Andy Merricks explains how being aware of risk doesn’t mean not taking any
I have recently been fielding questions about the shaping of our portfolio construction and with this in mind I thought in this month’s column I could go through it with you
So, volatility. It is unquestionably a worry that volatility has reached one of its lowest measures in a decade, but this doesn’t necessarily predict an instant reaction. Many people look to mean reversion as a guide (what goes up must go down and vice versa). The FTSE 100 has been nudging an all time high, but this was achieved in the year 2000.
Also, we have not experienced a period of prolonged low interest rates in most of our lifetimes. We complain of low growth, but maybe this is what happens in such a cycle. The downturns may be less emphatic too. In other words, there is a lack of the boom/bust cycles that typified more active interest rate management from the Central Banks. And of course, boom/bust equals volatility. In a cycle-less cycle, it’s possible that lower volatility is a longer-term feature.
What are the biggest risks?
Many people are concerned about the Ukrainian problem at the moment, while others point to the situation in Iraq, Israel and Palestine as the major worry. While they are not helpful, we would argue that their effect on global markets are nowhere near as potentially dangerous as the credit crunch and Eurozone crisis that we have endured recently.
On the geopolitical front we are more concerned about the rising tensions in Eastern Asia, a region that has been largely forgotten due to the aforementioned concerns. A spat between Vietnam and China for example would be extremely unsettling to the Asian markets, and because of their deeper influence, quite possibly to global markets as well. But this is not a risk that we can necessarily defend against in advance, so we remain unprotected to such a move.
Interest Rates
Rising interest rates have been an inevitability at some point since they fell to zero, but the timing of the rise is still unknown. There have been a few false dawns and the markets have not reacted well to them. This is an obvious risk.
No one can really say whether the rise, when it comes, is “priced in” – we’ll find out when it happens – but what we can quite confidently predict is that there will be a bout of volatility at the time because the markets will go into “recalculation” mode. At this point there will be both risk and opportunity.
Intuitively investors think that strong economic growth is a good thing, so there may well be some head scratching if markets sell-off on the back of some strong data. Why would this be? In short, inflation. If the economy grows strongly it will mean that more people are in work.
If more people are in work it means that they will have more money in their pockets to spend. If they have more money in their pockets to spend the companies that make things and employ them will know this and so pricing pressure will occur.
And if there are fewer people unemployed, those in work will feel more confident about asking the boss for a pay rise to buy the very things that are becoming more expensive.
This is inflation, and if it looks like growing too strongly the banks will raise interest rates more. And this is the scenario that the markets will be trying to get to grips with when they go into “recalculation” mode, which we suspect will trigger a fall.
On the flip side, we don’t think that, once they’ve recalculated, they will be too alarmed by what they see, so our guess is that any volatility for this reason will be relatively shallow, albeit uncomfortable.
European Banking System
July saw a small panic occur when the Portuguese bank, Banco Espirito Santo, revealed large hidden losses on its balance sheet. This was not good news for our investment strategy that consists of being overweight in the European Periphery (Italy, Spain and Greece) in our portfolios, as these were the very markets that sold off most aggressively. We turned to the excellent BCA Research for guidance and were reassured by what we found.
The ECB has bulked up its stress-testing of European banks, and what happened to Espirito Santo was exactly what the Asset Quality Review (AQR) was designed to do – namely flush out the skeletons in the cupboard.
From data that BCA published, it appears that most of the European banks are adequately covered and those that fail (such as the Portuguese one) will not pose a systemic risk to the system (as seen by the Portuguese one!).
At the same time there are strong signals that the Spanish housing market may have bottomed and that European bank lending in general has once again turned positive, so if the banking system itself is not threatened the biggest beneficiaries of improved sentiment towards banks will be those very indices that have a higher weighting towards them. Which is why we maintained our overweight position to the Periphery markets.
So these are just some of the discussions that we are currently having as we weigh up the correct mix of risk on and risk off in our portfolios.
While we do see threats looming through current valuations and low volatility as well as geopolitical issues in Eastern Europe, Eastern Asia and the Middle East; are these threats sufficient for us to run to the hills seeking cover? Not yet. Not just yet.