The 7IM Personal Injury Fund January 2016 – Comment

Stockmarkets sold-off sharply in January 2016 as investors sought to draw a link between significant falls in oil prices and the health of the global economy. It was an extraordinary start to the year, with equity markets posting one of their worst starts in decades, before a modest rebound in the last week or so of January.

For the month as a whole, global equities fell around 6% (with the deepest falls in local currency terms for European and Asian markets). Global government bond yields fell as investors favoured traditional safe havens: the Citigroup World Government Bond index returned around 2% in local currency, and gilts returned around 3.6%, despite very low yields. The Pound fell, undermined by falling expectations for the future path of interest rates and by growing concern over the risks of the UK leaving the EU – Sterling fell as much as 3% against the Dollar and Euro, and more against the Yen, making foreign currency exposure a helpful diversifier yet again.

The continued volatile environment led to losses for the 7IM Personal Injury Fund in January, with a total return of ­1.93% (B Acc) for the month:

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This means that the 7IM Personal Injury Fund has now delivered a total return of -­3.21% (B Acc) over the last 12 months, at the low end of 7IM’s projected range of likely outcomes:

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Over the last five years, annualised returns are 4.0%, close to the centre of 7IM’s projected range of outcomes. 20.76% (B Acc):

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7IM have implemented some significant changes to the 7IM Personal Injury Fund during January. In the first few days of January, 7IM started building a meaningful allocation to US ten-­year Treasury bonds (adding to US Dollar exposure at the same time). Yields around 2.2% are low by historical standards, but above the record lows seen in 2012, and Treasuries can play a role in helping to manage overall fund volatility, with scope for yields to fall (and prices to rise) in periods of risk aversion or deflation fear: that’s worthwhile insurance for an element of the 7IM Personal Injury Fund. 7IM also increased global government bonds (mostly US Treasuries) to over 8% by mid­January, alongside existing holdings of global inflation-­linked bonds (9%), gilts and other public sector securities (7%) and substantial defensive holdings of cash and short-­term bonds. These positions somewhat mitigated the impact of the weakness in global equity.

7IM made changes in the equity allocations too. Although 7IM see Chinese stocks listed in Hong Kong (so-­called H­shares) as extremely attractive value against vastly overstated risks in China, they are conscious that their current volatility is especially hard to bear in more cautious portfolios. 7IM therefore exited the small holding of Chinese equities and switched into US equity, where the sell­off has opened-up the most attractive valuations we have seen in several years for broad US stockmarkets – 7IM added further to US equities later in the month, taking US equity up to 10% of the 7IM Personal Injury Fund (mostly allocated to 7IM’s value strategy) by the end of January, and equities in total amount to 29% of the fund. 7IM had also made some small reductions to Japanese equity early in the month, but the dramatic fall in Japanese stocks caused them to stop any further reductions, as 7IM saw Japanese stocks fall as much as 20% below their projection of fair value.

If 7IM expected a global recession, their funds would look very different; 7IM don’t. But current market valuations appear already to be pricing in a recession – a downturn in corporate earnings, higher credit defaults and stress in the banking system. There’s an old saying that markets have predicted nine of the last five recessions: this looks to 7IM like another false alarm, and the fund should lean against the tide of panic. 7IM don’t know how long the panic will last but they do know that economic data and corporate earnings over the coming weeks and months will demonstrate either that the panic is justified, or that it is not. 7IM see a very high probability that it is not justified.

Investors face some critical questions as markets remain stuck in a cycle of volatility and pessimism. 7IM must consider whether we are going into a deep global recession that will drag corporate profits lower (and might justify current asset prices), or not? We must weigh the appeal of the short-­term safety of cash against the longer-­term certainty that cash will not help investors meet their goals – where only riskier assets can offer the possibility of sufficient investment returns. And we must weigh the appeal of assets that have already fallen a long way, and look cheap, against the possibility that they might – perhaps irrationally – stay volatile and become cheaper still.

Many investors are succumbing to a narrative that regards cheap oil prices as a sign of weak global demand, that suggests a spillover from cuts in jobs and capex in the energy sector to cause a recession in the broader economy, and that sees impending debt defaults by energy companies as another 2008-­style system-­wide credit crunch. Under this scenario, the Federal Reserves’ modest interest rate hike in December might be regarded as a policy error and adding bite to this pessimistic narrative is a perception both that China’s manufacturing slowdown reflects an economy grinding to a halt and that China faces uncontrollable capital flight.

This narrative is seductive and has come to dominate market commentaries and media headlines, crushing investor risk appetites, but it is inaccurate in almost every respect. Oil prices have fallen, but this reflects a supply glut (caused by US shale production growth amongst other factors): there is no problem with oil demand, either in China or the world as a whole. Oil consumption continues to grow steadily: there is no evidence at all that today’s weaker oil prices are an indicator of weak demand. Far from it: according to the IEA, “2015 saw one of the highest volume increases in global oil demand this century”. Rather than leading to recession in developed economies, past evidence suggests that sharp oil price declines typically result in stronger growth in developed markets (with around an 18-month lag) as consumers benefit from higher disposable income. Job losses and lower capital investment in oil-­related industries are to be expected, but markets have lost perspective: energy accounts for only around 1% of jobs in the US, and energy-­related capex (after falls in the last year or so) is only around 0.5% of GDP. There will be pain in these segments, but they are dwarfed by other sectors of the economy, which are in better health and many of which actively benefit from lower oil prices: the risk of a recession in the US, when the consumer is seeing wage rises, stronger job prospects, cheap energy and cheap debt, appears very low. There will be defaults by highly leveraged energy companies – these will be worse the longer that lower oil prices persist – and the US high yield bond market (which has a heavy energy-­related company exposure) has already priced in substantial defaults. But the banking system – in particular the major, systemic banks – has very little exposure to the energy sector, and is at any rate far better capitalised than in 2007-­08. A credit crunch sparked by the energy sector therefore looks extremely unlikely: this is not 2008. While market volatility – and especially the widening of credit spreads – may be doing some of the Fed’s work for it, reducing the need for further interest rate hikes at present, the economy remains in resilient shape and the Fed’s 25 basis point rate rise in December does not have the capacity to cause particular harm.

As for China – among some commentators, there is perennial suspicion of Chinese data and a perennial expectation of imminent collapse, which conspicuously fails to materialise. China’s economy is modernising at an extraordinary pace, pivoting from the low-­end manufacturing and infrastructure investment drivers of the last decade or so, towards a greater emphasis on services and consumption. Growth in retail sales and household consumption, e-­commerce, financial services, leisure and travel spending remains breath-­taking: clear-­thinking investors will want their portfolios to be exposed to that growth when the current panic passes. China continues to enjoy a massive trade surplus and substantial foreign direct investment; these inflows, together with China’s deep official reserves, offset the capital outflows that are inevitable as China’s currency regime liberalises, and local savers gain the ability to diversify their holdings. Amid all the panic of Chinese devaluation, it’s worth highlighting that the Renminbi’s total fall against the US Dollar since the exchange rate regime was liberalised in August is a little over 5%. Sterling has devalued by more (around 7%) against the Dollar in the same period – some devaluation: the Renminbi has actually gone up against the Pound in the period!

Investors appear to be over-­emphasising short-­term asset price volatility and neglecting the importance of fundamentals. Volatility matters in investment decision-­making, but the increasing prevalence of investment strategies that target particular ranges of volatility may be leading to vicious circles of selling: a spike in market volatility can push some holders of assets into selling, regardless of fundamentals or valuations, in order to avoid a breach of their short-­term volatility limits – thereby causing further volatility and further selling. Investors and the media then need a narrative to explain why markets have fallen so much, so commentators attempt to find one from a skewed version of the facts. We should be wary of accepting these after-­the-­event rationales. Economic fundamentals are substantially better than implied by recent market moves, cheap oil is a net positive for most of the world (especially Japan, most of the rest of Asia and the Eurozone) and corporate earnings – outside the commodities sector – are in pretty good shape. Cheap oil may cause a transitory period of headline price deflation, but its longer-­term impact is stimulative for demand and the deflationary impact at the headline level will pass.

Bouts of panic are a feature of markets: they have happened many times before, and will happen again. They can blow over quickly, or last a long time. 7IM cannot predict when the current panic will pass, but they can observe, firstly, that investor behaviour is showing signs of extreme pessimism that is very rarely justified and, secondly, that signs of activity in the real economy and in the health of companies around the world are far better than markets would have us believe. The right strategy at times like this is to stick to their investment process, with a keen eye on the fundamental health of the assets they are investing in, and to buy sensibly where they see value – this is how they can build strong long-­term returns when the recovery comes.

The 7IM Personal Injury Fund held over 10% in cash at the end of January, after making some investments during the month. 7IM expect to deploy more capital as volatile pricing creates attractive opportunities – it will feel painful at the time but “buying low” should underpin attractive long-­term returns.

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 4.30(1).

(1): Source: Analytic: 12 Months to 8th February 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.