The 7IM Personal Injury Fund March 2016 – Comment

Stock markets had rallied sharply in the second half of February as investors came to realise that their varied fears of a US recession, a dramatic Chinese economic slowdown or fatal weaknesses in the Eurozone banking system – were not supported by the facts.

Stock markets had rallied sharply in the second half of February, as investors came to realise that their varied fears – of a US recession, a dramatic Chinese economic slowdown or fatal weaknesses in the Eurozone banking system – were not supported by the facts. Economic data and surveys confirmed that the US economy continues to grow and add jobs at a fair clip and that stimulus efforts by the Chinese authorities are bearing fruit. Further economic stimulus measures announced by the European Central Bank in early March went further than investors expected and were structured to mitigate pressures on banks’ profitability. Oil prices rallied too through March, supported by expectations of more controlled production growth from major suppliers: this helped dispel market fears that a deep trough in crude oil prices could cause a steeper collapse in profits in the oil industry and a destabilising wave of defaults in the sector. Global equities rebounded a little over 3% in Sterling terms in March; while UK equities lagged a little, emerging markets (including Asia – a key overweight position for 7IM) rebounded very strongly.

Gilts were broadly flat over the month, with yields staying close to historic lows around 1.4%. Riskier bonds – including corporate bonds and emerging markets – generally performed better, with credit spreads narrowing and investment flows returning to the asset class. Sterling recovered some ground against the Dollar, but continued to weaken against the Euro.

Over the month of March 2016, the 7IM Personal Injury Fund gained 1.57% (B Acc):

chart1March16chart1

As a result, the fund now achieved a small gain of 0.78% (B acc) year-­to-­date for the first quarter of 2016:

March16chart2

Over the last 12 months, the 7IM Personal Injury Fund shows a loss of -­2.75% (B Acc):

March16chart3

Over the longer term, the 7IM Personal Injury Fund has delivered returns close to 7IM’s central projections, with compound returns of 4.2% p.a. over the last five years:

March16chart4

The market dislocations of the early part of 2016 have created opportunities, where assets may be significantly mispricing the real economic risks. 7IM added modestly to equity allocations in February, which generally paid-off well as stockmarkets recovered, but the dislocations have persisted longer in some other, less liquid markets, for example, in credit. High yield bonds and secured loans to sub-­investment grade companies saw significant rises in yields in the first two months of 2016, implying that investors in these asset classes were pricing in a very high probability of recession and a wave of corporate defaults across many sectors of the economy. 7IM are expecting quite high defaults across the energy sector and its suppliers, the consequence of weak oil prices and the collapse in capital spending in the sector, but these expected defaults (and more) are already priced-in. With little evidence to suggest that a broad recession and an associated wave of defaults is likely, the return prospects for high yield bonds loans look good – the balance of risk-­reward appears favourable against US equities in most plausible scenarios, given the fairly demanding valuations of US stocks. 7IM trimmed US equity allocations to fund increased allocations to credit, adding to the Robeco Quant High Yield fund and to the NB Global Floating Rate Income fund.

To help protect against growing and underappreciated inflation risks, 7IM have increased the fund’s allocation to inflation-­linked bonds (adding to US TIPS) and invested in gold for the first time in several years. Inflation-­linked bonds now account for 11% of the fund and gold for 4%.

7IM have, for some months, been invested in short-­dated Eurostoxx dividend futures, as a relatively low risk way to gain exposure to the performance of European companies, with much lower volatility than a direct equity investment. The market is still pricing-in significant and sustained falls in corporate dividend payouts, which seems implausible in the context of ongoing economic recovery and a reasonable outlook for corporate profits (outside the energy sector). 7IM have extended their exposure, adding to EuroStoxx dividends for 2017 and 2018. These investments stand to gain even if dividend payouts are stable or slightly lower – they could generate very attractive returns if European company dividends rise modestly, as they expect.

The Pound has been weak in 2016, but recovered somewhat against the Dollar during March (from $1.39 to around $1.44). This has opened a window to prepare the fund for possible further currency volatility in the run-­up to the Brexit Referendum: if the Pound is volatile, holdings of foreign currency should provide a cushion. However, relatively weak Sterling may be a boon for profitability of FTSE 100 companies, which tend to be global players doing relatively little business domestically: a weak Pound means that the value of overseas profits is greater in Sterling terms. 7IM have been cautious for some time on the outlook for the FTSE 100 (which has an unusually high representation of resource-­related companies), but with signs of stabilisation in commodity price trends and with the possibility of more favourable currency trends, 7IM have switched some exposure from European to UK equities.

The panic may be over for now, but investor sentiment remains skittish, with fears of a renewed bout of volatility buried not far under the surface. There may be little fundamental justification for this: corporate profit growth has been disappointing (to a large extent due to the collapse in commodity-­sector profits), but the weight of data confirms that the US economic cycle continues, with signs of life re-emerging in manufacturing after the lull of the last few months. Central banks across the major economies continue to tilt policy towards growth and promoting credit, and subtly away from the beggar-­thy-­neighbour currency devaluation policies of the last few years. The European Central Bank (ECB) has eased further, with targeted measures to improve credit availability; the People’s Bank of China continues to implement fiscal and monetary support measures and to improve its communication with markets on currency policy; and the Bank of Japan seems likely to attempt further stimulus in April. And, since their initial rate hike in December, the US Federal Reserve has been at pains to calm markets about the likely pace of future rate rises.

Some investors are now fearful that loose monetary policy at a time when the economic recovery continues may be building a nasty inflation surprise. This is a risk worth guarding against: markets have been preoccupied with deflation risks in the early part of the year – only weeks ago, investors were speculating about the Federal Reserve cutting interest rates into negative territory to fight deflation. But, with oil prices stabilising, employment increasing and wages rising, the risks to inflation could indeed be on the upside. Where 7IM can find further protection at reasonable prices, this looks a sensible precaution: inflation-­linked bonds in the US are cheap relative to Treasuries, pricing in inflation as low as 1.5% on average over the next decade – 7IM have added to their positions. 7IM have been wary of gold for several years, and have seen prices fall from around $1900/oz in 2011 to around $1200/oz now. Gold is seen as a solid hedge against unexpected inflation (and against unanticipated risks generally); in a world where cash yields zero and many government bonds offer negative yields, the opportunity cost of holding the yellow metal is low, and it can again play a role in the defensive side of 7IM’s funds. The 7IM Personal Injury Fund now has a 4% allocation to gold.

Markets have become quite focused on the implications of the UK’s forthcoming EU Referendum, and this obsession can intensify further in the next couple of months. 7IM continue to believe that currency markets will see the biggest impact from Brexit fears. Sterling has already weakened markedly since the turn of the year, but this reflects deferred expectations of UK rate hikes as well as concerns over the Referendum. The UK’s deep current account deficit leaves the Pound very vulnerable to uncertainty over trade and international investment flows: leaving aside the politics, it seems plausible to 7IM that a vote to leave the EU could result in significant Sterling weakness. Holding a globally diversified fund, with meaningful allocations to the Dollar, Euro and emerging market currencies, is a reasonable defence. But 7IM remain agile and prepared to reverse course: uncertainty between now and rd June 23 could undermine Sterling, but if the polls – currently predicting a tight victory for “Remain” – are correct, there could be considerable scope for a relief rally. 7IM will be ready to act.

7IM are reassured to some extent by the progress of the global economy and the support that central banks continue to provide. However, 7IM have seen again over the last year how markets can take a course that has little basis in the macro data. When fear takes hold, a little volatility can rapidly breed a lot more volatility. While relative calm reigns at present, 7IM cannot be sure that such an environment will persist. The challenge then is to balance the aim of generating attractive long-­term returns by investing in undervalued and sometimes unpopular asset classes, with the need to manage shorter-­term volatility – at a time when traditional safe havens are unusually expensive and the investing environment can turn on a sixpence. The environment requires some resilience from investors – an acceptance that generating investment returns requires some volatility – but it requires strong portfolio construction to manage a challenging combination of risks, and a nimble tactical approach, able to adjust exposures as markets move and the outlook evolves, ensuring that 7IM have the scope to add to favoured assets when future bouts of market volatility inevitability create opportunities. 7IM’s fund moves in March have reduced overall levels of risk, while retaining exposure to assets that still have strong potential to perform.

Twelve months volatility of the 7IM Personal Injury Fund, as measured by standard deviation is currently 4.69(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 4.33(1). (1):

Source: Analytic: Twelve Months to 12 April 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.