A combination of events led to ‘peak uncertainty’ for markets by the end of 2019. Whilst we are now past ‘peak uncertainty’, some key issues prevail, and patience remains our watch word.
In the UK, 'peak-uncertainty' was only really relieved after the general election by a majority government determined to push Brexit through once and for all.
With capital preservation, or the avoidance of a permanent loss of capital, at the forefront of our investment process for the Tenax Absolute Return Strategies Fund, cash is always, unashamedly, our starting point.
It is not that we shun equities and bonds, quite the opposite in fact, but rather we feel that every investment beyond cash should offer a compelling reward potential, for an appropriate level of risk. Right now, the opportunities we see in front of us are simply not attractive enough.
Why so cautious?
Equity markets are fully valued, particularly in the US and even, arguably, in the UK.
Apart from a bounce in December, the FTSE 100 hasn’t made progress recently, currently trading at May 2017 levels. We have seen progress in more UK-focused names, mainly in the FTSE 250, but many still look too expensive for our liking.
To say the FTSE 100 is worth buying at current levels, you have to be happy to buy the likes of Shell, BP, HSBC, BAT & Glaxo, given that between them, they make up 30% of the Index.
Equally, in the US, yields on stocks are right at the bottom of the range. What worries us is pricing, particularly given that we are in an election year – President Trump has fallen short of his 4% GDP growth target and, looking at his presidency thus far, we know he is prone to making erratic decisions that can directly impact markets.
Equally, in the background, the concern is that many have discounted the threat of inflation. There are the beginnings of wage inflation already in the US, and, at effectively full employment, we could see this fuelled further.
In bond markets, credit spreads are back where they were in mid-2007, prior to the 2008 financial crisis. Whilst we are not trying to draw comparisons, spreads are now so low, it would be difficult to get much tighter, and we could begin to see a reversal.
Spreads did nothing but tighten last year, as the chase for yield gathered pace, and this is an effective driver of performance within credit markets.
Equally, the ‘risk-free’, or 10-year UK gilt rate stood at 1.25% in February 2019, subsequently falling to lows of 0.35% in September and, now, trading between 0.5% and 0.6%. At this level, it is not attractive and this limits the opportunities for an absolute return manager.
The current scourge of negative yielding government bonds across Europe is close to unique. There was $17 trillion worth of negative yielding debt last year. Whilst this has come down by around $5.5/6 trillion, this is still a substantial number. It’s not a policy we would encourage Central Banks to pursue.
In Germany (home to Europe’s largest saver base), spending has been encouraged to get the economy moving, but as yields on government bonds have dropped, saving rates have risen – possibly counter-intuitive but a reasonable response to ongoing political tension.
Conventional bonds are no longer looking attractive
We believe that bond yields have moved too far below the inflation rate (albeit there’s little inflation in the system as yet) but there is a risk of inflation returning - particularly if we move away from a long period of monetary stimulus toward some sort of fiscal stimulus.
In this environment, given capital preservation remains at the core of our investment objective, we look to err on the side of caution. Two of the key areas currently catching our eye are:
Floating rate notes
In this environment, cash (or cash equivalents) is king. Floating rate notes (FRN), for example, hold much appeal for us and have a 50% allocation within the portfolio (44% in AAA).
AAA FRNs offer many benefits amid volatile and unpredictable market conditions. They act as a free hedge against interest rate increases; the coupon on a FRN is reset every quarter to a specified level over a reference rate, previously three-month sterling LIBOR, now its successor, SONIA.
When interest rates are hiked, and the reference rate moves up, the coupons on FRNs increase, and, unlike other bonds, their capital value is protected by the floating rate. They also offer good liquidity, low volatility and an absolute return.
As a fixed interest security that can convert into the underlying equity of the issuing company at a specific share price, convertibles have an equity correlation, which can move with the underlying share price. But they also have a ‘bond floor’ - a price below which they are unlikely to fall (unless the company loses creditworthiness) due to the interest rate they are paying.
The convertible bond market has been limited in recent years as conventional bonds were so cheap to issue and companies have been able to borrow so inexpensively. But at a time when interest rates are starting to creep up, albeit slowly, and the sheer volume of lower grade securities being issued is so great, we suspect the window of cheap borrowing might be beginning to close.
From our perspective, with our core mandate of capital preservation, convertible bonds are an attractive asset. The bond is low risk and the equity call option could prove fruitful if the underlying stock rallies, and without the downside risk should the opposite happen.
It is true that neither convertible bonds nor FRNs offer particularly ‘dynamic’ returns, but mitigating downside risk is vital in absolute return investing and ‘dynamic’ returns can all too often lead to ‘dynamic’ losses. Thus far, employing a patient approach in buying stocks only when valuations look attractive has resulted in continuing success for our Tenax Fund over the course of its 12-year life-span.