Portfolio Management Service video: A false sense of security?

[Emma Wall, Head of Investment Analysis, and Lee Gardhouse, Chief Investment Officer, speak via video chat]

Hi. I'm Emma Wall and here with me today to discuss whether this is a false rally and what the outlook is for equities, bonds and the economy is Lee Gardhouse.

Hi Lee.

Hi there.

So, last time we spoke markets had seen massive falls in March as the world digested the impact of coronavirus and the resulting restrictions on the economy. Since then we've seen quite considerable rallies across asset classes, and particularly in certain equity markets such as the US. Before we go too deep into those specific asset classes I wanted to just take a step back and ask you what's going on with the underlying economy?

The fact is the economy, the global economy, is not in great shape at the moment.

It may surprise people to hear, or investors to hear, that actually economic growth this year is not highly correlated with what stock markets do. If anything actually there's proof that weak economies tend to lead to slightly better stock markets than strong economies which is really around sort of turning cycles so markets tend to sort of perform worse before an economic setback and then do well sort of through the trough. But yes, there's absolutely no doubt that the economic background is tough for businesses.

You know there'll be people in the UK and overseas that will have businesses that are struggling but that doesn't mean that there isn't opportunity out there and I think one of the things I often talk about is sort of human ingenuity and the profit incentive. You don't have to travel too far to see the actions that people are taking in order to change their business models in order to survive for the future.

What does that then mean for underlying equity markets? Well the key thing which is what we discussed last time is that sort of the government and central banks have kind of got your back. Equity markets and bond markets in particular have been supported by government action.

We continue to have a lot of debt issuance by countries because they know that they are going to have to do a lot of fiscal spending in order to support the economies, so for the time being markets have continued to be relatively strong on the back of all of the liquidity that is being pumped into the system.

The other thing that I think we all have to think about very deeply is what's called ‘financial repression’. So this means that governments have in effect got the bond markets into a position, and as a by-product of that what's being offered, the return on your cash, is at a level where, to be frank, people aren't highly incentivised in any way at all to put their money into bonds and cash apart from for two reasons.

One, that you think the economy is going to get worse and therefore will have a further slowdown and there'll be even more governments buying of their own bonds which could drive the yield down. Or, that you just want to keep your money safe, and therefore it's the return of your money rather than the return on your money.

But the financial repression is in effect meaning that you should not be getting over any longer period of time a positive return, after the effects of inflation, from your cash and low risk assets. So that is a background where people are being asked by governments to go out and either spend their money or to invest. Both of those things are things that governments want to see.

Now equity markets have moved quite considerably higher from those lows. You even see some specific indexes; I'm thinking of the Nasdaq in the US, which are higher than they were even before the coronavirus crisis.

It's the multi-billion dollar question but are those rallies justified? You've explained about what is propping those rallies up, but is that enough? Are these prices justified?

Okay. I think there's been two different markets - there's multiple markets across different asset classes but if we think about the equity market in particular it strikes me that there's a sort of a two market impact sort of taking place. I've seen this several times during my career and I have to say that it does it does concern me to some extent.

When you get certain parts of a market or certain types of stocks or just certain markets that everyone wants to buy or it's the only thing that people want to buy and so the market rally has not been that broad. And this rally, as opposed to let's say the tech rally of the late 1990s or the commodity/emerging market rally of the mid-2000s, this rally is very much around America and to some extent the dollar as well. And it's also around large digital businesses in the American market. Now it's not just America because actually if you go to Asia some of those large technology businesses in Asia have also sort of been driving the market up.

But whenever you get a market where very few stocks are leading the market up and a lot of a lot of other areas have been completely left behind it does start to create a situation where things get to an overvalued position, I think. You talk about the Nasdaq, or the S&P, it may well be that the markets continue to go higher as people move in, there's a lot of momentum investors out there, so because the momentum is in those markets it would not surprise me in the short term that they go higher. Does that mean that they are offering great value? I don't believe that it does. Do I think that markets more broadly are overvalued? No I don't actually because lots of areas of the market are looking relatively cheap and actually there's plenty of parts of the US market - not necessarily those large technology stocks that drive the market up - but you take a level or two below that and actually there's plenty of parts of the US market that themselves aren't particularly overvalued.

So, I've got some concerns around and somewhat of a bubble building in these sort of technology stocks. I don't know how long that is likely to go on for but it certainly is starting to feel a bit like a sort of a late 1990s or a sort of a 2006 situation with regards to emerging markets where the market has become very narrow in its growth.

So that's equities then, a disparate rally kind of a two tales. What about bonds? You mentioned that yields are basically low enough to mean it's about return of money rather than return on your money.

Yeah. So, all these things are linked together; financial repression, the kind of the strength in certain areas of the market.

I actually call all of this as sort of a bull market in bearishness because people are moving money towards the place where they feel the most safe. I don't think there's anything massively different between what we're seeing today and what we've been seeing for quite some time which is even though we had quite a bull market from sort of the 2008-2009 lows I don't think it's been a rally that people have been rushing into. I think people have been very cautious of it, the economic background backdrop hasn't been particularly strong even though markets recovered a long way from that 2009 low. So that bull market in bearishness has also been taking place within the fixed interest market.

So the reason that government bonds are yielding so lowly is because people have been looking to the government bond market as the place to put their money because of a perception of safety. Now that's absolutely right and you generally view your fixed interest and government bonds to be your lower risk assets and but obviously as prices go up and up eventually even those assets become slightly more risky so we're seeing government bond yields at or close to all-time lows both in America as well as across Europe and to some extent in some of the other stronger economies around the world.

But again you've got a sort of very big differential between what are considered the lowest risk assets which is the sort of the government bonds and the higher risk assets which is the company credit, so where companies borrow money.

Now investment grade bonds which is sort of the highest quality bonds are offering quite an attractive yield to pick up above and beyond government bonds and then if you step down into the high yield market you're getting you're getting yields of 6-7% there so strong real returns over the rate of inflation assuming lack of defaults and even in areas like emerging market debt where we haven't historically had very much exposure at all but those yields are relative to the kind of the low risk asset that the government bond these markets are actually offering quite attractive returns.

So you've got, as an investor, you've got a decision to make at this point in time I think. Which is, are you willing to take risk even with all the stuff that we talked around at the start which is a kind of a weaker global economy obviously COVID19, coronavirus, has not gone anywhere yet? Are you willing to take that longer-term view and take risk on where it appears to me anyway that you are being offered a reasonable potential return for taking that risk? Or, do you want to hide out as such and move your money into cash or those government bonds which if things do get worse will definitely protect you better?

So there is a big call for investors to make.

Now obviously it's always really easy to focus on the negatives. There is of course a chance, and I'm not an expert at all in coronavirus or how we tackle it, but of course we've got some of the greatest minds in the world that are trying to find solutions to the coronavirus problem. Now if someone comes out with an excellent treatment and we're already starting to see that we're able to treat people better - we're seeing less people dying than they were before - or do we have a cure for the virus in which case you know those higher risk more value orientated less perception of protection type of markets you know those could see a really quite a strong rally I think if we were to see that.

Now I don't know whether we will or we won't but there was obviously there are two sides to this and one where actually we get into a place where we see the light at the end of tunnel, we have a much better economic backdrop, and actually I think in that environment markets could rally quite hard, or you know, we can't get rid of this thing and it continues to just sort of drag on the economy in which case we get low growth for quite some considerable period of time.

Now as an investor you can't, I suppose, make predictions as you say about the coronavirus itself but putting that to one side and focusing on what you do know; the price of current assets, the yields that certain assets are projecting, what does that mean for PMS portfolios?

So we are in a kind of a balanced position I would say.

So each of the portfolios has its own sort of limit set for where we are on equity versus fixed interest and cash. We are in a sort of a normalized central position at the moment we see quite good value but also of course we see the risks are out there. If we were to see a cure from this stage I think we'd be willing to take on a bit more risk. We haven't retreated into our shells, not least because as I said that sort of the government still have got the markets' back. You know they're out there willing to buy bonds, buy government bonds, buy business bonds as well and some countries are even buying the equity markets.

So there's sort of an old saying which is "don't fight the Fed". Well, the Federal Reserve in America does not want to see a stock market crash and is taking action in order to sort of support the market. So we're in a in a balanced position from here.

The one thing I would say for all investors, they all have to take into account their own situation their willingness to sort of take risk within the portfolio and make sure that that fits with their needs at this point in their kind of their long-term investment journey.

Lee, thank you very much.

Thank you.

---

This presentation provides information, it is not personal advice. If you are in doubt about whether any investment is suitable for your circumstances, you should seek personal financial advice.

Unlike cash, stock market based investments are not guaranteed and fall in value as well as rise, we therefore believe you should only invest for the long term (5+ years). Ultimately you could get back less than you invest. Yields are variable and are not a reliable indicator of future income.

Past performance is not a guide to future returns.

The PMS portfolios use HL Multi-Manager funds which are managed by our sister company Hargreaves Lansdown Fund Managers Ltd.

Views correct as at 15.07.2020