Investors this year should be as happy as a guest on the Jeremy Kyle Show, who has just found out that they are not the father. Unfortunately, the returns have not come about through corporate performance, rather a continued compression in yields as discounts rates fall ever lower. By some accounts, discount rates are now as low as they have been in the last 5,000 years. Since the credit crisis we have been in unchartered economic waters and we are now even moving off the known map for many financial markets. This leaves us totally reliant on valuation metrics to act as our compass and liquidity analysis as our sextant. Equity valuations can be justified only in relation to bonds, unfortunately we are struggling to see any way to defend bond valuations. The relaxed nature of the recent market run has left us uneasy and sensing that market participants are becoming complacent.
The Brexit vote and the rise of Trump underline the growing dissatisfaction of the current political status quo. The gulf between the haves and the have nots has rarely been greater. Listed companies have benefitted from the trend in the explicit lowering of corporation tax or the de facto minimal rates paid by many US corporations. There are straws in the wind to suggest that this may be coming to a close, such as the EU's €13bn tax grab from Apple. EPS are expected to recover strongly next year following a fallow 2 years. In our view these expectations seem Pollyannaish given the growth and productivity trends, and leave far more room for surprise on the downside than the upside. This would appear to be a timely moment to take some profits.
It is becoming repetitive to continually talk of record new bond yields but this makes it no less true. Gilt yields reached a nadir in the mid-summer though over the last few weeks they have backed up a little. Nevertheless, government bonds have generated an enormous return YTD. FI managers are telling us that yields may remain low for a protracted period. However, many of these have been caught underweight duration for so long, they may have become punch drunk. Fortunately, we don't need to speculate on this. Yields are now so low to be inconsequential and the asset class represents a return free risk. We are bringing down exposure to gilts to the minimum that our mandates allow.
For some time, we have been favouring the US dollar in our matrix policy. Sterling devalued significantly on the result on the referendum, especially versus the dollar, since then it has displayed signs of stabilisation. The pound looks cheap on a PPP basis and the improved terms of trade should help exporters. The UK's current account is eyebrow raisingly in the red. Our contacts at Legg Mason Brandywine (the ex BCA team) advise that this has largely come about on the income statement which might have been distorted by the sell off in commodities. With commodity prices now stabilising, pressure here may ease. Remove guidance towards a favouring the dollar.
These decisions will trigger significant changes in our portfolio composition and they will lift cash positions significantly. We need to be on the look out for appropriate absolute return strategies and we should investigate the commodities futures space, which may be offering opportunities notwithstanding our cautious views on commodity prices. Any exposure in these areas could enhance our portfolio return prospects and help broaden diversification. The imminent defenestration of gilts from our portfolios means the latter point has suddenly become a pressing issue for us, although cash can perform the role for the moment.
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