Tony Cousins of Pyrford International, the Portfolio Managers for the Nedgroup Investments Global Cautious Fund, talks about their response to the extreme market turbulence.
Q1 has been very brutal for risk assets. We’ve felt for some time that equity markets have been extremely expensive. This happens when central banks print $15 trillion dollars of new money, which drives all financial assets up to excessive levels of valuation. When markets are as overvalued as they were at the end of 2019, they are vulnerable to sharp corrections. The catalyst was clearly the Coronavirus, but the fact that they were so expensive in the first place is why they have fallen so far and so fast in such a brief period of time.
We went into this period with a very defensive portfolio with a 72% allocation to sovereign bonds, 25% to global equity and 3% to cash. We don’t like to lose capital and the -6% return on the portfolio in first quarter was disappointing. However, this return must be viewed in the context of an equity market that fell by more than 20% and where very few assets classes, apart from government bonds, US cash and gold delivered a positive return. In this context the portfolio delivered a reasonably credible and defensive performance.
The low allocation to equity shielded investors from most of the equity market rout and importantly provided liquidity for investors wishing to drawdown on their investments. The second source of protection came from the hedged Australian dollar which weakened against the rallying US dollar as investors sought safety in US cash and treasury bonds. Unfortunately, the strengthening dollar was a source of negative return on the unhedged non-US dollar exposure in the fund, which had been positioned for dollar weakness leading into the events based on its elevated valuation against other developed world currencies. We could have done better if we’d been in longer duration bonds as yields fell over the period. We will maintain our short duration position as, if yields do rise, there will be significant capital destruction if you have long duration bonds in the portfolio.
In April, we managed to eliminate half of the negative performance in Q1 with a return of 3.1% gross of fees, reducing the year-to-date gross return - to -2.9%. This was as a result of the weakening of the dollar and a rebound in equities over the period.
The fund’s reaction to the sharp decline in markets
As markets fell very sharply, the facts clearly changed and the over valuation was corrected, enabling us to increase our equity weighting by 5% in March. Our approach is to put in trigger points based on pre-determined price levels. Once those trigger points are hit, we determine our response within 24 hours. We hit that number in March and hence the increase in our equity holding to 30%, which has benefitted the portfolio. We bought only non-US equities as they had fallen further, which were already trading at cheaper valuation levels to US equities leading into the crisis and the valuation gap only widened.
In terms of our currency exposure, we had 6.9% in the British pound, 9.8% in the Canadian dollar and 14.9% in the Australian dollar, which was the first currency that we had hedged and which fell the most against the US dollar. We had unhedged exposure to the pound and Canadian dollar, which did hurt the portfolio. We use power purchasing parity to value currency. If your currency is overvalued for too long using this measure of valuation then your exports will be priced out of the market and the trade account of the country will deteriorate leading to a depreciation of the currency. This valuation method is not a good short-term tool for forecasting currency movements, but is very effective as a long-term tool. What we see now is an extremely overvalued US dollar, more than 40% overvalued at its height in Q1 against Sterling. This is extremely rare if you track it historically and is why we’re prepared maintain a 45% exposure to foreign currency in the portfolio.
Our current positioning
We have 30% in equities given. our concern is that the recent rally, particularly in the US equity market, is showing far too much optimism about the upturn for the economy. Corporate earnings in the US and valuations have returned to quite stretched levels with the S&P 500 trading at its highest valuation level, implied by Shillers Price Earnings Ratio, since 2001. On valuation measures, the US equity market level today is not warranted and we have therefore increased into non-US equities and will only look at the US market when we see significantly better valuations.
We continue to have significant bond holdings of 28% in US and 39% in non-US bonds in quality market sterling, Australia and Canada. We will not invest in low quality bonds, whether sovereign or credit, and the duration will remain exceptionally low of 1.05 years. As we increased the equity weighting, we did need to put on a further hedge to remain within the 45% currency exposure level and we now have hedged exposure to the Swiss Franc of 1.2%, the next most expensive currency the portfolio is exposed to after the Australian dollar.
Equity portfolio characteristics
The yield on equities in the portfolio is significantly higher than the world market, 4.3 versus 2.9. The portfolio’s return on equity is also significantly higher, 13.6 versus 11.7 and the debt to equity is far lower at 82.4 versus 138.7. These are characteristics that we always have within our equity portfolio and are the representation of both value and quality. The debt to equity measure is very important for us given the large amount of corporate debt that has been raised, especially in the US. The gap between the index and our portfolio has never been higher than it is today, which is very concerning to us. Companies are seeing a severe demand shock as a result of the virus and, in that environment, you do not want to have a lot of debt in your portfolio.