The 7IM Personal Injury Fund February 2016 – Comment

February was an extraordinary month for global markets. At one level, not much happened: the FTSE 100 gained 0.2% for the month. But this hides a more volatile journey, with the index falling 9% in the first ten days of the month before recouping these losses in a violent rally to the end of the month. The picture was similar for US, European and emerging market equities (with most of the losses from the first week or two recovered by the end of the month). Japanese stocks fell further and recovered less, standing 9% lower at the end of the month than the start, however, the sharp rise in the Japanese Yen meant that investors who had not hedged the currency did, indeed, recoup most of the losses in Sterling terms. While market commentators put forward many reasons for the market correction (counting over 30 “justifications” highlighted by investors to explain the sell-­off) this had the hallmarks of a panic, a collapse of investor sentiment in the face of market volatility, with little basis in economic reality or business fundamentals.

Sterling was very weak during the month as uncertainty over the forthcoming EU membership Referendum began to weigh more heavily on sentiment. The UK runs a very large current account deficit, and therefore needs to attract international capital flows, for example, capital investment into housing, infrastructure and corporate assets and more liquid portfolio investments (like equities and gilts). Uncertainty over the future acts as a headwind for these capital flows and, therefore, a dampener on Sterling. The Pound fell 2% against the Dollar in February, a little more against the Euro, and also weakened against emerging market currencies like the Brazilian Real and Russian Rouble (this move also boosted emerging market debt, in Sterling terms). 7IM’s funds typically have rather high allocations to non-­Sterling currencies, so a period of weakness for the Pound tends to be beneficial for returns.

Bonds performed well again, as investors favoured short-­term security of capital over long-­term return prospects: ten-year gilt yields fell from just under 1.6% to around 1.3% in February (i.e. prices rose, with the gilt index as a whole returning around 1.4% in the month), and 7IM’s US Treasury bond positions also performed well as it seemed more likely that the US Federal Reserve would have to defer interest rate rises. Investors – including 7IM – who have seen bond yields as too low to justify significant weightings have clearly been too early in expressing that view, but it is fair to question the outlook from here.  A ten-­year gilt offering an annual yield of 1.3% may be attractive in an environment of sustained uncertainty and very low inflation, perhaps even deflation; but a yield of 1.3% may look less attractive if the economy continues to recover and inflation pressures return. It’s worth bearing mind that a return towards more “normal” levels of yield would be very damaging for capital values of bonds: even a return to a yield of 2.5% would cause a capital loss of close to 10%. Apparent safe havens may carry unexpected dangers.

Although market volatility took the 7IM Personal Injury Fund to a painful low in mid-­month, the rebound has been significant and the fund made gains of 1.17% (B acc) for the month as a whole:

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The fund has returned -­3.0% (B Acc) over the past year, at the low end of expectations but within 7IM’s projected range for a 12-month period:

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Over the last five years, despite the recent weakness, the fund has achieved annualised returns of 3.95%, close to 7IM’s long-­term projections (B Acc) = 20.97%:

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As markets sank and investors flitted from one fear to the next, 7IM continued to review and re-­assess their scenarios for the world economy and markets. 7IM still found overwhelming evidence that investors’ fears were overblown and that market weakness was out of line with economic reality. It is impossible to know when a storm of panic will subside, but the right tactic in markets gripped by unfounded fears is to hold steady, and to add selectively to favoured assets on weakness: 7IM therefore topped-up allocations to Japanese and European equity and tilted their European equities towards small and mid-­cap stocks. 7IM have wanted to hold European small and mid-­sized companies for some time, for their greater exposure to a recovering domestic economy, but were previously deterred by valuations: the correction gave them an attractive entry point. 7IM are also struck by very attractive valuations in some of the less liquid credit markets, where prices of bonds and loans have been marked down aggressively by brokers – often because the brokers no longer have the capacity to take bonds onto their own books and have, therefore, fixed their bids to dampen trading. Current valuations are pricing in a deep recession in some parts of the credit market: this looks implausible. Clearly, 7IM need to approach the less liquid segments of credit markets with caution and limit the overall size of the exposure, but they see deep value and the opportunity to lock in very high yields. 7IM will take advantage.

Robust data on the labour market, consumer spending and even signs of a stabilisation in the manufacturing sector show that the US economy is very clearly not slipping into recession; recent market speculation that the US Federal Reserve could cut interest rates into negative territory looks increasingly absurd and will look even more absurd if inflation picks-up in the second half of the year, as 7IM expect. China’s Renminbi has been gradually strengthening since the 8th January, the People’s Bank of China is starting to communicate more effectively and clearly with markets, and China’s foreign currency reserves are steadying. Oil prices appear to have stabilised, at least for now, as more signs emerge that demand is robust and that supply can be slowed. Although investors are newly concerned about the impact of negative interest rates on bank profitability, the majority of European banks reported strong earnings and dividend increases (for which they need specific permission from the ECB). Even weaker players have looked to demonstrate the depth of capital reserves by buying in subordinated bonds. The austerity policies seen in much of Europe and the US are moderating. As the bearish narratives have been undermined, one-by-one, markets have found some stability and rallied almost as rapidly as they fell.

Question marks remain over corporate earnings expectations and over the robustness of future growth indicated by business and consumer confidence surveys. Company profits in 2015 lagged expectations, but the vast majority of this can be traced either to commodity price falls (hurting profits for miners and energy companies) or currency shifts. Analysts’ forecasts of company profits have dropped in recent weeks, but this may be a case of analysts following rather than leading markets, simply cutting their forecasts after a sell-­off. Sentiment and confidence surveys have weakened in the last few weeks too but, again, 7IM need to be careful of over-­interpretation: this may largely reflect the impact of the market correction. These indicators need to be monitored but, in contrast to the popular theory that market panics can cause economic downturns, 7IM find few if any examples through history where a stockmarket fall has in itself caused a recession in the real economy. Today looks no different.

Clearly, there is a lot of ground to recover still. Looking in the rear view mirror, most equity markets still stand well below their highs of a year ago. Expectations for economic growth in 2016 have moderated a touch since then, as consumers have been a little slow to spend all the recent gains from wage growth and cheap fuel, but perhaps that boost still lies ahead of us (and will be bigger than anticipated, with oil below $40 – compared to $60 a year ago) and there could be room for surprises to the upside on household consumption and on construction. Company earnings expectations have fallen – especially in the energy sector – but overall profit forecasts for a year ahead are not so different to where they stood a year ago, and equities are significantly cheaper. 7IM may be in the second half of a long and subdued cyclical recovery, but there’s little to suggest we are close to the end: central banks are still running very supportive policy, debt is available and cheap, firms are hiring more workers and paying them more, and both companies and households have scope to borrow more if they feel confident enough to do so. The global economy is not as bad as all that, and markets may still be playing catch up.

12 months volatility of the 7IM Personal Injury Fund, as measured by standard deviation is currently 4.63(1), which is well below the long-­term maximum target of 7.1 and similar to the IA Mixed Investment (0%-­35% shares benchmark) of 4.28(1).

(1): Source: Analytic: Twelve Months to 12 March 2016

This document is for information purposes only and should not be considered to be an offer to invest. The past performance of any investment is not necessarily a guide to future performance. The value of investments or income from them may go down as well as up. As stocks and shares are valued from second to second, their bid and offer value fluctuates sometimes widely. The value of shares may rise as well as fall due to, and not just including, the volatility of world markets, interest rates, economic conditions/data and/or changes in the rate of exchange in the currency in which the investments are denominated. You may not necessarily get back the amount you invested.