This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Tom Becket, chief investment officer of Psigma considers where investors may find the most stable returns in the near future.
I read with interest that Crispin Odey has totally flattened his “book” in recent weeks in anticipation of rocky times for global asset markets; he is considered a predictive genius. I have also enjoyed recent comments from the legendary Jeremy Grantham of GMO who stated that he expects the real returns from US equities to be 0% in the next seven years; he is rightly perceived as a deep-thinking investment virtuoso.
Valuations of all asset classes are stretched, it is right to consider what might go wrong
The regular bearish reports from the miserable maestro, Albert Edwards, are savoured by the financial community. There have been other warnings from my investing heroes, such as Seth Klarman and David Einhorn, of Baupost and Greenlight fame respectively, warning investors over rich valuations and complacency. However, when I recommend taking some money out of equities and holding it in cash, I’m considered a crank. That labelling is possibly, dare I say probably, correct.
Last week I detailed quite how difficult it was to find new ideas to invest in. For the first time in my six years as Psigma’s CIO, the creative cogs have ground together, requiring the oil that only a correction in values can bring. Bond, credit, equity and property markets have risen so strongly in the last few years that it is hard to spot immediate value. That is not to say that you should sell up and run for the hills, but rather glance through your portfolio, sell anything that you don’t trust impeccably and hold a cash buffer; both in anticipation of better opportunities and as protection against a potentially challenging summer.
“Cash? You are a crank”, you are probably shouting. What justification can there be for holding cash when interest rates are nothing? On a medium term basis, I would find it hard to argue a bullish case, unless we do move in to a truly deflationary world, a risk which we still evaluate as a low probability scenario. The economy should continue its post-Global Financial Crisis recovery, boosting sentiment, helping corporate profits and making optically expensive equity valuations look more compelling. Central bankers seem set to persist with their role as cheerleaders from the side-lines.
However, in a world where complacency is rife, where huge utterly underserved confidence is placed in central bankers and where valuations of all asset classes are uniformly stretched, it is right to consider what might go wrong. For us the greatest risk is an upside surprise in inflation in the US, which could force Dr Yellen and her sleepy pals at the Federal Reserve to raise monetary policy more quickly than the markets expect. Indeed, Goldman Sachs joined the throng bringing forward their forecast for the first rate hike in the US to Q3 2015.
If the bond markets get spooked by the threat of tighter monetary policy then there is a high chance that all asset markets suffer potentially significant losses, especially in credit markets where the excess yield over government bonds has rarely been skinnier and absolute yields never lower. Let us not forget we saw the trailer for this particular film last summer; “The Taper Tantrum”. In such an instance there will be nowhere to hide and downside protection will be limited.
I am not suggesting that the scenario outlined above is a certainty, far from it, but it is appropriate that all investors recognise that the risk of it has risen, as asset markets have leapt and bond yields have collapsed. The fact that everyone is now so comfortable taking equity risk should serve as a warning to investors. That we are seeing certain late-equity cycle characteristics, such as mammoth buy-backs and corporate take-overs, should also sharpen the mind to the possibility of an overdue correction.
Central bankers will do all they can to keep volatility low and asset prices rising and investors will remain desperate to make a return. This party could continue for some time to come. But for now I am a crank and I am holding a higher level of “dirty cash”.
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