to buy company B. Once the transaction is announced, the target company may trade at a discount to the takeover price – this is what is called the ‘merger spread’.
If you buy the target company B and sell short company A after the deal is announced and hold it to closing, you will make the spread. The risk in merger deals is that they do not close. There are many issues that could cause a deal to break – legal, financing, regulatory, strategic, performance, etc. We are experts at evaluating those issues and by understanding them we aim to avoid those merger deals that break. The beauty of arbitraging the spread in these mergers is that even if the market falls 20% during the closing period, provided the deal closes, we still make our return equal to the merger spread. Currently there are hundreds, if not thousands of mergers and acquisitions (M&A) deals outstanding. For example, M&A activity in 2015 was US $5.5 trillion. Our portfolio strategy is to include merger deals with the best risk/reward profiles and avoid deals that might break.
The sub-prime crisis
One of the important aspects of running a hedge fund is to ‘hedge’, which helps protect capital when the market goes down. We are always looking for good hedges – short positions – that will do well in a weaker environment. The question then is what do you short – an equity or a bond? Normally if an investor shorts an equity, they have unlimited downside because, in theory, that equity can go up infinitely. If, instead, a corporate bond is shorted at par, the downside is limited because in your worst case scenario the bond will be redeemed at par. As a short seller of a bond at par you have to pay the coupon due so there may be a 1-2% negative carry, but you cannot lose more. Your downside is capped.
The ideal situation is to find a bond at or near par that trades at a low spread over treasuries but is likely to default. The difficulty is very few bonds trade at such low spread levels and default. That is exactly what we found in the sub-prime credit market: “No doc, no credit, no money? No problem!” but the bonds were trading at par. It was a bubble. Sub-prime bond buyers were not paying attention to risk, and consequently we thought those bonds would default so were seriously mispriced. For us, shorting sub-prime bonds was a good way to protect the portfolio because if we went into a recession the bonds could default and ultimately go to zero, producing large gains for our funds with very little downside risk.
Looking at the situation today, predicting a recession is difficult, but what we can say is that the level of uncertainty today is greater than it was a year ago. We are seeing weakness in the US economy: S&P 500 earnings are down around 3% year over year. Indeed this is the third successive quarter where earnings of the S&P 500 have declined. This is a sign of uncertainty, along with the energy sector and commodities in general, which have gone through a severe correction. On top of that concern, when you factor in rising interest rates from the Fed and the strength of the US dollar, it points to a weaker economic outlook. Internationally, China’s credit excesses have gotten to a point, which have led to problems for other countries historically. All of this gives rise to a more uncertain outlook so we have reduced our net exposure in our funds to the broader market on the basis that it is better to be ‘safe than sorry’. What will drive our performance from here is our selection of individual long positions versus shorts, rather than the broader market direction.
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This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.