The 7IM Personal Injury Fund November 2015 – Comment

Global equities paused in November after October’s strong rebound (the strongest month for global equities in four years). While UK and US stocks were essentially flat for the month, other developed markets made further gains: European equities gained 2.8%, Japanese 1.4%. The US Dollar was strong, rising 3% against a basket of its key trading partners. Commodities were extremely weak again, in part due to the strong Dollar, with crude oil prices down 9%. Emerging markets were dragged down in commodities’ wake – even Asian equity markets, which are generally importers of commodities, and benefit from weaker commodity prices. Gilts made ground in November too, with 10-yr gilt yields falling from 1.92% to 1.83%.

The 7IM Personal Injury Fund achieved a modest gain in November, returning 0.38% (B Acc). This takes returns for the year-to-date in 2015 to 1.0% (B Acc) to the end of November:

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While this is below 7IM’s base case for long-term average expected returns, it is well within the expected range for shorter periods. Longer-term returns remain close to 7IM’s expectations, with the fund having achieved compound returns of 3.9% p.a. (B Acc) over three years:

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Over five years, the 7IM Personal Injury Fund has returned 4.6% p.a. (B Acc) to the end of November 2015:

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It was an active period for the 7IM Personal Injury Fund, with several significant changes implemented. 7IM reversed their recent addition to UK large cap equities. 7IM had increased allocations to FTSE 100 stocks in late September, seeing them as excessively sold off in the market panic, and as a potential beneficiary (through the high commodity sector weighting in the FTSE) to a rebound in growth in China. The FTSE’s strong rebound in October left relatively little upside in their view, so 7IM took profit on the position. 7IM also exited the tactical position in Eurozone Bank equities: although banks in the Eurozone look cheap, have seen earnings recovering through the year, and generally see stronger lending demand, they remain unloved and have underperformed broader Eurozone equities. 7IM step aside for now, reallocating the capital into broader Eurozone equities.

7IM have long been looking to increase exposure to alternative strategies, which may be uncorrelated to equities and bonds and help reduce portfolio volatility, while still contributing to portfolio returns. Their existing alternative investments – including a very diversified market neutral equity strategy and a strategy investing in UK residential mortgages – have performed well this year.  After extended due diligence, 7IM have now added a strategy aiming to capture the difference between the volatility of an equity index (the German DAX index) and the volatility of the index constituents – called “dispersion”. Dispersion tends to rise when volatility is increasing across the board, or when an increase in volatility is concentrated in particular companies or sectors, so the strategy has potential to add value at times when equity markets are going through stress.

7IM have also made important adjustments to the currency exposure, recognising that 2016 may bring a change in the tone of monetary policy. 7IM have been hedging most of the Euro exposure throughout 2015, expecting weakness as a result of the ECB’s quantitative easing policy and negative interest rates – in contrast to the UK and US, where central banks are edging away from ultra-loose policy: the US Federal Reserve has ended Quantative Easing (QE) and stands ready to hike interest rates, the Bank of England looks reasonably likely to raise rates at least once in 2016. The Euro weakened substantially through 2015, driven by divergent interest rate expectations, so 7IM’s hedging worked well. However, the risk of a reversal in this trend over the coming months is meaningful: an end to crisis-driven monetary policy may prompt markets to refocus on fundamentals, where the Eurozone’s strong trade balance stands in contrast to the UK’s deficit. The uncertainty of a “Brexit” Referendum also hangs over Sterling as a potential source of risk. 7IM may be early in looking for a reversal of this trend but the balance of risks is shifting: 7IM are now hedging only 50% of the Euro exposure, happy to have some modest exposure to the currency. 7IM have also pared their Japanese Yen hedges to 50%, as the Bank of Japan appears to be edging away from further rounds of QE, as the economy there improves.

Markets are intensely focused on the impending US interest rate cycle. While the immediate focus is on the first rate hike (the first in almost a decade!), the focus will naturally shift to the trajectory of subsequent interest rate hikes: how many, how quickly and to what peak level for the cycle? 7IM share the broad market expectation that a first hike will be followed by a steady drip of reassurance that the economy is continuing to perform and that monetary policy remains very stimulative. Market volatility as a prelude to the Federal Reserves’ lift-off could very well be followed by relative calm if the Fed successfully delivers a “dovish hike” (i.e. a small interest rate rise, accompanied by soothing language about the future path of interest rates). Investors feel bruised by the stockmarket volatility of the last few months, but there is scope for sentiment to recover quite markedly if – as 7IM expect – the sky does not fall in after a first Fed hike. It’s worth remembering that the early stages of past Fed hiking cycles have tended to be good periods for equities, as optimism and earnings growth offset higher rates. 7IM are wary of the consensus view that higher US interest rates automatically mean higher bond yields and a stronger US Dollar: markets are efficient – they know rate hikes are coming and have priced assets in that expectation. Bond yields can rise, or the Dollar strengthen, if interest rates rise faster than expected – but a slower pace of hikes would still leave scope for consensus to be surprised: recent rises in US Treasury yields (and US inflation-linked bonds, or TIPS in particular) start to appear quite interesting.

Beyond the immediate hurdle of interest rate decisions, markets are also wrestling with the outlook for commodities. Commodity producers have been slow to reduce excess supply after a decade or two of heavy investment in capacity. This perceived overhang has further undermined prices, reopening debate about where a potential trading range for oil and other resources may settle. With crude oil prices over $46 at the start of November, one could foresee a less challenging picture for energy-related deflation, global trade data, and perhaps energy company profits and capital spending in the not too distant future, with year-on-year stabilisation in prices vs levels seen in Q1 2015. However, renewed weakness in oil prices (below $42 by the end of November and below $40 as we write in December) raises the possibility of more of what we saw in 2015: downward pressure on headline inflation, disappointing global trade data and cuts to energy companies’ earnings expectations. The open question remains: will lower energy prices help to fan consumer demand? The world consumes around 90m barrels of oil per day: with oil prices over $60 a barrel lower today than in late 2014, the collapse in oil prices looks to have shifted almost $2tn from producers to consumers over that period. Consumer trends in developed markets seem reasonably strong, but with improving labour markets, rising wages, decent availability of credit and now this boost to disposable income from lower fuel costs, it’s surprising that consumer demand is not yet stronger. That may yet come.

Commodities form part of 7IM’s strategic asset allocation. They expect to hold some allocation to commodities in normal circumstances. In fact, they have been holding zero weight for the past few years, and the decision to avoid buying back in appears a good one. 7IM remain watchful, and continue to weigh opportunities in commodities as elsewhere, but stay on the sidelines for now. Equity markets will remain volatile – one consequence of a subdued global growth rate is that a minor scare on the growth outlook can result in a quite significant market panic – but offer value and reasonable upside as the economic cycle continues to develop. The change in the interest rate cycle, and the divergence between the US and Europe, will create opportunities in bonds too, for return generation as well as portfolio diversification.

Twelve months volatility of the 7IM Personal Injury Fund, as measured by standard deviation is currently 4.56(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: 12 Months to 13 December 2015

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.