Looking back over the last decade, three aspects stand out to me: Firstly, we have seen a tremendous rise in passive investing. It is estimated that around US$8 trillion of assets are passive, accounting for about a fifth of global assets under management. Today there are more indices than there are individual stocks, which says something about how people are investing. There seems to be more importance placed on a top-down view than bottom-up fundamental stock analysis, which we believe could be a potential pitfall as we move into the next crisis.
Secondly, we saw that investors would accept negative yields, with around 20% of the developed market government bond index offering such returns. While the situation has rebalanced somewhat, across many parts of Europe and in Japan you are still guaranteed – if you hold it to maturity – a negative return on your investment in government bonds.
Finally, and related perhaps to the previous two points raised above, is that Central Banks could create money through their Quantitative Easing programmes. The US Federal Reserve's balance sheet alone, for example, grew from around US$1 trillion to US$4.5 trillion at its peak, and they did this without stoking significant economic inflation.
We worry that all of these conflate to represent the potential downfalls of a lesson which remains to be learnt – that investors still have a tendency to “herd” into popular trades.
At the beginning of 2008 financial companies represented the largest exposure in the S&P500 index (nearly 20%). Today, financial stocks represent a smaller weight than healthcare companies, with technology firms taking the lion's share. Investors have a habit of moving swiftly and en masse into trades.
As the tidal wave of money created by Quantitative Easing begins to turn this year, we worry that sharp moves in bonds and equities could become more commonplace.
We currently judge the chance of recession over the next year to be relatively low, likely around 10%. Over the next two years, however, this rises sharply to around 50% based on the yield curve and output gap.
So, in addition to the economic cycle starting to look a little bit frayed, we are also sitting at record highs for the S&P 500, valuations are looking less than appealing, quantitative easing is starting to go into reverse and liquidity is less readily available because central banks are still in a tightening cycle. Taking all of this into account, we believe investors should start giving serious consideration to how they will insulate their portfolios from potential falls and lock in some of the gains from the past decade.
We therefore hold our lowest allocation to “growth” assets, i.e. those which benefit from a positive economic environment, for the last 5 years. This has meant selling equity and corporate bond exposure, whilst maintaining some upside via call options. We are also running a relatively low duration as we believe government bonds may not provide such a reliable offset to equity losses as they once did.