16 Jul Baggot Multi-Asset Strategy (BMA) Update, Risk Profile 4 14 July 2020
BMA posted a gain of 8.97%, including all charges, in the Q2 2020. Currently as of today (Tuesday July 14), including all charges, BMA is down – 2.87% year to date (YTD).
In comparing BMA to peers, the largest risk profile 4 investment product in Ireland, posted a loss of – 7.43% YTD so far, not including charges. Of the 14 largest risk profile 4 investment products in Ireland, avg returns YTD came in at a loss of – 4.58% so far, again – not including all charges. We highlight the charges factor in bold print because our returns include all charges and our peers do not, which only widens the outperformance of BMA this year in real terms.
BMA is a longer term multi-asset strategy. Our views haven’t changed much since our last quarterly update.
We continue to have a very negative view of US equities relative to European and Emerging Market (EM) equities. Our reasoning has been simple. In the shorter term valuations are a poor predictor of future returns but over the longer term they are by far the most important factor in terms of predicting future returns. Valuations have been and still are very high in the US relative to Europe and EM.
If you’d like to see proof, let us know and we can show you the evidence between different valuation metrics and subsequent returns, on data going as far back as the 1880s. It is a fact that if you invest in Equity indices that trade at cheaper valuations, they provide higher subsequent longer term returns. It is also true that if you invest in equity indices at higher valuations you will experience lower subsequent returns.
Out of 40 countries, the US ranks as the third most expensive country. It is by far the most expensive in developed markets.
Going back to 1950, Developed (ex-US) & Emerging Markets have never been this cheap relative to the US.
US Dollar Headwinds
This is the main reason that we have been so negative on US indices and why we’ve had no risk exposure in that area for some time now.
In our last quarterly update we wrote about the reasons why we believe US indices will underperform Europe and EM Equities. I won’t re-write everything I wrote because my view is the same, but I do believe that a very large rotation out of US Equities is highly likely over the coming years and I would like to share some recent comments from Larry McDonald (one of the most highly respected market pundits in the world) from his Bear Traps Report, as he gives an interesting perspective here and he is not often wrong;
“A Very Large Rotation is Near: If Eurodollars, U.S. Treasury curve flattening, U.S. high yield, and U.S. hospitalization data are correct – then there is a meaningful transition in the works, follow the money. Last in, last out of the COVID19 storm; the U.S. slowing relative to RoW (rest of world) gets you a weaker USD. Next, the colossal spread between the crowded tech sector vs. unloved value/commodities should collapse. From 2015- 2020; Brexit fears, a Trade War, and COVID19 all gave global investors reason after reason to hide out in the USA. Now we have election uncertainty, another approaching $1.5T of deficit spending, U.S. racial tensions (the rise of left populism), and crushed global rate differentials. These forces are all giving global investors a reason to exit the USA. But there’s close to $40T in Big Tech, Treasuries, HY, IGs, Loans, and Munis vs. weak USD. This $40T was $30T two to three years ago; and it hasn’t had to worry about a weak USD for a long, long, long time. A weaker USD will help the global picture and a new feedback loop is starting to form, all pulling capital away from U.S. shores. This all speaks to being overweight EM, commodities and Value relative to US tech.”
On top of that Joe Biden has a clear lead in election polls and his gains continue to widen. I am not making an election statement here, merely stating the obvious…Biden wants to raise US corporate taxes. He has also stated publicly that taxpayer money shouldn’t be used to pay out dividends, fund stock buybacks or give raises to corporate executives. Here are some recent quotes by Joe Biden;
“I’m going to get rid of the bulk of Trump’s $2 trillion tax cut and a lot of you may not like that but I’m going to close loopholes like capital gains and stepped-up basis.”
On his economic agenda; “It’s time to help small businesses, middle-class folks manage their way through the pandemic… the days of Amazon paying nothing in federal income tax will be over”. Biden wants to end the days of big-tech not paying taxes and “pay their fair share, not simply earn profits on the backs of hard working Americans”.
Joe Biden is exploiting the extreme gap between the rich and the poor. This may be good for the average American but it is highly unlikely to be good for the US stock market.
There are many things pointing to a weaker Dollar over the coming years and remember that the Dollar is the reserve currency of the world. Much of the world borrow in Dollars even though they have different native currencies. So when the Dollar rises it has the effect of increasing the liability to the borrower because they eventually have to pay back the borrowed funds in Dollars. So when you get a global crisis like this the borrowers scramble to buy Dollars in order to cover the liability. When the Dollar goes down, it has the opposite effect of decreasing the liability to borrowers.
We could see a lot of money leaving the US in search of better returns elsewhere. Given the sheer size of the US Equity market relative to other markets, we could see huge inflows into commodities, non-US Developed Equity Markets and Emerging Markets. When you couple that dynamic with the fact that valuations in all those markets trade at absolutely historic discounts to the US, you have the recipe for huge outperformance in commodities, non-US Developed Equity Markets and Emerging Markets.
Our view has not changed much in precious metals from our last quarterly report. I don’t want to tell you all the things I’ve already written, but I would encourage you to read it if you haven’t already.
We have a relatively high weighting in Gold & Silver vs most of our peers within the same risk profile. In higher risk profile strategies we carry even higher weights in precious metals.
We see the next few years as inflationary because we are seeing monetary and fiscal stimulus around the world. If inflation jumps then real interest rates (current interest rates vs inflation rates) will become even more negative than they already are. Remember precious metals have been money for 6000 years. They’ve outlasted all other forms of money because they are finite stores of value, valued in infinitely printable currency.
We continue to have an initial target of $2400 an ounce for Gold.
This next bit of the update was in our last quarterly update but we feel it is still relevant.
After the Global Financial Crisis in 2008, we saw an incredible rally in Gold and Silver until they topped out in 2011. During that period the ratio of Silver ounces to one ounce of Gold dropped from around 82 to nearly 35…. meaning Silver more than doubled the performance of Gold during that period. We see that scenario as highly likely in the coming years, so while we are bullish on Gold, we are very bullish on Silver. Currently the ratio is 92 ounces of Silver to one ounce of Gold. It has come down from 110 ounces which we noted in our last quarterly update….We see a ratio of 65 ounces of Silver to one ounce of Gold as fair value. Markets rarely mean revert to fair value, they tend to overshoot in both directions. We see Gold at $2400. Divide our projected Gold price by 65 ounces (where we see fair value) and you get a price $36.92 per ounce for Silver.
Silver is much more volatile than Gold so that must be a consideration when you factor your investment size relative to the risk profile of the investment strategy. This means that there are limits to how much Silver we can hold in this risk profile. In higher risk profile strategies we obviously like a higher weighting to Silver.
Generally our Dollar theme doesn’t just extend to precious metals. We’re still very bullish on companies/funds in the Agricultural and Industrial miners. Those are areas where we are always looking for opportunities.
Food commodities are cheap, people need them and again this is an area where assets in limited supply are valued in infinitely printable money.
Commodities look exceptionally cheap relative to stocks;
We think the fiscal and monetary system look a lot like the environment we saw in the late 1960s, early 1970s. If you look at the chart below you see very strong returns in Commodities relative to the Dow. That period in the 1970s was very kind to commodity focused investors. Companies in the commodity space should do well, so long as they are not highly geared.
From Goehring & Rozencwajg piece;
“We are entering into an era of inflation. Are you prepared?”:
That period was not kind to debt holders though so that has to be a consideration for Equities going forward. High debt/equity levels are not good in this environment.
In terms of total equity exposure, we have roughly 47% invested in Europe and EM equities, with a focus on Quality and Income. Roughly 31% of that is European equities and roughly 16% in EM equities. We have zero exposure to US Equities at this time.
We have an 18% weighting in EM government bonds. EM government bonds are more volatile than their western counterparts but they actually pay a yield in excess of inflation. Isn’t that the point of owning bonds? We think EM bonds will benefit from a Dollar selloff as well.
We are running cash levels of roughly 20%. When you don’t earn anything on cash, it is an opportunity cost that we are very aware of. However cash is also an option to buy something cheaper in the future. We are very keen to deploy cash to more productive assets, but we don’t want to do it just for the sake of doing it, and to be fair, performance relative to peers has not been handicapped because we have had a high cash buffer in the last quarter. Markets have been very quiet and trading volumes have generally been quite thin since the school year ended. We expect more sideways type markets until we get closer to the new school year in the next 6 weeks.
We’ve seen a big recovery since the end of Q1. Things felt extraordinarily pessimistic at that time. Clearly in hindsight they were nowhere near as bad as they seemed, thanks to fiscal and monetary stimulus. We are still very optimistic in our long term outlook for commodities, emerging markets and non-US Developed Markets but we are still facing a lot of uncertainty.
We are not as optimistic in regards to US Large Cap Equities. We continue to feel that US Equities are facing a toxic combination overvaluation, less buyback support, negative political headwinds, social unrest, and potentially a potentially very negative capital flows. We see money flowing out of the US and into Europe and EM. Global fiscal and monetary stimulus has been extraordinary! We see that as a major supportive tailwind in the coming 12 – 18 months but markets have had a big recovery in a short space of time and just as investor sentiment was overly pessimistic three months ago, perhaps investor sentiment is a little too optimistic right now, particularly with regards to the US market.
Chief Investment Strategist and Director at Baggot Investment Partners