Table of Contents
It is worth just taking a moment to remember how we got here. After more than a decade of near zero interest rates and benign inflation that pushed up all asset values and rewarded speculation, we got that very sharp bout of inflation towards the end of 2021 followed by sharply rising interest rates in 2022.
Bond prices suffered immediately, and it has taken just about 2 years to recover losses in our fixed income funds. In Gilt and Corporate Bond index funds it is going to take much longer than that. In equities, many share prices, like bonds, did correct downwards and some of our active managers are still nursing some losses. But then along came the fervour over AI.
This turned past behaviour and experience on its head. Whilst it would have been expected that higher interest rates would have hurt the values of growth stocks (which put a premium value on future earnings) more than more defensive stocks, the exact opposite happened. AI allowed the speculation to continue driving a handful of already expensive companies to even greater values. As these companies started to dominate world indices the clamour for index tracking also increased compounding the issue.
Without lifting the bonnet to see what’s going on you can see why – save money by cutting out management fees and make bigger returns – what’s not to like?
We thought it was all going to end at some point, but it was very hard to see when, why or how. At the end of last week, we got some clues:
The Japanese Yen ‘carry trade’.
The Japanese Yen had been the last vestige of cheap money. With interest rates less than 1% and a currency generally falling in value, borrowing in Yen provided a great source of cheap money to speculate with. That was until last week. To stop their currency falling further, Japan put up its base rates sending the Yen upwards against all currencies. Here is the Yen against the US$ for this year.
Source: Yahoo Finance 9th August 2024
As those who took out foreign currency mortgages (quite fashionable in the 80’s and 90’s) for example borrowing in Swiss Francs found out, whilst the interest may have been cheap the exchange rate made the loans very expensive as the cost of repayment increased. Yen loans just became c10% more expensive to repay in two weeks. TS Lombard estimate there could be as much as $1.1 trillion of borrowings in Yen used to finance investments elsewhere in the world, that’s a sizeable position if it’s all to unwind. That some investors started to unwind last week may have triggered the sell off. At 12% the Yen base rate rise certainly caused the biggest single day sell off in Japanese equities since 1987.
Earnings Valuation Compression and the Impact of AI.
Whilst US big techs have generally reported good earnings, it’s the earnings outlooks which have been the issue. Remember these are not the loss-making tech companies of the 1990’s with the internet explosion ahead of them, these are relatively mature and already hugely profitable businesses. To sustain a business valuation of more than 30 x your earnings investors need to be confident those earnings will keep growing fast. AI was the catalyst that would keep those already colossal earnings growing at pace – or perhaps not?
We already looked at Tesla and its falling earnings in a previous update, but let’s look at tech behemoth and AI beneficiary Microsoft. For its quarter ending 30th June it confirmed on the 30th July a 15% increase in revenue and 10% increase in profits. Most investors would be delighted if a company they owned a share in did that, but since the 8th July the value of Microsoft shares has fallen roughly 14%.
Source: Yahoo Finance 9th August 2024
Investors are getting more risk averse in assessing how Microsoft, even with AI will be able to keep growing its profits. Despite the recent correction, according to website GuruFocus Microsoft is today valued at 30.64 times forward earnings. According to the same website the median forward p.e. for the S&P 500 historically is 18.1 times. Microsoft remains an expensive business to invest in today.
Threat of Recession.
Since 2022 equity markets have been helped by a stronger than expected economy, particularly in the US. Whilst unlike the Bank of England the US Federal Reserve (the Fed) is yet to drop its base interest rate. However, the expectation that these rates cuts will come soon has increased as the US economic outlook softens. Some investors now worry the Fed will leave it too late to cut rates actually causing a recession.
Base rate rises have probably had less of an effect in cooling economies that economists expected. Many households’ finances are in good shape and both corporates and households have been sheltered from the base interest rate rises since 2022 through fixed rate borrowing. So, the impact of higher base rates is likely delayed. But those loans will roll over onto new rates in due course as we all adjust to the higher cost of money.
In the US consumers have very long fixed rate loans and are almost impervious to base rate changes. They are however highly leveraged to US stock markets through their 401ks and brokerage accounts. TS Lombard have held a longstanding view that the US consumer would be more likely to become risk averse and spend less if stock values fall rather than because of a rise in base rates. Time will tell if they are right.
US Politics.
A chat with my old college chum now an oil and gas minor magnate in Austin Texas revealed the side of US politics we don’t always get from the UK media. The momentum is indeed with the Democrats as we speculated in the last update. With Trump apparently failing to capitalise with the centre ground after his survived assassination attempt.
The view of the average oil magnate in Texas is that a “left wing, European, style over regulating, interfering, overly woke Democrat Government” would be bad for the US economy and bad for stocks. This could cause some to de risk ahead of the election.
For now, I am very pleased Tideway’s investment committee resisted the pressure last year and earlier this year to invest more in indices focused on US mega cap equities. On face value it appeared to be a great way to lower portfolio costs and increase returns, but the last week has shown us some of the very real risks associated with buying an index concentrated in a handful of highly valued businesses.
So far since 2009 ‘buying the dip’ has been the right strategy for any correction like this and as I look at markets this morning that looks like it may be the case again. Time will tell, but if we think we can continue to deliver good returns without betting too heavily on the tech giants, this will be our preferred lower risk route.
Nick Gait, below looks at how Tideway’s portfolios have fared through the turmoil with reference to a few specific funds.
Finally, a big shout out to our Team GB Olympic sailors, it’s been a tough regatta in typical light wind, fickle, Mediterranean conditions. All but one Team GB sailor is going to be disappointed with their final standings with seven different countries getting Gold medals and only Italy and the Netherlands gaining two. Very different from past Olympics with sailing dominated by the US, Australia and more recently Team GB.
We were very lucky to have Ellie Aldridge on our table last year for the Andrew Simpson Foundation fund raising dinner. A guest courtesy of our men’s dinghy entry Micky Becket who we know well and was highly favoured to medal thanks to his strong run in international events which continued right up to the Olympics. Ellie was less well known to us having just been selected to compete in the new event – Kite Foiling. I won’t try and explain Kite Foiling, nor the event scoring system, but you can watch Ellie win her gold medal in some style on the BBC I Player……wow she made it look easy!
Introduction
The past week has seen markets swing wildly as a perfect storm of factors ranging from mixed company earnings and softening economic indicators to geopolitical tensions and technical triggers has fuelled uncertainty and sparked widespread selling in major markets.
Tideway’s Multi-Asset Portfolios have held up relatively well versus the peer group with Tideway’s Investment Committee having resisted the temptation to sell more defensive or insurance assets whilst a select few global technology companies drove global equity markets ever higher throughout the earlier part of the year. Although Equities are generally accepted as the top performing asset class over the long term, returns are rarely linear for an extended period with intermittent sharp selloffs the primary downside of the asset class.
Those who don’t hold more defensive assets are often reminded of this when they cannot handle market drawdowns and end up selling their risk assets at inopportune moments. Retaining defensive assets, even when markets are performing strongly, makes holding onto strong performing riskier investments much more palatable in the periods where they do struggle. We will continue to believe in a diversified portfolio approach.
Performance
Source: Tideway & FE Analytics 09/08/24
Ruffer Diversified Return
One of our primary defensive positions in Tideway Multi-Asset portfolios is Ruffer Diversified Return. Although lagging year to date due to its defensive positioning, the team have held up their end of the bargain so far amid the most recent bout of market volatility reminding us of the benefits of holding such a strategy which has made money in every major market stress event over the last three decades.
Given the magnitude of market moves we are happy to see Ruffer’s portfolio protections are behaving as envisioned allowing the manager to deliver positive returns whilst major asset classes are struggling. The portfolio has appreciated +1.9% over the last week, +4.3% over the last month bring the fund to a positive +3.7% YTD, ahead of cash for those monitoring.
- The yen: the portfolio has an approximately 15% exposure to the yen (across bonds, and options). The yen has been strengthening since 9 July 2024, appreciating c10% versus the dollar. The portfolio is up c4.6% since that date, with the yen position being a significant contributor.
- Credit protection, S&P puts (Profits when S&P500 falls), VIX calls (Profits when volatility is high): with markets falling and volatility rising, the derivative protection has behaved as the manager intended. The team continue to actively trade these positions whilst retaining the portfolio’s protective ability.
- Inflation linked bonds: given the weak US payrolls print from last Friday, markets have been quick to price in additional rate cuts from the Fed. More than 200bps of cuts are now priced over the next 12 months which has only really been seen before in a recession.
Fixed Income
The Fixed income portion of Tideway’s Multi-Asset portfolios has held strong, relative to Equities, over the last week despite widening Credit spreads with lower yields across the board as markets anticipate central bank rate cuts. Although underperforming longer duration government assets, we are handily ahead over longer time periods. These assets do not provide the same level of protection as Ruffer Diversified Return over short time periods, though any losses are likely to be recovered quickly with healthy real yields still available combined with low default rates.
- The content of this document is for information purposes only and should not be construed as financial advice.
- Any rates of return used are for illustrative purposes only. Please be aware that the value of investments, and the income you may receive from them, cannot be guaranteed and may fall as well as rise.
- Any rates of tax referred to are correct as at the date of this document and may be subject to change in the future.
