Tavistock Asset Management
Quarter 4 2021
Written by Titan Asset Management Investment Team
Welcome to the Q4-2021 ‘Quarterly Perspectives’ publication
Tavistock Asset Management
Written by Titan Asset Management Investment Team
Welcome to the Q4-2021 ‘Quarterly Perspectives’ publication
Since the 30th of June 2020, which is the date we use for monitoring performance since the start of our strategic review process, the ACUMEN Portfolios have delivered strong risk-adjusted returns, largely outperforming their respective IA sectors.
It’s a similar story for the model portfolios and inception-to-date across the range, where most funds/models appear in the first or second quartiles relative to their respective IA sectors.
During the third quarter the ACUMEN Portfolios lagged the model portfolios slightly as investors reassessed lofty valuations against growing economic headwinds and rotated out of value and back into growth stocks, which have driven market gains since the great financial crisis in 2008.
The reversal in the relative fortune of growth stocks over value in Q3 runs contrary to our long-term outlook and means the valuation disparity remains at historic levels.
On a long-term basis, the growth/value ratio remains at extreme levels. The prior chart is a zoomed in version of the red circle.
Whilst we retain our medium-term view that mean reversion will eventually kick-in, it’s much harder to know when. Being early is another way of being wrong. When the time comes, value stocks will be the place to be, but for now we have shifted tack, reduced active risk and pivoted towards a barbell strategy across the more actively managed ACUMEN Portfolios. This has worked well so far, contributing to strong performance in October.
The risk of recession is low, and TINA (“There Is No Alternative”) dictates equities should continue to drive future returns from here. However, there is no denying global headwinds have risen over the last few months.
First and foremost, valuations remain expensive. The following chart shows the total dollar value of securities held across global stock exchanges, in red, versus GDP, in blue. As you can see, the prior relationship between these two metrics has completely broken down, spurred-on by a central bank liquidity sugar-rush and unprecedented levels of stimulus.
Against that backdrop, global economic growth has likely peaked and is now in the process of rolling-over, albeit from very high levels. This is reflected across a variety of economic indicators including the global economic surprise index which is now back in negative territory (as the inflation surprise index continues to gain).
Numbers above zero demonstrate economic data coming in above expectations, and vice versa.
In Germany, the cyclical bellwether of Europe, the economic data has been particularly disappointing. That’s not surprising when you consider Germany’s dependence on exports to China (it’s largest auto market) where President Xi Jinping’s strategic vision implies short-term (economic) pain for long-term potential gain. Credit creation, from central banks and the private sector, plays a key role in the global economy. Whilst the overall level remains positive, it is the rate of change, or ‘impulse’, that matters most to markets. In many regions this has shifted from positive to neutral, or even negative. The hope is this will just take the wind out of current market exuberance. The concern is it takes a positive delta to keep markets rallying and any sustained weakness could translate into risk assets.
There is a close relationship between the China credit impulse and Chinese imports from Germany.
The Bloomberg Economics US Credit Impulse index has turned negative, which points to lower US equity returns.
Prior market performance has been driven by global liquidity. Over the coming months central banks look set to rein that in, as demonstrated last week by the surprise end to QE in Canada. In the US, asset purchase tapering and the end of the Treasury General Account drawdown means the liquidity tide is turning.
Part of the reason for this hawkish turn, is inflation. Central bankers are slowly coming around to the idea that inflation could prove longer and more persistent than previously expected. Particularly if supply constraints remain or rising inflation expectations feed into wage demands. Our inflation model did a great job of forecasting the pick-up in inflation during the crisis, something we were able to capitalise upon at the time. It is therefore somewhat interesting that the same model now points to lower core-inflation moving forward.
Core-inflation is easier to model because it strips out the more volatile food and energy sub-components, where we see risks skewed to the upside. No model works perfectly all the time, and we are aware of its limits, so we are taking this forecast with a healthy dose of scepticism whilst monitoring key levels, such as the price of oil, which is now at key resistance (beyond which we can’t rule out $100+ per barrel).
To summarise, the business cycle is a key driver of market returns, and on a variety of metrics we see growing downside risks, particularly to equity market valuations. Whilst we see elevated risks, there are still some positives worth mentioning, including corporate resilience to rising input prices, a potential US spending package and high levels of side-line cash, meaning we could yet see a “Santa Clause rally” as the holiday season approaches.
Given this market dynamic, we have repositioned the portfolios and shifted towards a barbell strategy. Specifically, we have reduced exposure and/or turned defensive in those markets we consider most vulnerable. Conversely, we retain exposure to those tactical and thematic opportunities we consider most attractive or resilient in the current climate. This includes dividend paying equities, clean energy and parts of the commodity complex. In the event of a tactical correction, we would look to rotate back towards our medium-term outlook characterised by a preference for equities over bonds and value over growth.
Asset Allocation Outlook
The dislocations in markets that we have discussed in previous pieces, and positioned for, have begun to unwind. Nominal rates put in a short-term bottom in early August, and it is our view that this will remain the case over the coming months. Catalysts for both higher rates and inflation continue to be seen with strong returns for industrial commodities, continued supply-chain disruptions, increasing wage pressures and more-concrete talks of tapering. The duration-yield trade-off between short and long maturity rates poses a problem for fixed income portfolio managers. As demonstrated in the chart, despite a flattening of the 5s30s curve, longer-maturity bonds nonetheless underperformed their shorter-maturity counterparts.
In credit markets, we continue to favour global high yield debt relative to investment grade. With a traditionally shorter duration, high weight to energy-focused firms and a lower correlation to the yield curve this exposure poses an attractive position in the current macro framework. Despite this, emerging market corporates, which are similarly heavily weighted to financials and commodity producers, have sold off on the back of a stronger dollar. We have benefited from this via our current allocation to emerging market government securities, via a broad-based basket of hard currency government bonds and Chinese government bonds denominated in local currency.
The spread between emerging market hard-currency corporates and government debt is at the top of its decade long range.
As the narrative of inflation, and now potential stagflation, permeate through investors’ minds, we have reduced the beta of our equity exposure. Minimum volatility factor solutions find their place in the portfolios as well as an increased allocation to high quality stocks, particularly in the US where stretched relative valuations give room for greater volatility. While we have added themes to protect against downside risk, we also see cyclical bright spots in the market predominantly but not exclusively outside of the US, and therefore adopt a barbell strategy.
Our UK equity exposure offers cyclicality via its high exposure to commodity producers which have performed well in recent weeks. The region’s valuation disparity coupled with healthy dividend yields could attract fund flows to a region that has struggled to gather sustained
momentum. We also look beyond the UK, to other parts of Europe in search of value. After three consecutive quarters of record European profit beats, we seek to gain exposure to those companies that can maintain revenue growth and withstand margin pressures from rising input prices and supply-chain bottlenecks.
Historically, peak earnings growth tends to precede downward pressure on equities. We will find out if this time is different given a moderation in earnings growth was highly anticipated after the post-lockdown seismic rebound in Q2 earnings.
In the US, the passing of Biden’s infrastructure bill would be a welcomed catalyst for capex sensitive stocks that lagged the broader market last quarter. At the time of writing, political gridlock remains in place, and we reserve conviction on this theme until we gain further clarity in Washington. Instead, we opt for a quality bias in the region suited to a mid-to-late cycle regime while adding resilience to the portfolios.
Russian equities remain one of our favoured emerging market investments as we believe their dominance in the energy market and prudent fiscal regime currently outweighs the geopolitical risk. Despite formidable gains this year, the Russian equity market still trades at a steep valuation discount vis a vis their emerging market peers giving scope for further upside.
The technical setup for our position in Russian equities has worked in our favour with potential for further gains
Diversification and selectivity will be key to navigating the equity markets going into year-end as the economic restart progresses, and central bank tapering draws closer.
The third quarter saw a ratcheting higher of global energy prices, as well as concentrated outperformance in certain commodities subject to supply chain disruptions. Natural gas, palm oil and aluminium were amongst assets reaching multi-year highs. This came despite fears of a Chinese economic slowdown. Looking forward we see continued supply tightness in the short term, manifested in higher prices. Most notably, we expect oil prices to remain in this current elevated range, with upside risk. Entities such as OPEC have been reluctant to increase supply and reduced capex spending by oil majors has left drillable well-counts lower. Notably the US energy secretary has told people to brace for winter gas shortages, due to diminished stockpiles.
Coupled with the potential for persistent inflation, and fears over equity valuations, diversification is prudent within a multi-asset portfolio. Indeed, last quarter we enjoyed outperformance from most of our commodity-focused allocations. Our position in the iShares Bloomberg Roll Select Commodity ETF, Russian equities and US midstream energy companies have delivered exceptional returns on the back of higher energy prices. We also took substantial profit on our tactical copper exposure, a barometer for global growth.
Our strategic allocation to gold underperformed developed market equities by 1% this quarter and outperformed emerging markets by around 6.5%. This is a stronger quarter for the yellow metal, which has underperformed throughout this year.
We continue to believe that gold plays a role in the portfolios to counter volatility, as we have seen repeatedly through history. If supply chain shocks become more extreme, forcing intervention, the futures curve may ‘blow out’ creating high volatility. Here, physically backed investments or derivative focused products with a focus on contract term selection will continue to provide security within the portfolios.
With nearly all property indices struggling significantly relative to equity markets through the third quarter, our decision to avoid exposure was well warranted. With property fears in China and elsewhere still present, we prefer to sit on the side lines.
The cost of moving goods around the world has risen at record pace over the last 12 months, with the cost of shipping a 40-foot box from Shanghai to LA now costing 5 times what it did 3 years ago. This supply chain squeeze provides further upwards support for physical goods.
Monetary and fiscal stimulus euphoria that previously propped up risk-on currencies began to subside in the third quarter, as investors started to question the looming economic repercussions on future growth and inflation. The moderate risk-off sentiment led to US dollar strength, fuelled by Federal Reserve rhetoric alluding to a tapering of asset purchases before the end of the year. The US dollar bull-case lies in higher yields, lower money supply and a continuation of the economic recovery. Last quarter we decided to take on additional US dollar exposure and we see the opportunity for further strength into year-end.
Surging energy prices have contributed to the rise in inflation over the last few months. These higher energy prices have resulted in currency appreciation to those energy rich exporters who look to improve their expanding current account, whilst resource scarce energy importers such as the Philippines and Chile have suffered expensive energy imports and naturally depreciating currency.
One position held across the ACUMEN Portfolios and model portfolios that has fared on the right side of this trade has been Russian equities, with unhedged currency exposure to the Russian ruble. As shown in the chart below, since the end of April the Russian ruble has appreciated over 6% versus emerging market currencies in general, which have gone sideways. This reinforces our approach to be selective in EM currency exposure, adding to performance.
The COVID-19 pandemic dominated the thoughts and dictated the actions of policymakers, investors and the public in 2020. The mood was sour and, consequently, everybody sought an ‘escapegoat’ of sorts; defined as a different global challenge to focus on, one that was immediate, free from blame and not as dramatically immediate as the pandemic; one with a solution that could be fuelled, at least in the short-term, by an exciting cocktail of optimism, investment and innovation. The challenge of unsustainability proved an excellent ‘escapegoat’. Best captured by the UN Sustainable Development Goals, calls to combat climate change and reduce inequalities of all kinds offered everybody an opportunity to devote time, energy and capital to ‘Build Back Better’. Institutional and retail investors flocked to sustainability-linked assets of every size and shape. They were duly rewarded; sustainability-linked proxies for equities, bonds and thematics had a bumper 2020 in absolute and compared to their vanilla equivalents (see chart). These proxies have performed less well so far this year. We have explained in prior commentaries that 2021 has proved a sober reminder that optimism, investment and innovation is a necessary but insufficient combination to depend on to solve global challenges. Decarbonisation involves a series of difficult trade-offs which must be managed sustainably (from an ecosystem and an economic point of view) and, importantly, transparently. Buzzwords like ESG have put investors in a tricky spot as they attempt to out-innovate their peers without playing foul.
An important question will be answered this quarter: with a fuller (but far from complete) understanding of the opportunity costs, do policymakers, investors and the public have the gumption to solve the unsustainability challenge? A pair of UN conferences about biodiversity (COP 15, in China) and climate change (COP26, in Scotland) will elucidate the mood of policymakers, which will in turn influence the sustainability-linked asset allocation decisions of institutional and retail investors in 2022. We maintain high conviction in core ESG-labelled strategies (which helpfully also have a bias towards the quality style factor) and thematic baskets which balance purity of theme with diversification and liquidity concerns. We are also excited by developments that have the potential to improve the sustainability profile of our proposition in 2022. First, passive product providers are responding to client requests to provide more transparency about how they are voting at shareholder meetings. Second, those same providers are launching new tools to allow investors to mitigate the greenhouse gas emissions of their investments in the same way that large emitters in dirty industries already do.
As mentioned in the key themes section, we see growing downside risks to equity markets. Key areas of concern include lofty valuations, near-euphoric sentiment and peak margins given ongoing supply chain restrictions, energy and labour market inflation and a slowdown in China. With the bulk of prior gains stemming from central bank liquidity, it is concerning that many central banks look set to turn off that tap, via asset purchase tapering. That said, there’s always an opportunity somewhere and we increasingly see dividend preservation and growth as a key driver of returns moving forward.
There’s a phrase that history doesn’t repeat itself, but it does rhyme. The chart below is quite interesting as it shows how pessimistic US equity markets were in the immediate aftermath of the 2008 financial crisis versus what actually happened to dividend strategies. Specifically, it shows the dividend per share for the S&P 500 versus the implied dividend derived from swap-based market data at that time. We may be seeing something very similar playing out right now. This presents a compelling longer-term investment opportunity. Further, from a historical perspective, dividend paying strategies have tended to outperform late cycle, and if inflation does turn out to be a problem, the best place to be is in those companies positioned to benefit from rising rates that have pricing power and can deliver dividends.
Tavistock Asset Management Limited is authorised and regulated by the Financial Conduct Authority with FRN 955719. Tavistock Asset Management Limited is a wholly owned subsidiary of Tavistock Investments Plc. This content is for financial intermediaries, it is not aimed at the general public. This document is published and provided for informational purposes only. The information contained within constitutes the author’s own opinions. Tavistock Asset Management do not provide financial advice. None of the information contained in the document constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Titan Asset Management unless otherwise stated. Registered address, Tavistock Asset Management, 1 Queen’s Square, Ascot Business Park, Lyndhurst Road, Ascot, Berkshire, SL5 9FE.