The 7IM Personal Injury Fund December 2015 – Comment

Markets ended the year with a fall back into the pessimism that dominated the second half of 2015. Almost every asset class was hit. Global equities fell 1.8% in December 2015, with European equities hit hardest, falling almost 5%. European equities were particularly hit by the mismanagement of expectations by the European Central Bank (ECB). What should have been a helpful policy stimulus was greeted by markets as a disappointment, and the credibility of ECB head Mario Draghi was somewhat diminished.

The Federal Reserve in the US played a better hand in its own policy change. The Federal Reserve hiked interest rates in mid-­December in an extremely well-­telegraphed move. The reaction to the rate rise – the first in a decade – was muted, with US equities, bonds and the Dollar all relatively stable after the announcement.

Currencies did see sharp moves, but the dominant theme was of Sterling weakness (in particularly against the Euro), driven by concerns over a slowing in UK growth and by greater market attention to the risks around a Brexit Referendum in 2016. A Euro bought 70.2 pence at the end of November and 73.7p by the end of December, a rise of roughly 5%. The Yen and Dollar also strengthened against the Pound. This brings relief to the range of 7IM funds, with their overseas currency diversification helping at times when the Pound is under pressure.

The collapse in commodity prices continued in December too, with oil prices crashing through $40 a barrel and losing around 10% for the month, as it became clear that OPEC nations would not curb supply. Broader commodity prices continued to fall too – a diversified commodities index shows a decline of 8% in December and -­33% for the year as a whole. Even gold fell, inching lower in December and declining by more than 10% for the year as a whole.

The 7IM Personal Injury Fund saw negative returns in December, down -­ 0.46% (B Acc) for the month:

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Returns for the year as a whole (+0.57% for 2015 – B Acc) were disappointing rather than disastrous, standing below 7IM’s central projection but well within the range of likely outcomes:

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The returns on the 7IM Personal Injury Fund were better than the returns to be had for the year as a whole from either gilts, index-­linked gilts or UK equities. This performance was the net result of very strong gains in the first half of the year and painful losses in the second half. 7IM recognise that this volatile journey is a deeply uncomfortable one for investors, but reiterate that market sell offs like this provide opportunity as well as pain: today’s excessive losses in markets build the potential for tomorrow’s outsized recoveries, with scope to own fundamentally attractive assets at discounted valuations.

Despite the subdued returns for 2015, the fund’s medium to longer-­term returns remain close to 7IM’s central projections. Over the last three years, the 7IM Personal Injury Fund has delivered compound annual average returns of 3.7% (B Acc = 16.56%):

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Over the last five years to 31 December 2015, the fund has returned 28.77% (B Acc), equating to 4.15% per annum:

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7IM changed relatively little in the fund in December, focusing on reassessing the fundamental outlook for 2016 and identifying key fund developments to put in place in the new year. 7IM still have a tilt towards equity, as they are some way from maximum risk exposures but, with decent valuations and a fundamental outlook for economic growth and corporate earnings, that is far better than the pessimistic picture implied by volatile and downbeat markets, an overweight allocation is justified, however uncomfortable it may feel.

The 7IM Personal Injury Fund ended the year with a fairly high allocation to cash (around 15%). This provides a degree of flexibility to act opportunistically if the correction in risky assets worsens. However, rises in bond yields through 2015, as markets have moved to price in expectations of more interest rate rises in the Federal Reserve cycle that is now underway, shift the picture somewhat – particularly for US Treasuries. While 7IM may still expect to make little return over the next year or so on Treasuries, yields have risen through 2015 to levels where they can offer a reasonable volatility buffer. With scope for more volatility in 2016, it makes more sense to hold such a buffer than it has over the past few more benign years.

The decision to shy away from direct commodity exposure and resist calling a bottom in resource price declines has been a good one. Over the long-­term, 7IM expect commodity investments to deliver modest positive returns and to offer diversification, with fairly low correlations to equities and bonds: they form a part of 7IM’s portfolio strategic asset allocation. However, the oversupply in many commodities as a result of years of over-­investment will take a long time to adjust: there will no doubt be vicious bounces but it seems too soon to expect a sustained recovery in commodity prices, until supply is more closely aligned to demand. That can happen slowly (through demand growth over time) or more quickly (through producers cutting back on capacity and closing down operations), but it doesn’t seem to be happening yet. 7IM stay at zero weightings for now.

As 7IM write in early 2016, stock markets are enduring their worst start to the year in decades. The current market volatility is extremely uncomfortable and the environment could persist for longer; equally, they know that it can reverse violently, often with no obvious catalyst.

The vital question is whether the market’s pessimism is justified. 7IM’s analysis is clear: the global economy faces some challenges but the key drivers of growth are not broken. China is making a transition from an economy based on manufacturing and capital investment to one where services and consumption already play the bigger role: 7IM should not mistake weak manufacturing data for weakness across the whole economy, with the increasingly dominant services sector experiencing very strong growth still. Commodity­ related industries worldwide face a tough and prolonged adjustment; but 7IM would be wrong to extrapolate deep pain for a small sector of the economy to suggest the same pain is universal. Weak commodity prices are clearly a negative for oil producers and miners, and for the industrial companies who provide hardware to those sectors. However, there is a great deal of off-­setting good news from oil price falls. The world consumes around 90m barrels of oil per day: with oil prices well over $60 a barrel lower today than in late 2014, the collapse in oil prices has shifted over $2tn (somewhere around 2.5% of global GDP) of annual spending power from producers to users. Lower oil prices mean lower input costs for many companies (a helpful boost for margins) but, more significantly, it means a significant boost to disposable income for consumers as it costs less to fuel our cars and heat our homes. No wonder consumer confidence is strong and household spending on goods and services is robust.

This is not what recession looks like, so why do investors appear to be pricing in a downturn? For that, 7IM might consider the difficult combination of fragile sentiment as scars of the 2008 crisis still run deep; scarce liquidity, as regulation has constrained banks from acting as market maker and taking risk onto their own books; the increasing use of index investments, which may lead to higher correlations between stocks and bursts of volatility as investors switch from risk-­on to risk-­off; and above all the investment industry’s acute sensitivity to short-­term price volatility: with fewer investors able to take a genuine long-­term view, a small rise in price volatility can push other investors to sell, as their own volatility limits become tested – establishing a vicious circle that leads to asset prices losing touch with fundamentals. It’s hard to prove, but 7IM suspect these factors explain a lot about their current environment, and how a little volatility can quickly breed a lot more, flying in the face of logic and reasoning.

Short-­term price volatility is uncomfortable, but it is not the only risk that investors face. In the real world, the biggest risk that we face is earning low returns over the long-­term. Sadly, trying to avoid short-term volatility at all costs could bring about that exact result. The current panic will pass and investors will focus again on fundamentals. When that happens, equity assets on decent valuations, with realistic expectations of earnings growth this year and in the years to come, will come back into favour. In the meantime, holdings of cash, bonds, alternative investments and currency exposures can help to cushion against the volatility, but they cannot stop it altogether. 12 months’ volatility of the 7IM Personal Injury Fund, as measured by standard deviation is currently 4.58(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 18 January 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.