Between fortune-telling and careful strategic planning

One of the most striking aspects of the global economy is how complex it is and how it is influenced by an immense numbers of parameters which are often not well understood and hardly predictable. Although it incorporates mathematical tools and concepts from the sciences, the field of economics remains very much a social “science”.

Trying to forecast the future with imprecise tools can prove very disappointing and amounts oftentimes to fortune-telling. Faced with ambiguous and often contradictory data many investors nevertheless feel that they need to “predict” future market developments. And what will happen is that their forecasts will, like a Rorschach test, reveal more about their mindset than about markets and the economy. The optimists will mainly look at the positives while overlooking the negatives; the pessimists and the alarmists will focus on the negatives and dismiss the positives.

In addition there is no lack of players who face business conflicts of interests that will impact their forecasts. And in many cases there is an interest to just stick to the herd mentality and follow the crowd even though it is often wrong as it is perceived as safer and more comfortable.

Looking at history we are not aware of anyone neither in academia nor in the investing world who has over the long term been able to successfully and systematically anticipate the major economic and financial developments. Of course, some people accurately predicted some crisis or some other event but usually on a punctual rather than sustained basis.The situation over the last two years illustrates well the challenge of making predictions. As is usually the case with the economy at any point in time there are both positives and negatives. 

For example, the macro-economic data in America is undeniably positive with unemployment at 3.7%, a 49 years low while the economy continues to show solid growth with no sign of abating. Interest rates remain low and financial valuations are not extreme. On the other side the current bull-market has been going on for a decade with no major correction which is relatively rare (but has happened before). History would suggest that at some point in time a correction is due and this has been expected for a long time by some intelligent investors who, at least in the past, had a solid track record of success. Albeit not extreme, valuations are high by historic standard according to most yardsticks. 

So if predicting economic developments is so hard what can be done? Are we suggesting, as some do, to disregard the macro picture? Absolutely not – to the contrary we believe that it should be addressed through careful strategic planning. But this should be done in a constructive way by identifying the main risks and opportunities in the market. The smart investor should like a radar be constantly screening the markets for risks and opportunities and make sure that he takes preventive measures to minimize the risks and that he also actively takes advantage of the opportunities. The investor should think in terms of how (s)he can optimally position him/herself for a range of possible scenarios rather than somehow naively trying to predict what will precisely happen in any given year. Importantly, this reflection should focus on both the short, middle and long terms.

Of particular importance to the reflection are the large megatrends that can last for decades. They have the strongest and most sustained impact on markets, much more so than short-term economic developments such as a temporary economic slowdown. 

The continued reduction of interest rates since the peak in the 1980s and then following the 2008 financial crisis was a major megatrend of the last decades and certainly the key driver of the 30-years bond bull market that is now in our view coming to an end. 

The IT revolution has been a large megatrend for the last two decades at least and is still unfolding. It continues to provide excellent opportunities for wealth generation. This can be capitalized on both through investment into the right listed tech companies as well as through smart venture capital investing.

The aging of the population and the revolutionary developments in the pharma and biotech industry represent another such trend which can similarly be capitalized on. After a few years of under performance due to now resolved regulatory uncertainty in the U.S. the pharma/biotech sector is attractive. Listed companies in the sector are quite resilient to the economic cycle and a good fund manager will be able to pick-up the winners and outperform the market.

While these mega trends have deeply transformed the world and our lives and have had major economic impact, the effect of international wars and tensions over the same period amounted to blips at most. Similarly in Israel the reduction in interest rate over the last decade was a key driver of the real-estate bull market while repeated wars and tensions had no significant impact on prices.

In the current environment we continue to see an increase in interest rates as one of the major risks. The 10-year Treasury recently broke the 3.2% level. As we mentioned previously, an increase to 5% in the middle term is a possibility. This would affect first and foremost fixed rate bonds and that is why we are by and large avoiding that asset class. On the other side, the recent increase in LIBOR means that some floating-rate notes (FRNs) are currently offering an attractive risk-reward as it is possible to get yields of around 3% from solid issuers without interest-rate risk.

The fact that the valuations in equity markets are elevated means that the risks are increasing and that conservative investors in particular should be cautious in terms of their exposure. As we have said before, we believe that the current times are particularly well-suited for alternative investments offering limited correlation to the developments in the financial markets. Alternatives, a field in which we have a deep understanding, have therefore a high weight in our portfolios.

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Market Review, first-half of 2018

The first half of 2018 has been weak for virtually all asset classes except the particularly volatile commodity sector. In equities the S&P 500 was almost flat (+1.7%) and most other equity markets were flattish or down -3% to -5%. 

In fixed income the iBoxx Corporate Investment Grade index was down 4.3%. We view this as a significant development which illustrates well the often underestimated risk related to fixed income. While it is often presented as the “safe part” of a portfolio, it is in reality subject, like any investment, to significant risks, particularly the risk of rising interest rates. This risk has been latent for the past couple of years - when interest rates get close to zero they cannot fall much lower but on the other side they have room to go up markedly.

It is noteworthy that Jamie Dimon, CEO of JP Morgan, one of the wisest financial people of our time, has recently mentioned the possibility that the interest rate on the 10-year Treasuries could reach 5% after it temporarily went above the 3% level in April. This would have major implications for the financial markets and could lead to significant losses on long-dated fixed incomed bonds, which we have been avoiding for a long time. A few months ago, such a scenario would have been considered as science-fiction by many. This illustrates well the need to be ahead of the market in anticipating the risks.

Beside the particularly important interest rate risk there remains a range of geopolitical risks. The increasing tensions between the US and the world in trade matters is starting to have implications for companies but the real extent and impact is still unclear and might be less dramatic than the spectacular newspaper headlines regarding “trade wars” would suggest. The election of right-wing parties hostile to the European Union in Italy represents a further risk but the ability of the newly elected to effectively implement dramatic changes in the short term is limited.

A significant development in recent weeks has been the dramatic loss in value of the Turkish lira which has the potential of creating a full-blown economic crisis in Turkey. As European banks have exposure to Turkish banks they could be affected by such a situation although the magnitude of the exposure is relatively limited (and not comparable for example with the major exposure to Italian debt). In addition, Turkey is the fifth-largest trading partner of the European Union and exports could also be affected. In view of this risk we recommend minimizing exposure to the Euro and European equity markets.

American equities did well in July-August; the S&P is now up 6.2% since the beginning of the year. The performance of equity markets in other countries and of most other asset classes continues to be weak. 

No one knows what will happen in the next six months but we believe that in current circumstances one should rather stay on the side of caution.

 

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