How markets have performed (to end May 2018)
Investors will have to wait until the autumn to see whether the old adage of ‘sell in May and go away’ is valid for 2018, but the Italian political stalemate in the final week of May has sparked investor fears of European political risk (largely absent since the French elections 12 months ago) and put a halt to a strong recovery rally from the volatility and market falls of the first quarter.
What are we thinking
We fear that the impact of Italy in 2018 could be greater in magnitude on markets and the future path of the Eurozone than Greece, Ireland, Italy, Spain and Portugal were in the early 2010s. Italy was drawn into the previous crisis, however this time it has the potential to be at the epicenter. As the 3rd largest economy in the Eurozone, its problems will be felt widely within the region, and we are fearful of contagion beyond its borders.
In 2010-12, most peripheral EU economies faced significant fiscal issues and under pressure from fellow EU members and the financial markets undertook painful economic reforms and restructuring to alleviate their problems. Despite these tough measures, an unwavering support for the continued existence of the EU and euro remained and was encapsulated by ECB Chairman Draghi’s famous commitment to do ‘whatever it takes’. Key to our greater concern regarding Italy is our assessment and perception that the ‘base’ support for the Eurozone, and the wider EU integration project that has been in the making for decades is lacking.
More widely, any long term solution for the EU has to be based on a sovereignty vs. stability trade off (the periphery giving up some sovereignty and the core providing stability via mutualisation of risks in different forms – Eurobonds, banking union, bail-out funds, etc) and the current episode is proving that the sovereignty concession is revocable. This will make any further commitment by the core very difficult – Draghi could not repeat the “whatever it takes” sentence in this scenario. Furthermore, the ECB would find it very hard to extend and enhance the current bond buying programme. This is a structural change which could have a long term detrimental impact on the sustainability of the euro.
In the short term, if a solution in Italy is found, and the main Italian actors (Di Maio and Salvini) change their minds, it is likely to have been after the financial markets have exerted a lot of pressure. If this pressure proves successful (as it did with Greece back in 2012) it will only reinforce its value in the eyes of the Germans, who will be unwilling to give up this “tool”. Again, less likely that further integration is obtained.
In the face of such uncertainty and potential risk, and following a strong rally in equity markets, we have taken the opportunity to reduce our equity exposure further, concentrated on a reduction in explicit European equity exposure. Within our portfolios we retain a healthy cash balance and allocation to gold as defensive assets and remain cautious on bond market duration in the face of expected continuation of inflationary pressures globally.
Insights from some of our managers
One of our value managers presented some analysis they had conducted on close to 1,800 global equity funds, representing $850bn of assets under management. Their assessment of the style exposures of this cohort shows that only 10% of the assets were managed to a predominantly value style strategy, with the majority of assets invested in strategies pursuing a predominantly, or outright, growth investment strategy.
A research report produced by CEM Benchmarking looked at the value added by hedge funds in the face of their increased popularity amongst pension fund portfolios as low risk, absolute return generators. The report concluded that over the period 2000-16, hedge funds behaved like simple blends of equity and debt. Gross of fees they outperformed, on average by 1.45% p.a, but net of costs this turned into an annual underperformance of 1.27%. Wren thinks that selectively there are opportunities in hedge funds, but at an industry aggregate level investors are poorly served.