An independent professional's take on the latest news and trends in global financial markets

The risk of a short circuit in markets

Richard Burns, until recently the senior partner at Baillie Gifford, is now chairman of a range of the firm’s investment trusts, including Mid Wynd International, a special situations fund that holds positions in interesting companies that are too small to make a difference to its flagship funds. This is his most recent take on the investment environment, taken from the trust’s annual report. With the Eurozone crisis continuing to cast a shadow over events, and equity markets not obviously cheap, cautious and pragmatic investors (a type much in evidence in Edinburgh) are mostly marking time for now.

Repeated central bank stimuli have managed to contain, for now, what would otherwise have been a combination of Western debt deflation and deep recession. These interventions buy time, but not an indefinite amount. Policy making in the afflicted parts of the Western world appears to be running up against the laws of diminishing returns. Underlying sovereign balance sheets are deteriorating further meantime. What has happened is akin to stripping insulation from the bare economic wire – governments and central banks are that insulation. As time goes on, and in the absence of a more potent recovery, the risk of short-circuit increases.

Following a partial, tactical withdrawal from our sale of index futures following the European Central Bank intervention in the early part of this calendar year, we have reverted to the strategic position of having significant portfolio insurance. Should markets turn south unexpectedly, we would hope to find ourselves with cash flow from margin payments and to be in a position to exploit any major weakness in asset prices. This remains an unusual situation for the company but one we believe remains merited by the circumstances

As is exhaustively rehearsed in the media, the Eurozone political and financial drama appears to be nearing a denouement. Periodic flurries of politicking demonstrate strong intent but also rising north/south strains and questionable effectiveness. There do not appear to be any clear winners in this game in either the short or even perhaps the medium term. Recovering from the prolonged overindulgence of the past, in the case of Europe, which for this purpose includes the UK, is likely to take a long period of adjustment (perhaps alongside fiscal, political and banking integrations). The alternative is a short, sharp shock – some manner of Eurozone break-up and a complex web of accompanying unintended and mostly undesirable consequences.

Long term causes for optimism, however, are significant. They fall mainly into two categories – commercial innovation and renovation on the one hand, and a multi-decade long expansion of consumption across large swathes of the world’s population on the other. Most of Asia, for instance, continues to grow at a worthwhile pace and has high savings ratios to back up higher spending. It would not be immune in the short term from some dislocation in Western economies, but seems well placed over the next ten or twenty years. This would appear to be a more significant development than the moderate but fragile recovery in the US economy that has preoccupied markets over the past year.

The pace of global growth has mostly been slowing markedly of late. Rising commodity prices, a feature of last year’s report, have been reversing in the last few months, as has headline inflation. Industrial production indices and surveys have been slipping back into low growth or even flat to down territory. Inventory levels have not yet fallen, however, indicating a marked weakness in final demand and more weak output to come.

Overall, this is a subdued backdrop for equity investors despite or perhaps because of the recent success of companies and their profits. Outwith equities, where valuations seem from a long term perspective somewhere between moderately attractive to rather expensive, there appear to be few clear attractive asset classes. Some such, in the form of catastrophe bonds, litigation finance and assorted other forms of mispriced equity-like risk, are important and uncorrelated, if modest, elements of Mid Wynd’s portfolio. Volatility in asset prices deriving from high profile events may continue to throw up investment opportunities of a short term nature. Taking advantage of such a situation will require tenacity, fortitude and intelligence in equal measure.

Written by Jonathan Davis

August 30, 2012 at 9:04 AM