The first quarter of this year was characterised by a strong risk on environment, or more accurately a very positive quarter for US and Japanese equities. These markets finished the quarter up over 8% in dollars, whilst the Emerging and European markets were barely positive. Bond markets were virtually flat, to slightly down, and much was made of the Great Rotation trade in the popular press, arguing that we were now seeing the great switch from bonds to equities. We don’t think this is happening yet, but it is very pleasing to see that the rate of contraction in equities appears to be abating, which bodes well for this asset class.
Commodities suffered a lot of whipsawing, with base metals and gold ending the quarter in the red. Cross Border Capital, an international research house and asset manager, have long argued that commodities are a late stage cycle asset and so far this year they are being proved correct, as equities comfortably outperform commodities. Base metals were affected by slowdown concerns in China as well as excess supply, whilst the gold decline appeared to be a function of fear receding in markets.
Property enjoyed another strong quarter, largely on the back of the strength in US REITS.
Market moving events that happened during the quarter were the “bail in” of Cyprus, which, while pretty calamitous for the people of Cyprus, with some individuals waking up to find they had lost a substantial portion of their life savings, was largely ignored by the markets. The price tag to save their banking system of 10 billion Euros was seen as far too small for the world to worry about. Contagion fears were also largely dismissed, despite slight increases in credit spreads between peripheral Europe and Germany.
Investors appear to be more interested in Bernanke’s every utterance and improving economic data out of the US, than really being concerned about the European basket case. Easy money from the US, Bank of England and Bank of Japan is all that investors seem to care about and should underpin risk assets for the time being.
Cash
Cash ended the quarter slightly overweight vs. our own strategic neutral benchmarks in our portfolios, despite the lack of any credible yield. Furthermore, we don’t see yields moving up any time soon, as central bankers seem intent on keeping interest rates at really low levels.
The Global economy, whilst picking up (in the US especially), remains fragile and with austerity still on the table in Europe, keeping growth alive via loose monetary policy seems to be the only option.
We are holding slightly more cash, as we are waiting for an opportunity to buy equities within our funds, and we don’t want to rush into these markets, especially after the strong run in the first quarter.
Trades during the quarter included selling our short Yen position, as we were stopped out of our long dollar, short yen position. Given that this trade was always a risky one (there is a graveyard full of investors who have unsuccessfully shorted the yen), we have a stop “profit “ policy in place and were essentially stopped out when the Yen changed direction mid-February, but still managed to gain over 10% on the trade. Post the quarter-end the Bank of Japan has announced enormous money printing, planning to double the money supply in Japan over the next two years, so this is a trade we might relook at again.
We also sold our Emerging market cash fund, given concerns around rising current account deficits in certain parts of our Emerging Market basket, especially the likes of Turkey and South Africa.
We remain short Euro dollars and it would be lovely to say that we saw the problems in Cyprus coming, but truth be told, we did not. However, we did fundamentally believe that the dollar was undervalued relative to the Euro, especially considering poor growth rates in Europe vs. that of the US. As I write this commentary, Euro dollar is currently 1.2816, having fallen very quickly from 1.31 as Cyprus reminds the world why the Euro currency remains precarious.
Bonds & Bonds Long Short
Our view on bonds has not changed from that of the 4th Quarter of 2012 and we expect our negative view on sovereign bonds to be something that we will write about for years to come. If it weren’t for the fact that Central banks are unnaturally supporting the bond market, rates would be higher, especially in the US where growth is starting to improve.
As we keep saying, bonds are the “return free, risk asset” in markets and as such we continue to have negligible holdings in bonds, with our long-only exposure being a holding in Asian bonds at 2% of the fund.
We have not changed our view on high yield and investment grade corporate bonds, preferring to get our yield pick-up from dividend yielding stocks. The spreads between corporate bonds and sovereigns is not high enough to compensate investors for the very real possibility of capital losses, once the risk free rate starts rising.
In our view interest rates globally are artificially low, due to central bank buying and that the only long term direction is for rates to rise. Investors view bonds as a “risk free” asset, but having seen the 30 year secular bull market in bonds, the next upcoming bear market will be brutal indeed. Just to illustrate this point, a zero coupon bond maturing in 20 years, will lose the investor 20% for a one percent upward move in interest rate, a factor not considered by many investors.
But all is not lost and we maintain that one of the best ways to make money from what we see as the upcoming secular bond bear market is to go short the bond market, which we are doing via the Thames River Bond Fund. The fund was marginally down for the quarter, but we view this fund as offering portfolio insurance in the event that interest rates could spike up. We could find ourselves in a scenario similar to that of 1994, in which interest rates rose by 2% and over a very short period of time, equity markets lost over 20%. If this were to happen, the Thames River Bond Fund should do very well and help mitigate against losses in our equity holdings.
We are however underweight this fund relative to our own strategic benchmarks as we don’t think this is the time to go overweight this asset class, yet. The Fed appears intent on supporting the bond market via $85 billion per month asset purchases and to take an aggressive short position at the current time seems a little too risky to us. Couple this with the Bank of Japan (BOJ) aggressively supporting its bond market and you have two major central bankers artificially supporting sovereign bonds. To fight both the Fed and the BOJ might be too dangerous at the moment, but overstretched valuation on bonds will eventually have their comeuppance.
Equities & Equities Long Short
Equity markets had a stonking start to the first quarter, with US and Japanese markets comfortably outperforming those of the Emerging world and Europe.
Our equity holdings managed to approximate the returns of the MSCI for the quarter, despite an underweight position in US equities. It was active stock picking by our underlying managers that managed to help us achieve these returns, with our European and Asian managers managing to comfortably outperform their benchmarks.
Trades during the quarter were to sell our gold equities as we think that gold is no longer a good investment, in light of the more positive sentiment towards equities (the US especially). Gold does well during times of fear and with the US economy starting to recover, there is less need for fear assets in one’s portfolio. We also sold our physical gold holdings during the quarter and now for the first time in years have no exposure to gold.
There is currently a large disconnect between US markets and those of Europe and Emerging Markets and we think greater value lies in the former, however momentum does not currently appear to be on the side of this trade. We think the more likely outcome of this disconnect is that US markets succumb to a bit of profit-taking and we have started to see stocks more connected to the domestic economy starting to struggle in the last few weeks. Dow Transports and the Russell 2000 have not confirmed the highs in the Dow Industrial and S&P and traditionally this has been a sign that short term weakness is in the offing.
US markets have priced in a lot of good news, especially on the economic front and disappointments could lead to weakness. As we said in our last commentary, we will use this opportunity to buy into equity markets as we now believe we are in an era of “buying on dips” instead of “selling on rallies”, with respect to our investment strategy for equities.
Alternatives
As indicated in our last quarterly commentary, we began the process of reducing our weighting to alternative investments during the quarter, as we think there is better value to be had in long only investments such as equities. Those hedge funds that are truly not correlated to equity and bond markets will remain a core holding in our portfolios, albeit it at a lower weighting as we have decided to up our equity and property weighting in our strategic asset allocation models.
Hedge funds’ returns have had a poor number of years, as the industry has become populated by managers that were actually long only managers, masquerading as hedge fund managers and have ended up giving the industry a bad name. We believe that hedge funds offer diversification benefits and hence our managers are there to protect us against unforeseen risk and as such are not correlated to equities or bonds. Hedge funds for us have become our new bond proxy.
Property
During the quarter we made no changes to our property holdings, but were very pleased to see strong gains in our US REIT holdings, having lagged the market in 2012. Sterling property funds struggled when priced back into dollars, due to the weakness of Sterling, but in Sterling terms managed strong gains as the world wide theme of search for yield continues.
This search for yield will remain a key theme for markets, especially when returns from traditional investments such as bonds remain non-existent.
Summary
Looking forward central banks are “all in”, as Central Banks globally are in the race to the bottom in order to have the cheapest currency. Search for yield will remain the order of the day and this will continue to support property and dividend yielding stocks.
Equity markets, especially in the US, are looking like they need a breather and with our excess cash we will look to buy on dips.
