Lewis is neutral on bonds, but has a strong preference for sovereign bonds over corporate credit. In particular, the group has a zero weighting in US high yield, given its exposure to the oil & gas sector. He has been reducing the group’s UK gilt exposure more recently, after a long-held overweight position. This is partly on valuation grounds, but also on concerns that inflation may start to pick up a little if fiscal policy is called upon to boost the flagging economy.
The group has also been reducing its UK commercial property weightings. While yields remain attractive, says Lewis, there are concerns on liquidity.
Positive returns
Lewis notes that two of the group’s positions have attracted attention. He adds: “We have been investing in gold since October, on the basis that global currency devaluation could drive gold higher.”
This has worked well, and the group has gained more than 30% from the trade, helped by the weakness of sterling. Also, the opportunity cost of holding gold (which doesn’t pay an income) versus sovereign bonds is not material, given that yields are so low.
The other notable position is to be short the Chinese yuan and long the US dollar. Given Lewis’ gloomy position on the outlook for China, he believes currency devaluation looks likely.
Brexit is among the thorniest issues with which he has to contend on behalf of his clients at the moment. He says: “No one knows what the economic impact will be. Predictions have been made using a set of assumptions that have yet to be negotiated. This is creating headwinds. Whatever the outcome, it would certainly be naive to think the impact will be benign. The UK will take a short-term hit but there will also be damage for the EU. The same issues fester within Spain and France.”
The group’s portfolios held up relatively well in the wake of Brexit. Diversification proved very important. Positions such as short-dated US treasuries, gold and the short yuan/long dollar positions proved useful. However, small and mid-cap weightings in UK equity, and the group’s holdings in commercial property were less successful.
Perhaps, more importantly, Lewis believes that Brexit is symptomatic of wider international issues and highlights growing division. He says: “The way it shapes the future is unlikely to be beneficial for risk assets. Brexit is the manifestation of a much deeper problem.”
He believes investment returns have to start to reflect economic reality. “We have lost the relationship between risk and reward; it’s been all reward.”
Quantitative easing brings forward tomorrow’s consumption and will act as a drag on growth for some time into the future. The biggest driver of asset prices has been liquidity, which has left many assets looking highly correlated. This is a real challenge for investment managers struggling to protect client returns.
The outcome of easy credit, capital misallocation and excessive debt could well be secular stagnation. In fact, many countries are already showing signs. The absence of a true credit cycle has prevented the destruction of excess capacity, and monetary easing has distorted asset pricing, creating significant social imbalances.
In short, Lewis suggests, it is a mess, which is likely to constrain growth for some time. It is an environment that calls for defensive positioning. LW
Six key themes
Liquidity
The cause of, and solution to, all of life’s problems, excess liquidity provision is a key driver of the increase in global asset prices. It has also left many assets looking highly correlated, which remains a key challenge for investment managers that are trying to achieve diversification.
Chinese capital misallocation
This suggests a growing banking sector bad debt problem, and China faces a potential hard landing. GDP growth is only sustained by adding capacity or dumping on the rest of the world. This is giving rise to significant capital misallocation and we expect further yuan depreciation.
Interest rates – one and done?
Global economic weakness will stay in the hands of the Federal Reserve. In practice, further interest rate rises may seem less likely because the world cannot cope with a strong dollar. The group is underweight US equities across its portfolios.
The case for secular stagnation Growth will remain weak while past excesses remain in the system. This is the result of easy credit, capital misallocation and excessive debt. Built up over decades, it will take time for this to work its way out of the system.
Bond market
Stresses in the US high yield market could point to problems ahead. Default rates are rising and this may have an impact on corporate credit generally. The group prefers sovereign bonds over corporate bonds as a result.
Politics not economics
Social inequality will drive a shift in policy from monetary to fiscal policy. The wealth gap has widened as loose monetary policy has inflated asset prices. This is creating social unrest, of which Brexit is just one manifestation.
