It’s tough out there, and getting tougher; traditional investment ideas are becoming harder to find, while asset valuations are stretched and underlying risks are beginning to build.
That was the cautious tone struck by Georgina Taylor, multi asset research director at Invesco Perpetual, as she hosted a masterclass at the Hyatt Regency Birmingham on 18 October.
‘Although there’s an eerie calm in markets, it’s easy to be cautious,’ she reflected. ‘But what makes matters tougher is that growth has been subdued, so income investment ideas are hard to exploit.’
According to Taylor, while there are signs of cyclical growth, including better headline GDP numbers, structural weaknesses persist. In particular, the ‘killer Ds’ – debt and demographics – mean that we will face ‘low growth, low inflation and loose policy’ for some time to come.
That has proved a boon for passive investors, as central banks have remained accommodative. But Taylor warned that valuations are becoming stretched and volatility could soon return. ‘If you look at an index everything seems fine but underneath, volatility has returned and correlations are breaking down. At the same time, rates are beginning to rise as bonds look very much overvalued. If bond volatility picks up – and it’s currently at record lows - it could easily spill into equities too.’
Given this situation, Taylor said that many of the current ideas in the Invesco Perpetual Global Targeted Income Fund are not directional bets on a particular asset class or security. Rather, she said, ‘what we’re finding in the current low growth and richly valued environment is that some of the ideas that offer the best balance of risk and return are actually relative value, which currently accounts for around 50% of the fund.’
Relative value is an arbitrage strategy that seeks to profit from price differentials between related assets by simultaneously buying and selling different securities. ‘This means we don’t have to take a large directional position and rely on volatility remaining subdued. We just have to believe that one security will do better or worse than another.’
That appealed to several of the delegates at the event, who were concerned that high valuations in both stocks and bonds had led to an ‘everything bubble’, with the potential for both to sell off at the same time if things go wrong.
‘One example,’ Taylor said, ‘is shorting US Treasuries while holding Australian government bonds – essentially here, we will benefit if the spread between the two tightens.’
‘There are many reasons for this, including divergent central bank policy, inflation, and the fact that US rates appear too low given where it is in the cycle while Australian yields are some of the highest in the developed world.’
The trade has proved prescient thus far. While Australian government bonds remain mostly range bound amid low inflation and ballooning private debt, the yield on the 10-year US Treasury bond breached a critical support level of 2.4% recently, with many expecting it to rise further as the Federal Reserve eyes a rate rise in December and a balance sheet unwind in 2018.
Taylor said that the overall portfolio will typically contain between 20 and 30 investment ideas, covering virtually any asset class or geography. For example, aside from the relative value plays, she said they also hold a range of different yield curve steepeners and flatteners, Japanese equities, currency crosses and even swap spreads.
‘If you dive deeper into our portfolio,’ she said, ‘you’ll see that around two-thirds of the fund’s ideas are used to generate income, while the other third is primarily used for capital preservation.’
The fund’s targets can be split into three parts. The income target is to produce a gross income of cash (defined as UK 3-month Libor) plus 3.5% each calendar year. Then, the team aims to do this while preserving capital (after fees) over a three-year, rolling period. Finally, over the same three-year rolling period, the team aims to keep fund volatility below half that of global equities.
‘Given our unconstrained approach to sourcing investment ideas, we believe the fund is sufficiently flexible to achieve its targets even in a low growth world,’ she explained.