The 7IM Personal Injury Fund – May 2016 Comment

Stock markets generally rose through May around the world – at least for developed markets. Investors continued to step back from the growth scares that dominated the early part of the year, as  the  weight of data confirming a resilient global economy continued to build, and the recovery in oil prices (reaching close to $50 a barrel by late May – from a low of around $25 in February) continued to rein in fears of widespread bankruptcies among oil producers. Risky bonds, including high yield, continued to perform well, but investors remain circumspect – it was not a full ­blooded risk environment, with emerging markets like Brazil and Russia falling sharply. Government bonds continued to perform well, with yields grinding lower (to 1.4% for ten year gilts), helped by calming words on the likely interest rate trajectory from Janet Yellen at the Federal Reserve.

Markets began to shift focus away from the economic outlook and towards the UK’s EU Referendum and, despite the uncertainty associated with this event, the Pound actually strengthened against the Euro in May and fell only slightly against the Dollar.

The 7IM Personal Injury Fund lost a little ground in May, down 0.72% (B Acc) for the month:
chart1

Although exposures to market stocks and bonds made money, the fund was negatively impacted by exposure to the Euro and Asian equities, and by some of 7IM’s alternative assets and strategies,  including the new inflation protection certificates, which saw some weakness as markets continue to price in very low inflation over the next 30 years. 7IM expect clear inflation pressures over the course of 2016 to shake the market out of that view.

As a result, year-­to-­date returns now stands at +0.4%  (B acc):

chart2

Rolling 12 months returns are still negative at -­3.3% (B acc):

chart3

Five-year compound returns remain within touching distance of 7IM’s central case (at +3.7% annualised) and well within the range of projected probabilities 19.54%  (B acc):

chart4

Having bought inflation protection certificates (tied to market 30yr US inflation expectations) at the end of April, 7IM completed the sale of the holdings of inflation­-linked bonds, which provide less perfect protection against inflation. 7IM sold US TIPS, but also Italian and Spanish government bonds, where they have had exposure for a couple of years as the Euro crisis continued to subside. 7IM also made a small top-­up to the fund’s US Treasuries holding.

More significantly, 7IM made a large reduction to investment grade corporate bonds: high grade corporate bonds look challenged in a wide range of economic scenarios. In a benign, pro-­growth scenario, yields are likely to be pushed up (i.e. prices pushed down) by higher government bond yields – the extra yield from lending to companies rather than governments isn’t enough to offset this.  In a deflationary or recessionary scenario, government bond yields will fall (i.e. prices rise), but corporate bonds seem unlikely to capture the benefit, as markets will demand a higher risk premium for lending to companies in such a world.  Perhaps the best corporate bonds can reasonably hope for is muddling through in a subdued status quo, but yields are too low to provide much  return even in such a world.  There are specific, sub-­sector opportunities that seem more attractive (in floating rate credit, or in short-­term bonds) but 7IM have halved their allocation to corporate bonds in general, and hold the proceeds in cash for now.

Elsewhere, 7IM are holding the line on the fund’s foreign exchange positions, put in place to protect the fund from Referendum-­related volatility. 7IM are underweight Sterling (only around 65% of the 7IM Personal Injury Fund is in Sterling), with preferred exposures to the Dollar, Euro and small exposures to a diverse range of other currencies, so stand to be protected if Sterling falls in the weeks leading up to the vote.

It is virtually impossible for markets to focus on the global economy when faced with an imminent political risk event like the UK’s  EU Referendum.  The opposing outcomes are so different, and the potential for market reaction so severe if  the result is “Leave”, that the politics trumps all, and forces near-­term caution on all prudent investors; even those who – like  7IM – see an improving outlook for the global economy and corporate profits. But the political event risk will pass, one way or another, in a few days.

Assuming “Remain”, the threat of uncertainty fades and investors can refocus on the improving economic cycle. Europe continues its gradual recovery, and looks set to benefit from stronger global trade this year; fiscal stimulus and targeted measures to support housing markets have stabilised growth in China, and perennial concerns over Chinese debt can fade into the background.  And –   despite one month’s data showing a slower pace of  job creation in America – most indicators for the US point to continued employment growth, higher wages and a sustained improvement in consumers’ spending power, still receiving a boost from low energy prices.  That’s good news for global exporters. Corporate earnings should be able to grow in this environment.

Yet, investors are cautiously positioned and holding near-­record amounts of cash: if Brexit risk recedes and the global economy remains on track, investors are likely to be tempted back into assets with greater return potential, and that can support better stockmarket returns through the remainder of the year. Inflation pressures continue to build too, as commodity prices have stabilised, rents continue to rise and wages (a big driver of services price inflation) continue to grind higher in tighter labour markets: global bond yields are close to record lows, but this surely reflects investor risk aversion rather than a realistic near-­term outlook for inflation. Bond yields can grind higher if investor focus shifts back from near-­term fear to medium-­term inflation pressures.

If it’s Leave, the uncertainty will intensify. 7IM are pretty confident of significant weakness in Sterling as the UK’s huge current account deficit requires substantial capital inflows to the UK, and they suspect that those capital flows would, at the very least, be disrupted by uncertainty over the UK’s future trading relationships with Europe. Other impacts are less certain, but most independent economists project a meaningful negative impact on GDP growth, capital investment, jobs and housing in the UK, with negative implications for UK corporate profits. Of course, this affects domestic mid-­cap companies more than the globally-­oriented large caps of the FTSE 100, but investors may not make the distinction in an immediate knee-­jerk aftermath. 7IM suspect there would also be significant near-­term implications for other assets, especially European equities, peripheral bonds and the Euro, as investors  speculate on the possibility of other EU members leaving. Under some scenarios, the vote could become a significant risk-off event for most global markets.

So this is the near-­term challenge  being  faced.  Constructing portfolios for the medium-­term world post-­Referendum in the most likely scenario (which  is  still,  despite the  recent shift in polling, Remain) but ensures that 7IM have some near-­term protection both against volatility in the lead-­up to the vote and against the shifting probability of a Leave result; to be ready to shift exposures rapidly if polling indicators break one way or the other; and to be ready to act quickly in the aftermath.  7IM retain favoured equity positions, with an emphasis on Europe and Asia – where stocks look cheap versus history and where earnings growth potential is strongest; but they also have substantial risk buffers – as at the end of May, cash and short-­term bonds are over 18% of the fund, with a further 16% in government and public sector bonds (including US Treasuries) and 4% in Gold.  7IM also have well over a third of the fund allocated to currencies outside Sterling – substantially more than their long-­term norms for the 7IM Personal Injury Fund – mostly in the Dollar and Euro: this could help shield the fund from volatility if Sterling does, indeed, come under pressure around the Referendum.

12 months’ volatility of the 7IM Personal Injury Fund,  as measured by standard deviation is currently 4.70(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 4.31(1).

(1):  Source: Analytic: Twelve Months to 16 June 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.