Q1 2015 Review
These are historic times in the wealth management business. On the one hand, I am deeply concerned that the low interest rate environment will strain expectations for higher yielding portfolios, but on the other hand, the role of a financial advisor has never been more important. The market situation, as explained in more detail below, is extremely precarious and the value of independent and frank discussions about risk cannot be overstated. This is a not a Pioneer issue – it is a general issue facing the entire money management industry and clients are encouraged to try to understand the challenges, in order to make the appropriate decisions with their financial planners.
Why on earth would someone invest in something when they know, at the outset, that once they have received all their interest and their capital back, they will, without doubt, receive less than they had to start with? It is completely irrational, but it’s real! At the time of writing, the bond yields on German 2yr and 5yr bonds and the Swiss 10-year bond were negative. This means that you would be paying these governments for the privilege of holding your money. Even Nestle corporate 10yr bonds traded briefly in the negative territory. Why?
There are several possible reasons for this: Firstly, if you expect prices to decrease (i.e. deflation) then it can make sense to buy anything that gives returns greater than the level of deflation. So even if returns are negative on bonds, as long as the rate of deflation is even more negative, then the real return of the bond investments are positive. Secondly, and a little more sensibly, if Central Banks, like the ECB, come out and say they will be buying all bonds no matter what the price is, then you may profit by expecting the yields to drop further. Remember, bonds have an inverse relationship between yield and price, so if the yield goes even further down then the price will go up and the potential for capital profit exists. Since the ECB have said that they will be buying bonds for the next 18 months, then buying bonds at a negative yield is a reasonable trade if you have the stomach for the risk. The third reason for buying into a guaranteed loss is that you simply have to, because of the rules you fall under. E.g., a pension fund that is required to hold a certain percent in government bonds has to buy them no matter what the price is – no discussion required. The fourth reason, which is an extension of the third reason above, is that due to the limited supply of low risk bonds, if you want low risk, you have to buy negative yielding European government bonds at any price.
What does this mean for my portfolio?
We have been writing about low yields on bonds in this communique for the last three years. Each year we ask ourselves, “How low can yields go?” and each year we have seen our expectations exceeded. The message then is the same now, however it is more acute: each investor needs to ask himself, "How much risk can I tolerate and take in order to achieve my desired rate of return?"
- If the honest assessment is that no more risk can be taken, then the expectations of earning returns should be adjusted more towards preservation and avoiding mistakes.
- If the risk tolerance exists, which means that if plans do not work out there may be losses and that is something that can be lived with, than there are opportunities to exploit.
This is the essential issue. Taking risk means “I am prepared to lose money”; not taking risk means “My focus is on preserving my money”.
Many investors around the world are continuing to increase their allocation to equity. Global portfolios for balanced clients are seeing as much as 50% allocations to global equity as investors chase yield by allocating to large stocks. Another issue that many investors fail to realize is the inherent risk in bonds. Chasing higher and higher yields means taking more and more credit and liquidity risk. If we see a sudden turnaround in risk appetite, the downside on higher-risk bonds can easily exceed the downside on quality equities.
Brief Summary of Asset Classes Performance in Q1 2015
Some records were broken in Q1. Fifteen year record high on the FTSE 100 (7,037.67) and new record levels on the Dow and S&P were exciting, but the real records and new territory was in the bonds as explained above. History has almost no precedents for this so it is very difficult to understand what will happen next. The Dow and the S&P finished the quarter after hitting their record levels at 18,288.63 and 2,117.39 respectively. We feel this is macro driven of the back of the “divergent” economic theme of a strong USA and weaker rest of the world. Big gains were made in Q1 in European stocks in general and across all the major markets. The place to be invested was in Europe, however not in Euros. So if you had hedged exposure to Europe you would have done excellently in Q1 and we did have this is in our model portfolios. European gains were in the 12% to 18% range for the quarter, which is huge and reflects the expectation that European Quantitative Easing will do the same for Europe as it did for the USA (however, we feel this is over-simplistic as the European political structure differs fundamentally from the USA). Japan also performed well off the back of mixed quantitative messages measuring gains of 9%. Again – in order to enjoy these gains you needed hedged exposure. Emerging markets showed mixed results with many losses resulting from weaker currencies against the all-mighty USD.
Another area of big news in Q1 is currencies – with most currencies experiencing massive losses against the USD. We wrote in our Q3 2014 letter that we thought that “USD was the new gold” as money seeking relative yield moved towards the USD. The strong rally on the USD may possibly be peaking soon as the exporters around the world (excluding USA) now have a substantial price advantage, so there will be some headwinds to further strengthening of the USD. If USA 10yr are yielding 1.94% and European government bonds are yielding zero or negative, then there is an advantage to move further away from Euro towards the USD. This is called a "carry trade" and will work well so long as the USD continues to strengthen – any sudden move on the USD will quickly remove any gains.
Outlook for rest of 2015
The base case assumption for the rest of 2015 is more of the same with increased volatility. This means that the number of days where the S&P will fall or rise by more than 1.5% will most likely be more than previously recorded for in the last 24 months. However, we still assign a moderate to high probability of increasing equity valuations. We expect short-term interest rates to rise, but the long-term rates to remain range-bound between 2.2% and 2.8%. How the markets react to the rate increase is an unknown, but since it is so widely anticipated, it may actually pass without much market fuss.
The Euro looks set to continue to weaken and the USD looks set to continue to strengthen, based on the simple difference in yields between Euro and USD government bonds. We favor High Yield bonds, especially European High Yield bonds, as they look attractively priced. The political front and how the Europeans muddle on with Greece and their enigmatic finance minister continue to be in the back of our minds as a potential risk.
Israel at a glance
The quarter ended mixed.
On the one hand, stock and bond indices provided adequate returns and on the other hand, Consumer Price Index (CPI) fell, which together with the retailers' financial reports indicated a continued decline in demand and possible signs of a recession.
Although the elections results were followed by a re-confirmation of Israel’s debt rating at A+ by S&P rating agency, as well as a positive market sentiment, the expected unchanged social-economic policies may result in a further move towards a prolonged recession.
Consequently, we recommend holding long duration bonds alongside CPI index linked bonds with relative short duration. Combined they form a kind of a “synthetic medium duration portfolio”, acting as a hedge against inflation.
The aforementioned information is not a substitute for personal Investment marketing, which takes into account the particular circumstances and special needs of each person. The views expressed in this Review should be considered as market comment for the short term for information purposes only. As such the views herein may be subject to frequent change, are indicative only and no reliance should be placed thereon. This Review does not constitute legal, tax or accounting advice, or any investment recommendation, or any offer to buy or sell financial instruments of any kind, and does not take into account the investment objectives or needs of specific investors. Although this Review has been produced with all reasonable care, based on sources believed to be reliable, reflecting opinions at the time of its writing and subject to change at any time without prior notice, neither Pioneer Wealth Management Services nor any other entity or segment within the Pioneer International Group makes any representations or warranties as to the accuracy or completeness hereof and accepts no liability for any loss or damage which may arise from its use. The writer and the company are unaware of any conflict of interest at the time of publishing the above commentary.