Comment: Many imponderables for markets

Bill Jamieson

Bill Jamieson

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Another soggy, sagging week for markets returns us to that age-old question: where are we going from here? It seems calm enough – but for the uneasy sense of a rising swell of apprehension.

If it is not Greece, it is China. If not China, it’s the Middle East. These seemingly distant and perpetual troubles need not concern us unduly, but for our extraordinary vulnerability at this time. Economies and markets continue to rest on the continuance of unsustainable, ultra-low interest rates. And it is the sense of an approaching change here that fuels concerns of exposure to a convulsive change of direction and a bond market bust with destabilising impact on equity markets.

You don’t have to look far for signs of vulnerability. Sebastian Lyon, manager of the Edinburgh-based Personal Assets Trust, does not hold back in the latest annual report to shareholders. The trust may have had a better year, with net asset value per share up by 4.8 per cent in the year to end April compared with a rise of 3.9 per cent over the same period in the FTSE All Share Index but has this outperformance encouraged PAT to reduce its notoriously high level of holdings in cash and fixed interest – now close to 50 per cent of the trust – and step up its exposure to equities? Not at all. “After six years of the devil’s brew of zero interest rates and quantitative easing”, he writes, “there is evidence that bubbles are forming”.

For all the earnest central bank rhetoric over the past 20 years to moderate the business cycle and avoid bubbles and busts, they keep on coming – and created in large measure by central banks themselves. The dot com bubble was followed by the housing bubble and then the derivatives bubble and bust of the 2007-2009 financial crisis.

And even if central banks were able to identify from where the next bubble will come, they are in no mood to identify it.

Even if they were, writes, Lyon, “they would be as helpless as the Sorcerer’s Apprentice to mop up the flood, since the enchanted broom labelled ‘interest rates’ has lost all its bristles”.

Today’s bubbles, he points out, are occurring both in risky assets, like Chinese equities, and in perceived safe assets, like German government bonds. Shanghai-listed stocks are up by more than 100 per cent during the past year as margin financing has almost quadrupled in less than 12 months. He cites the example of an online audio and video entertainment business whose shares have risen 4,000 per cent since it came to the market just two months ago.

But flights to safety look just as fanciful. “Since 2010 conventional wisdom has held that we are on a path towards normalised interest rates, yet in Europe over the past year some official interest rates have even fallen below zero.

In Switzerland and Denmark people are paid to take out mortgages and banks charge you to hold your cash. Savers looking to escape this Alice in Wonderland world may start hiding their notes under the mattress.”

For risk-averse investors the immediate outlook now looks very challenging.

Prices today, he warns, are predicated on interest rates staying permanently low (which cannot happen) while correlations between asset classes have moved closer to one, so diversification gives less protection.

While PAT with its massive cash holdings is well able to exploit market falls, “we do not propose to be lured down a path of decreasing quality. Instead, we will avoid the seductive trap pointed out by Benjamin Graham, “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of good business conditions. The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”

So what is the cautious investor to do? Maintain a portfolio of defensive equities and do not be afraid of building up cash and near cash holdings. It is not in itself as riskless strategy – they may suffer an opportunity cost in the form of gains forgone should the market rise further.

But that is true for all investors and at all times.

Without adding to the PAT treasury of golden quotations, we are led to the existentialist truth of the Danish philosopher Soren Kierkegaard that a seasoned investor will immediately recognise: “There are two possible situations – one can either do this or that. My advice is this: do it or do not do it – you will regret both.”

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