The 7IM Personal Injury Fund April 2016 – Comment

For most major equity markets, the rally seen in March carried on, at least for the first three weeks of April. Equities generally took heart from a pick-­up in the tone of economic data and leading indicators, confirming that February’s recession fears were wide of the mark and from a continued rebound in the oil price. Higher oil prices are not an obvious benefit to economic growth; all would rather be spending less on fuel. However, the extreme drop in oil prices towards $20 a barrel earlier in 2016 had raised concerns about defaults by borrowers in the energy sector whose businesses and balance sheets were structured for a meaningfully higher oil price. The rebound to prices around the mid $40s/barrel relieves some of this pressure, while still being cheap enough to increase consumers’ disposable income meaningfully versus a year or two years ago. The oil price rally also helped commodity sensitive sectors and markets (including the UK FTSE 100). Gold also rallied almost 5% – a boost after 7IM’s recent allocation.

For many markets – the US, UK and especially emerging economies – equity returns are now slightly positive year-­to-­date. For Europe and especially Japan where corporate profit expectations have been undermined by local currency strength, stocks remain in negative territory for the year.

The Pound strengthened a little during April, detracting from returns on 7IM’s foreign assets when measured in Sterling terms. Gilts fell (with yields pushing higher from 1.4% to 1.6% in the month) but riskier bonds rallied as economic concerns eased and liquidity conditions improved: US high yield bonds (where we had increased allocations in March) beat most equity indices in April, helped particularly by easing concerns about the energy sector.

The 7IM Personal Injury Fund achieved modestly positive returns in April, gaining 0.35% (B Acc):

7imApril16chart1

The year-­to-­date returns of the 7IM Personal Injury Fund now stand at 1.13% (B Acc) , despite the extreme volatility experienced in January and February:

7imApril16chart2

After the tough market conditions of the last year, longer-­run returns are a little behind 7IM’s projections, with five-­year compound annual returns as at the end of April standing at 4.03% (B Acc):

7imApril16chart3

Market volatility and a shifting risk landscape has continued to create opportunities and driven meaningful shifts in the 7IM Personal Injury Fund’s holdings. 7IM completed the planned sales of Japanese equity at the beginning of April (reducing it to zero), reflecting 7IM’s concerns that Japanese stocks are vulnerable to a Yen rebound; this reduced the impact on the fund of continued weakness in Tokyo stocks through the month. 7IM increased US Dollar holdings during April, partly to build protection against volatility ahead of the UK’s EU Referendum in late June. 7IM took some steps back into emerging market bonds (having sold out in the third quarter last year): yields look attractive and potential stability in commodity prices reduces pressure on some riskier borrowers, allowing scope for currencies to rally further. 7IM made a small investment in an absolute-­return commodity strategy, which looks to generate uncorrelated returns by exploiting the structure of commodities futures pricing at different maturities: this adds to a selection of absolute return strategies in the fund that are not directly sensitive to the direction of equity markets, interest rates or bond yields, but have potential to generate returns in varying market environments, and thereby reduce the fund’s overall volatility.

7IM have held US TIPs and Italian/Spanish inflation-­linked bonds for some time, as it appears that markets are underpricing inflation risks. This has worked reasonably well, with real yields falling (i.e. bond prices rising) in both the US and Eurozone. However, inflation-­linked bonds effectively comprise both an inflation-­protection component (which looks good value) and a long-­
dated bond component (which looks less attractive); and in many plausible scenarios, these offset each other. For example, if inflation surprises to the upside, as 7IM expect, the inflation-­protection component can pay-off handsomely but, if unexpected inflation leads to higher conventional bond yields, then the long-­dated bond component could suffer. At current yield levels, 7IM see little value in TIPs or Eurozone Index Linked (and 7IM have long regarded UK Index Linked as expensive). 7IM have also reallocated into inflation protection certificates, structured to give targeted exposure to long-­dated inflation.

The market horrors of January and February have largely dissipated: deflation and recession fears looked misplaced to us then, and the market has reverted to a more sanguine view. Economic data and leading indicators have been robust enough to show-up the January sell-off as an unjustified panic, but perhaps not yet strong enough to give a clear signal that the economy is accelerating and enjoying the benefits of cheaper oil prices. Markets are in something of a holding pattern, looking for direction. This looks a helpful environment for riskier debt, especially where pricing became severely dislocated in Q1. High yield bonds – and less liquid loans and structured credit – were discounting a severe and drawn out recession and, while pricing has recovered somewhat through March and April, good value can still be found. Prospective returns look attractive, with high yields on offer and the possibility of some capital growth if excess credit spreads narrow to factor in a less downbeat view of the economy.

Equities have recovered somewhat from the pain in early 2016 and can make further ground, but valuations are critical. US companies have seen a strong recovery in profits since the 2009 lows, and profits broadly continue to look reasonably healthy when 7IM take account of the drag from a strong Dollar and the collapse in profits from energy companies: these factors will pass. But, while 7IM may feel reasonably optimistic about the US economy and the profit outlook, a degree of optimism is already reflected in US equity valuations, which do not look cheap relative to history. Stocks in much of Asia, including both China and Japan, do look very cheap relative to history: profit growth may be rather sluggish, but there’s no optimism priced in here. Europe comes into particular focus: signs of recovery in corporate profits since 2009 have been repeatedly snuffed out – first by double-­dip recession and the peripheral Eurozone crisis, then by the recovery in the Euro as a headwind to exports and foreign profits, latterly by the collapse in energy sector profits and a squeeze on bank net interest margins. As a result, expected annual profits for large-­cap Eurozone stocks are barely above Lehman crisis lows: an extraordinary situation. If one believes that Eurozone companies are broken and profitability permanently impaired, European stocks are clearly too expensive, on the other hand, if one believes that the series of profit headwinds will pass and that profits can normalise over time, higher valuations are reasonable. 7IM lean to the latter view – the series of specific headwinds to a profit recovery has been damaging, but is not permanent: but it’s clear that the market’s patience has been severely tested and stocks will be volatile if investors lose reasons to expect profits to recover.

Markets worried about deflation earlier in the year: perhaps unsurprising, as weak energy prices dragged headline inflation to very low levels in many economies, but energy prices are volatile and their impact on inflation can be transient. While markets were worrying about deflation and speculating that the Federal Reserve’s next move could be to cut interest rates, core measures of inflation (which exclude energy and food) have actually been pushing higher, and a range of indicators suggest inflation pressures continue to build. Wages – a major component of services inflation – are rising and the combined effects of minimum wage hikes and tight labour markets suggest they will continue to do so; tenant demand for housing is pushing rents higher (that’s a big factor in US CPI) and healthcare costs (another big factor in US CPI) are also rising. As the headwinds of weak commodity prices and a strong Dollar fade and base effects kick in, the conditions are there for markets to be wrong-­footed on inflation. While headline inflation today has been dragged lower by weak oil prices, inflation markets have extrapolated today’s oil price effects on inflation over the next 30 years: this seems unwarranted, and we’d expect it to reverse. With a high probability of US headline inflation readings later in 2016 rebounding quite meaningfully, this is not only a risk we can protect against cheaply, but an opportunity 7IM can try to exploit. Gold, equities, property all play a role, alongside more targeted inflation protection contracts.

The Brexit Referendum remains an important factor. 7IM already see some effects from Referendum-­related uncertainty in economic indicators, for example, in corporate capital spending intentions and in London housebuyer enquiries. The Remain camp seem to be holding a small but firm lead, and this has seen some of Sterling’s previous weakness dissipate. Markets appear to regard the Pound as the principal area of vulnerability in the event of a vote to leave the EU: the UK’s large current account deficit leaves the UK reliant on capital inflows, which may be at risk in an environment of political and economic uncertainty. Although the polls and bookmakers’ odds suggest that a Remain outcome is the most likely, events over the next six weeks may yet have a bearing, and the outcome – in terms of market impact – looks very asymmetrical: a vote to stay could see a modest Sterling rally, but a vote to exit could see both significant Sterling weakness* and the potential for volatility across a range of other risky assets. Even if Remain still appears the most likely result, it is prudent to build some protection against a less probable, but potentially damaging alternative scenario. 7IM maintain an underweight in GBP as a hedge against the potential for meaningful weakness in Sterling if Remain’s lead is threatened, with tilts towards the Euro, emerging market currencies and the Dollar.

*the independent National Institute of Economic and Social Research has estimated that Sterling could fall by 20% on a Brexit vote (10 May 2016.)

Twelve months volatility of the 7IM Personal Injury Fund, as measured by standard deviation is currently 4.67(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 4.30(1).

(1): Source: Analytic: Twelve Months to 18 May 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.