Cerno Capital supports UK women athletes, explorers and adventurers. (more…)

The world is guessing as to what parts of Donald Trump’s electioneering agenda he will deliver on. (more…)

Financial markets will struggle to adjust to what was a very possible, however largely unexpected and definitely undesired result. (more…)

In an endemically low growth world, prone to accelerating forces of disruption, (more…)

Whilst the headline indices held up in 2015, the drivers behind the US equity market have been weakening for sometime. (more…)

How many of you cycled today? A few but well below the national average. (more…)

The change to China’s currency regime has potentially large consequences for global financial assets. It should prompt new thoughts. The reason why it surprised many was on account of the authorities’ insistence that they did not see the currency as a tool to promote growth,  the relative stability and strength of the currency in the past 20 years and, due to the tight way in which it is managed, the lack of volatility over recent years. The general consensus was that relative currency stability would further China’s desires for the RMB to be accepted as a transactional base currency with regards to their longer range plans for capital account opening and inclusion in the IMF’s currency basket of Special Drawing Rights.

Whereas the relationship between monetary policy and currency in, for example, the Eurozone or Japan is readily accepted, in the case of China, it comes with a heavy freight of political considerations, both within Asia and, in particular, the US. Opinion could be said to be asymmetric as it is only weakness that vexes, not RMB strength. In the past two decades, nations, both sides of the Pacific, have come to fear China’s export strength and have had to deal with the hollowing out of their own domestic industries.

The economic context of the three day weakening of the daily fix between the 11th and 13th of August was clear enough. A persistently weak run of economic data, capped off by the July export numbers (-8% yoy) in light of a persistent relative strengthening of RMB, evidenced in the below chart of real effective exchange rates.

REER relative to 10year average

Source: Bank for International Settlements

Professional investment managers had, perhaps surprisingly, not much active exposure in the RMB which is freely traded in non-deliverable offshore contracts. Investing in Chinese equity and bonds remains more a regional, specialist activity managed from Shanghai, Hong Kong or Singapore. The offshore rates differ from official onshore rates which fluctuate within a 2% band of the daily fix. The onshore rate regime sits somewhere between a fixed currency and a floating currency; an area normally referred to as a dirty float, though, perhaps in this case would be better referred to as a dirty fix.

In suggesting that the daily fix would reference the offshore rate, the officials at the Peoples Bank of China (PBoC) promulgated a powerful logic that then pushed the fix down three consecutive days before the resultant back-draft of surprise prompted them to halt the process on day three. This has not done anything for Beijing’s reputation for financial management which was undeservedly robust.

From their perspective, all subsequent decisions carry gargantuan risks and the ranks of bureaucrats are no longer peppered with international experience: none have had any education outside of China or Russia. On the one hand, further steps to weaken the currency will stimulate increased capital flight, but, if not of sufficient size, will not provide assistance to the export sector. If the new flexibility in the fixing is abandoned, China’s aim for capital account opening and international recognition of its currency is in jeopardy. There is a risk of incoherence in policy setting and adoption.

A meaningful depreciation of the RMB will set off a deflationary pulse around the world. Reduced purchasing power from China may remove an element of global corporate profit growth. This in turn crimps returns from the only remaining prospective asset class: equities.

By being short the Chinese currency, part of the negative impact of this possibility is offset.

For our own part, we hold a short RMB position in our core portfolios, including TM Cerno Select. We increased this position on August 11th. Prior to that date, it was our view that the weakness in the Chinese economy would be persistent enough that there was a moderate medium term possibility of a large currency adjustment. What has taken place is a small (-2.9% as at August 14), near-term adjustment to its currency which presages further near to medium term adjustments. To gauge a sense of magnitude, the currency would have to weaken by 23% to return to its relative 10 year average on a Real Effective Exchange Rate* basis.

*The weighted average of a country’s currency relative to a basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country’s currency, with each other country within the index.

Sometimes one comes across a written piece that so succinctly expresses a held point of view that the only job in hand is to circulate it. (more…)

Value Ranking for Government Bonds

The above chart, which is sourced from the Bank Credit Analyst, depicts the deviation from mean real yields since 1980 for the world’s major government bond markets.

The picture it paints is stark: with a very few exceptions, the valuation of most bond markets stand at more than one standard deviation from long term norms. Some bond markets are approaching or have exceeded two times normal levels.

For the kind of new normal described by these valuations to prevail, something definitive and long lasting has to have taken place with regards to inflation.

We continue to be of the view that greatest risk facing markets is that either growth or inflation surprises to the upside. Bond markets, inflated by non-price sentive buyers, are now priced for only one environment: pervading disinflation.

At Cerno Capital, we believe in a) the ability of some managers to outperform and b) our ability to identify them. (more…)

When investors talk of long-term trends, they are often referring to the next three to five years. (more…)

On the 10th of June Cerno Capital hosted a round table discussion with Douglas Brodie, (more…)

For the unconstrained global investor, Australia is a prospective hunting ground for profit. Any comprehensive analysis of the main trade and capital trends at work in the world find their conflux in Australia’s capital markets. Predicated on China’s fixed asset investment boom over the past quarter century, Australia’s economy has been substantially driven by demand for its ores and minerals. It relates uneasily, it seems at times, on account of deep cultural differences, to the rest of Asia, in particular Indonesia.

Australia is an affluent, urbanised society. It is, above all, a consumerised population that is, in economic jargon, fully financially included. It has an independent central bank and currency.

On account of these features, backed by disciplined capital markets and secure laws, Australia’s equities, government bonds and currency have been a destination for macro investors of all stripes, including hedge funds.

We measure recent opportunities by looking at 12 month rolling returns of its currency, benchmark bond and main equity index.

12M Rolling Returns - Australian Equity, Bond & Currency

Source: Morningstar/Bloomberg

When the currency is weakening, returns from key asset classes are crimped, as can be seen in the below chart.

12M Rolling Returns - Astralian Equity, Bond & Currency

Source: Morningstar/Bloomberg

The tricky thing with macro investing, prosecuted via Australian instruments, is the various counter influences at work. We list these as follows:

– Shorting the AUD is intrinsically expensive on account of the yield differential between AUD and its obvious corollaries. For example, the yield differential between AUD and USD, based on 1Y rates has averaged 304bps over the past 5 years.

– Outright investments in the sovereign bond market have delivered returns in AUD based on the general fall in rates accompanied by some flattening of the curve. However, for a non-domestic investor, these gains have been crimped by AUD weakness. Longer range, strategic investments in the bonds require the adoption of significant currency risk. Against them are lined up the yield hunters and persistently positive capital flows of new immigrants from China and elsewhere.

– Many macro commentators have long predicted the demise of the economy as they surmised that that falling commodity prices would spur some form of recession that could include a property down cycle. This has tempted some funds to go short Australian equities and the banking sector, in particular, has been targeted. To their frustration, the Australian equity market has remained peachy, supported by Australia’s superannuation schemes (government mandated pensions), with the banks especially valued for their income stream.

– To cap these, the various identified trends have been subject to reversal. In particular the currency which fell 20.1% between July 2014 and April 2015 has strengthened by 6.7% from 2nd April 2015 to the time of writing.

Cerno Capital’s core strategy ran a short Australian dollar position profitably until it was closed on 16th February 2015. We currently hold no specific exposures to Australia directly.

Comments surrounding the report of negative inflation for the UK are designed to insinuate that negative inflation does not equal deflation. (more…)

One of our larger accounts rang me this week to ask what we thought of the geopolitical situation and how we were positioning for this.

Where? I asked.

Well, there’s the Ukraine, we really need to let them fight it out, he replied. What a desperate situation. And then there’s Greece: that’s an intractable one isn’t it? And then ISIS and that conflagration.

Our investor warmed to his topics but, after he had finished speaking I told him I was worried about other things.

What?

My two biggest concerns are lack of depth in markets and concentrated positioning.

What do you mean?

Well, on the first point, one of the consequences of the Global Financial Crisis was to place much stricter limits on banks’ activities and capital ratios applied to each activity. The sum consequence of these measures is to drive banks out of proprietary trading and to severely restrict their market making activity. Fund managers talk obsessively about liquidity but, in truth, liquidity in many markets is a mirage. Last year we witnessed a bizarre phenomenon in the US Treasury market that was termed the “fall fall” by FT columnist #James Mackintosh. The UST gapped down in a way no participant could remember having ever happened before. For a period of time there was no other side to the market. If that doesn’t give you the heebies nothing will.

The consequence of this is that market corrections will be violent.

On the second point, there are a number of interlocking themes that have played very well in the past two years but are now quite crowded.

For instance?

Almost everybody is bullish on the US dollar, bearish on the euro, European growth, Emerging Markets, China and the mining sector. Positioning is about as extreme as I’ve ever seen it.

Sometimes fund managers’ greatest risks are to themselves and this is one of those times.

Note: This week, Cerno Capital portfolio managers have materially reduced US dollar positioning and eliminated bearish positions in Emerging Markets and Industrial Metals and the Australian dollar. New positions in European cyclicals have been introduced to portfolios.

The launch of QE by the ECB on January 22nd represents a milestone in the drawn out campaign against disinflation. With all the major Central Banks of the world having ‘deployed’, it is logical to begin to contemplate the consequences of failure in these monetary campaigns.

Extending the military analogy to ISIS or the Taliban, one’s foe can prove more malicious and tenacious than anticipated. So of deflation, where the collapse in the price of oil surely skewers the thought that other vestiges of disinflation are just isolated events.

In the instance of the failure of uncoordinated monetary easing we might expect coordinated money easing which, if that in turn fails, genuine helicopter money becomes the final barrage.

This is the mechanism where deflation could flip to inflation in an uncontrolled manner. That disastrous phase can plausibly take us to a place where there is a general loss of confidence in money.

We now rate the probability of this sequence of events as higher than zero. January 22nd of this year is a significant date: the ECB is now firing its bullets. Beyond these, there will be no more bullets other than the ones that, eventually and if they are not successful, risk these outcomes.

What are the defences against such an outcome? Relative value protection would be achieved in land, gold, diamonds and jewels. These are about the only things that would work.

Of great interest to us are the internal workings of markets. These are often very good indicators of where we are in the ebb and flow of valuation cycles. Valuations work, provided you are patient. They especially work if the constructed relationship is mean reverting and also non-mainstream.

Recently, we have been looking at equity valuation dispersions: that is, the gap between highly valued equities at one end and lowly valued equities at the other. It is unproductive to guess at where the natural relationship lies: it can be plotted and therefore a mean or average level can be observed, but does the average mean anything in this instance?

Of greater interest is when the range relationship becomes distorted due to the radical re-pricing of one group, or a thematically linked group of stocks.

 

normalised

 

A glance at the above chart indicates that, in recent financial times, this happened most dramatically in the TMT bubble which burst in 2000. In 2000 the ratio of the book multiple of the high price to book value stocks ran up to a multiple of 2x that of low price to book value stocks. Bear in mind, this is a measurement of all listed equities, not the most highly rated, nor is it sector specific. In the TMT boom, a group of telecom and tech companies became so spectacularly overvalued that they pushed the averages.

The most recent plot of this relationship is suggestive that another wave of enthusiasm is engulfing markets and in some of the same places: tech and biotech, two sectors that are very well represented in the NASDAQ index. The cumulative annual rate of outperformance of the NASDAQ compared with global equities has reached.

A simple chart of the world internet index against a world equities index reveals the magnum of outperformance very clearly.

BBIvsBBW

Turning back to our valuation dispersion chart: we note that an upswing is clearly underway. We also note that at a multiple of 1.3x, the relative valuation contortion is nothing compared to the 2000 period. Limited comfort can be drawn from this; the 2000 period measures as a 3.5x standard deviation event. It was the mother of all bubbles, unsurpassed by anything of the past 100 years and comparable only to the Japanese equity market bubble of the late ‘80s and the US residential bubbles of the ‘00s.

Financial commentators have become very sensitive in this area and the tendency to cry bubble has multiplied in recent years. Whereas we would certainly question the valuations on offer in some of the hotter concept areas, it is hard to entirely back the bubble claim.

The growth oriented equity investor is left in an uncomfortable place. In a world where the paths to commercialising intellectual property have become admirably short, we wish to invest in new technologies where human inventiveness is at its best. On the other hand, investors of every stamp know that one of the greatest determinants of value obtained is the price paid.

A cooling would be helpful now, it has just started.

 

Before addressing the particular merits of dynamic asset allocation it is worthwhile examining the attributes of its notional alternative: static asset allocation.

Termed in this manner, we might not immediately recognise static asset allocation. To a marketer’s attuned ears, it lacks intuitive appeal: stasis being less comment worthy than dynamism. Dynamism, after all, is an appealing personal attribute. Being called static is not often a compliment. It suggests a degree of unresponsiveness and lack of sensitivity to environment.

The practical application of what we have mischievously called static asset allocation is most commonly found in balanced strategies and mandates. A little bell of recognition is now heard. Balance has much greater intuitive appeal and practical application.

The balanced mandate, an exemplar being a constantly held mix of equities and bonds (say, 60/40 in relative proportions), owes its existence to the following four phenomenon:

– equity and debt are the two key, entirely dominant, asset classes of finance,

-by holding a proportion of bonds, the investor offsets the perceived high volatility of the equity return stream,

-the fixed nature of the allocation removes the risk of poor timing decisions &

-the mixed nature of the allocation somewhat reduces the effects of periods of bad performance in either part of the allocation.

Of course, the balanced approach is not immune to losses. It does not, in any way, address the effects from periods when both equity and debt perform poorly.

However, the experience of the 20th century, from which almost all our notions of financial return derive, reveals that, in the US, there was only one month since 1925 (September 1974) over which a 7 year rolling return was negative. The remarkably positive experiences of twentieth century investors explains the popularity and underwrites the endurance of the balanced (or, static) strategy.

The chart below describes this long period in the sun:

7 Year Annualised Rolling Returns 1926-2013 (US)

chart
Source: Morningstar/ Cerno Capital

The question we should ask is whether the philosophical underpinnings of the static approach, or its dynamic alternative, holds greater appeal for the century we live in notwithstanding what transpired in the last?

Part of the answer to this lies in an imagination of future long term asset class performance and the factors that will shape it.

The product of our own meditation on these matters is the ineluctable conclusion that the debt mountain that has been built up in the second half of the 20th century is likely to cause great problems within financial assets in the first half of the 21st.

The 2008 crisis had at its cause indebtedness and the misunderstanding, mismarketing and mishandling of debts. The solution has been extraordinary dollops of liquidity, liquidity that is now in retreat. We are deeply concerned that many businesses and the consumer sector, at large, have become accustomed to super low interest rates and will have trouble weathering more normal interest rates. This suggests to us the beckoning of a period when both the equity and debt asset classes may struggle to record positive returns.

If this indeed transpires, this cratering of returns will pose great challenges for balanced managers on account of the flexibility that they have denied themselves. It will also place a substantial log in the path of the onward marching passive industry. For whilst ETF providers like to trumpet periodic innovations such as smart beta and putative ability to track alternative indices, their assets are substantially gathered in long only, headline index tracking strategies.

The appeal of passive investment rises as bull markets extend. For, during these times, index returns and reduced fee drag appear to be just the ticket. It is our belief that this appeal will tarnish if the next bear market envelops both bonds and stocks, as we believe it might. To have “gone passive” will cease to be quite the boast it is today for trustees of charities and educational endowments.

The merits of active or dynamic allocation are to be found first in both the flexibility to have sharply different allocations to debt, equity and cash over time and secondly in the ability to seek out and utilise other asset classes or sub classes of the main classes.

On the first point, it is hard to be doctrinaire as to the optimal approach: the allocation cat can be skinned in a number of ways. At Cerno Capital we use a three year forward return framework to guide our allocations. Three years allows us to frame our thoughts outside the very crowded near-term, long enough for valuation disparities and extremes to possibly mean revert but not so long that our clients find themselves disadvantaged by logically sound but practically profitless investment positions.

Flexibility also allows participation in specific asset classes whose attractions only manifest when the stars periodically align. For example, the corporate credit sector offered, in 2009, a once in a generation set of possibilities: deeply discounted paper with marvelously fat yields to maturity, secured against still robust cash flows. In the four years since 2009, valuations have travelled full circle to a point where future returns are likely to correlate very strongly with normalising government curves. The opportunity has been fully mined. It does not, therefore, make sense to retain a permanent allocation to corporate credit or its higher yield cousin.

Presently we see a developing opportunity in merger arbitrage strategies. Specialist merger arbitrage and event driven managers make money by investing in and around announced acquisitions, mergers and other corporate activity. We anticipate activity will rise as companies become more expansionary into an improving global economic environment. However, merger arbitrage is not plausibly an evergreen investment for the flexible multi-asset class investor. There can be long drought periods: for example, capital committed in Europe over the past five years sat idle.

In the field of global macro, no two managers invest in an identical fashion, however certain firms have a greater concentration in strategies grouped around policy rates (the official rate of borrow that central bankers control). During a period when most key central bankers are operating what they term “forward guidance” which entails anchoring policy rates at their current levels for the foreseeable future, the managers with the highest dependence on short term rates trading are working within the most reduced opportunity set: another reason for flexible allocation.

Within mainstream equity strategies, we see plenty of reason to challenge the orthodoxy that emerging markets are intrinsically better places to invest than developed markets. We are fully cognisant of the long term trend for small capitalisation issues to outperform larger cap shares, however we would not invest in a static manner unless valuations were reasonable.

There are certain asset classes that lack a core attribute for long term investment but may prove to be excellent investments in certain periods. Good examples are found in gold and commodities, both of which lack income attributes.

We periodically deploy currency overlay strategies when we wish to hedge out foreign exchange risk: another example of necessary flexibility, to our minds.

Finally, when we read through our own choices to the strategies of the managers we might select as allocators, we are drawn to those that themselves secure adequate flexibility.

Our adherence to the credo and practices of active asset management are anchored on two beliefs: firstly, that a minority of investment teams and processes can secure meaningful outperformance against indexes and secondly that we reject the inbuilt biases that investors have carried forth from the twentieth century. As the warming comfort blanket of central bank support is gradually peeled away from our beds, we are likely to find additional evidence of the fundamental instability of global capital markets and global money flows throughout these markets. This, we contend, is a time to be flexible and not to buckle into strictures whose rationale is based almost entirely on past performance of a time past.

Extracts of this article appeared in the Charity Times, February-March 2014

http://www.charitytimes.com/digital_editions_eblasts/CT_feb-march2014_digital_edition.pdf

The wish to protect against inflation is a base emotion within investor psychology: one that lies deep within.  Failure to offset inflation results in a decrease in real spending power. Over half a generation, the effects of this are meaningful; over multiple generations, families fall, countries fail and the formerly rich become only averagely endowed.

No sane investor would object to inflation protection: it would be akin to refusing indoor plumbing. However does the impetus to seek inflation protection entail investing differently from simply seeking to beat the rate of inflation, in the long run?

The question is: to what extent does the impetus to seek returns that are better than inflation result in a wish-fulfilment exercise? In this guise, certain assets are accorded inflation protecting powers and these attributes are then routinely overstated.

Our investigations suggest that several notable asset classes are flawed in this respect:

Commodities: historical returns should not be relied upon – due to a significant change in market structure, the long run expected return from commodities is lower than in the past

Inflation linked bonds: Investors have imperfect knowledge of how inflation linked bonds will perform under different inflation scenarios. Irrespective of theory, real yields may change when inflation rises and create losses for holder of ILBs

REITS should never be confused with the actual property they own. Direct property has good inflation protection features, but REITs do not

Gold: history provides little support for the contention that gold is an effective inflation protection asset

Equities do fine in moderate inflation environments but do not keep pace in high inflation environments

We all wish to beat inflation but it is not easily possible to commute this desire into being. That is because some assets are inimical to inflation, others are inherently unreliable, and the remainder are only partly reliable.

We contest that the asset with the best all-weather nominal (pre-inflation returns) is quite likely to have the best real (post-inflation returns).

In the past five years since the onset of the 2008 financial crisis, it has been tempting to view the key investment choices through either end of a long scope with one view depicting inflation and the other deflation.

Seeing the world in polar opposite terms, or binary terms, leads to quite distinctly  different asset allocations. In a deflationary environment, cash and government bonds (both nominal and linked) are the assets of choice whereas, should inflation reign, equities should be preferred over bonds or cash and other putative real assets such as commodities and properties become legitimate alternatives.

Some asset managers, Ruffer springs to mind, have defined themselves by an historically referenced projection of hyperinflation and have made sympathetic allocations.

For a while, we were swayed by this line of reasoning.  In the early part of the crisis period, key global economies veered toward deflation at an alarming rate, and whilst Central Bank and Treasury intervention did avert this, the threat persisted for a good deal longer than the performance of risk assets would suggest. It was argued that Central Banks, by debasing fiat currency values, would create high or hyper-inflation as they took gargantuan steps to avert negative inflation (deflation).

However, we abandoned the axiom, recognising that whilst monetary expansion might be a necessary condition to generating inflation, it is not a sufficient one.  It seemed to us that there was too much store placed in the belief that QE would generate the continued outperformance of gold and inflation linked bonds and other assets labelled “inflation protection”. Our own work suggested that very few assets, perhaps none, should be regarded as offering water-tight inflation protection.

They fail for various reasons.  The failure of gold and equities is observable from history.  Inflation linked bonds, which is a relatively new asset class, fail on account of their direct linkage to nominal bonds. ILBs are in fact not a real asset at all but a nominal asset with an indexed cash-flow stream. ILBs have only existed in an era of disinflation, so are not that well understood by the investing community at large.

Better returns have been possible by underpinning asset allocation with a forecast that global inflation remains within normal boundaries, neither deflationary nor hyper-inflationary.

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