What are the prospects for gold?

Gold has not been particularly fashionable as an investment since the heady days of 2013 when the price reached nearly US$2,000 per ounce.  The undoubted heightening of political risk (think superpower jostling, demographic challenges, European constitutional uncertainty and terrorism) might lead one to expect the price to approach that level again.  It has risen about 25% from its low in late 2015, but either investors are not worried by events or they do not see gold as the ‘go to’ safe haven. We like to think of gold as being a measure of the overall demand for fiat money, almost the inverse of its price.  The price of paper money increases if investors are confident enough to want to invest more (ie. demand rises) and goes down if central banks print more (ie. supply rises).  Demand for gold - whether bullion, jewellery or whatever - is simply the other side of that economic equation. It is gratifying that the data from our friends at CrossBorder Capital backs this up.  They measure the price of gold inverted against net demand for paper money and there is a strong correlation between the two.  No surprises that is the case during QE2; however the measure has picked up most of the major changes since the 1980s.   Today the data signals limited upside for gold, which should not be much of a surprise given that at least some of the central banks are beginning to withdraw QE.  Of course, there is always a case for holding gold as insurance against a major geo-political crisis but we would suggest there is likely to be an opportunity cost attached. For more on Linchpin IFM and asset allocation please click here.​

THE REVERSE YIELD GAP RE-EMERGES

Clearing out some archives the other day, I came across a research paper written in 1978 on the subject of the relationship between equities and bonds.  The Yield Gap (ie. the spread between the equity and bond yield) was of course a staple relative valuation measure until it became the Reverse Yield Gap in 1958.  In recent years, as bond yields plunged, it again became, at least until very recently, the Yield Gap but it seems that investors do not pay it the same attention. I do not know the author of the paper, except that his (I assume his) initials were ebd and that it was written on behalf of the Common Stock Research Committee, by which I imagine he was American.  I reproduce below the historic path of the Yield Gap until 1978 but perhaps what is interesting is the conclusions he drew. The first is that bond and stock yields usually move in the same direction, at least in the long term.  The author acknowledges that in the short term that may not be the case; in contrast I can remember as a graduate trainee a senior bond manager describing an afternoon when both equity and bond yields fell in unison following an interest rate cut as being ‘unusual’. He thought that the reverse spread was a reaction to increased fears of inflation following the 1957 recession, which unusually did not create deflation.  He suggested its persistence was due to higher return on equity and he quotes 13.8% for the period 1973-1978.  Today both inflation and returns on equity have fallen, so he would correctly have predicted the 2008 re-emergence of the Yield Gap in place of the Reverse Yield Gap.  My old professor at the London Business School, Paul Marsh, theorised that the Yield Gap should be the expected risk premium on equities minus the growth in dividends.  But, as he pointed out, we can only observe the equity risk premium in retrospect. Ebd did not believe that inflation was a significant factor in equity markets, citing that two major bull markets had been in deflationary conditions and one during inflationary times.  We can broadly add further bull markets in deflationary times in the 1990s and since 2009, so might choose to disagree with him on this point. Perhaps most interestingly, writing at a time when the biggest bull market in history was about to begin and the Reverse Yield Gap was extreme at 384bps, he didn’t believe that stock prices were either ‘grossly underpriced or overpriced’. Today we again find ourselves with a Reverse Yield Gap, albeit small at 20bps (US 10 yr bond yield at 2.1%, S&P 500 1.9%), ie. just outside the long term range showed in the chart below.  Does that make equities ‘neither grossly underpriced nor overpriced’?  It is worth noting that if bond yields were to go to the upper end of the historic Yield Gap range they would have to rise by about 200bps compared to equity yields.  Or are we too at a turning point and unable to see a major inflationary sea-change approaching, much as in 1958? 

​THE US DOLLAR WILL BE WEAK, BUT NOT BECAUSE OF TRUMP

At Linchpin, on the back of the work at our colleagues from CrossBorder Capital, we have been gently but consistently bearish on the US$ for a number of months now.  We have been eyeing the deterioration in the quality of US capital flows, both domestic and overseas, in particular because  this is always a harbinger of a weaker currency eventually, regardless of interest rate differentials and The Federal Reserve’s policy statements.We see two major trends leading to a weaker dollar.  The first is the cash piles held by US corporates outside the US.  US banks have since 2012 increasingly re- lent these back into the US and borrowed Eurodollars against them.  The effect has been to boost US cashflow, effectively hiding the deterioration in cash generation from operations,  and to leverage the US corporate sector.  Today, these flows are drying up and we believe the effect will be to expose the shortage of operational cashflow from the corporate sector.  The effect on US eps growth can be hidden for a while but not for ever. The second major element is the flood of ‘safe haven’ money flowing out of US Treasuries, in particular into China, Europe and Japan as their economies recover.  Our friends at CrossBorder Capital calculate around US$3 trillion, or 5% of total US liquidity creation in this period, went in the direction of the US in 2014 and 2015, but since early 2016 the tide has been setting in the other direction. So we would argue that the US$ has in recent years been the beneficiary of two temporary flows of capital, both of which are slowing and reversing.  Against this is the Federal Reserve’s gradual tightening of monetary policy over the past two years, which economics 1.01 tells us should act as lower US$ supply and therefore a higher 'price'.  We would expect the US$ to be significantly weaker over the next 12 months.  Note we haven’t even mentioned the vagaries of Trump politics! A weaker US$ is both good and bad for investors.  It will act as a further boost for Emerging Markets, a Linchpin theme for some time.  However investors who use global equity managers or index funds will have over 50%, perhaps even 60%, of their assets held in US$.  If we are right, that is a major risk to performance.

Environment, social and governance (esg) is an opportunity for the new lgps pools

Almost every investment and governance conversation I’ve had in the past six months has, to a greater or lesser extent, mentioned ESG.  And almost every investment house, bar the hard-core profit-maximisers, have included ESG in their marketing in some form or another.   One driver is the pressure groups arguing for divestment.  Increasingly, they are moving away from demonstration tactics towards using financial arguments, such as the potential downside from being invested in stranded assets and the unsustainability of poor working practices.  They may still only be presenting one side of the argument but their voice is now heard at the table.  For example, a recent LGPS Strategy Day I attended focused on ESG and invited the local climate activists to attend to state their case. A second is the growth of funds focusing on sustainability.  Their argument is that it is better to focus on what works in the long term rather than explicitly excluding ‘sin’ stocks.  By virtue of their process, they argue, the latter will be excluded anyway. A third is the public scrutiny around certain ESG issues such as executive remuneration and, increasingly, the realisation that shareholders can have significant influence through engagement.   The LGPS can take some pride that, via LAPFF, it has been at the forefront of engagement with some notable successes.  The debate between these three different approaches - whether to engage, divest or simply look elsewhere - is at the centre of today’s ESG policies.  There is, of course, unlikely to be a perfect answer and different companies will need different approaches.  Persuading a tobacco company to disengage from tobacco is always going to be a hard sell and yet mechanical divestment rules can easily lead to artificial (and potentially costly) investment decisions. Given the LGPS’s longstanding focus on ESG, this is something which all the pools currently being set up will have to embrace.  Some are already setting up sustainable or ethical funds.  If done well, it could be a major selling point to those participating Funds who are perhaps less convinced by the financial arguments for pooling.     At Linchpin we are ready to help - find out more here. 

A look at whether there really is an equity bubble yet

It is a commonplace today that equities are expensive by most historic standards. Whether the criterion be price to earnings, longer term Schiller ratios or the recently popular market cap to GDP measures, Developed Market equities are either at, or close to, all-time highs. The only precedent was the end of the 1990s and the eventual dotcom bubble. The explanation usually given to justify valuations, and one I would happily subscribe to, is the nine years of easy money which we have enjoyed since the last financial crisis. Because industry has found it hard to find profitable ways to employ this money in the real economy, much of it has flowed over into investment assets including financial ones. Prices of bonds, equities and property have all gone up. We have lacked, however, a way of quantifying how far prices have gone up relative to the level of liquidity – ie. how far the bubble has inflated. A recent article from CrossBorder Capital aims to do precisely that by looking at stock market capitalisation relative to the pool of available financial assets. It is effectively a measure of the size of the equity weighting within investors’ entire financial asset portfolio. In theory, much as with any portfolio, if the ratio becomes too high investors should react to reduce it. CrossBorder’s conclusions are that generally, on this market cap to liquidity basis, global equity valuations are at around the middle of the range pertaining since 2000 and well below the dotcom bubble peak. Even the US looks no more than a tad expensive while Emerging Markets, and to an extent Japan, look cheap. This is not an argument for complacency. There is clearly scope for a sharp fall in equity prices if the authorities choose to take liquidity, the ultimate denominator of this measure, out of the market by tighter monetary policy. But it does suggest that we are not really in a bubble yet and that if - admittedly a big ‘if’, given the noises coming out of the Federal Reserve - the level of cheap money is broadly sustained, valuation levels alone will not prevent equities from rising further.     CrossBorder's full article is available to purchase here.

Smooth sailing or stormy waters for the LGPS? William Bourne comments on the 2016 LGPS Annual Report

The LGPS 2016 Annual Report was published recently.  In many ways it shows a success story.  The number of employers is up 22% and, despite almost zero return in the year to March 2016, the long term investment returns show a healthy 3% real return annualised over 20 years.  However that is not a reason for complacency, on a whole range of fronts.    The rise in employers is largely driven by councils outsourcing jobs and the creation of academies.    The volume of the latter, which tend to be of relatively small size without dedicated HR departments, is undoubtedly putting pressure on fund administration departments.  The solution has to be some form of pooling, whether of academies into multi-trust academies, assets and liabilities into a single entity (as was done with The National Probation Service), or at the fund administration level. The 20 year investment return has, in contrast to private sector schemes, been driven by equities.     Some 35% is invested in equities directly, compared to 5% in bonds.  Pooled investment vehicles account for 44% and, while these cannot be categorised from the information available, the message is clear that equities comprise most funds’ major ‘growth’ asset class.  In contrast, private sector schemes have over 50%* invested in fixed income and, when LDI strategies are taken into account, the true number is probably closer to 70%.  In both cases, the level of return over the next five years is likely to be lower: government bonds yielding 1.5% over 10 years will by definition return that annualised figure if held to maturity; while equities would have to go to even higher valuation levels than at present to return more than their dividend (3% today) and the level of long term real economic growth (assume 2%). Paradoxically that may help funding levels.  Regardless of the precise discount rate valuation methodology used, either a fall in the valuation of bonds or equities, or higher inflation will lead to a lower estimate of the liabilities.  The 2016 Report, which used individual Fund valuations, gave an average funding level of 85% , whereas the Government Actuary’s Department’s Section 13 valuation of the whole Scheme based on standardised assumptions will, if we can judge by the anonymised 2016 valuations already published for each fund,  be closer to 100%.  If we allow for market movements between 31st March 2016 and today, the Scheme is almost certainly fully funded. However, funds are still going to have to make a choice between accepting lower returns from traditional asset classes such as bonds and equities, or branching out into newer asset classes in the search for higher returns.  It would be a mistake to be too complacent on the investment side. The 2016 report also shows that the cashflows from members - ie. contributions minus pension pay-outs - has, for the first time, tipped into the negative.  This has been long flagged up and has been delayed by the inflow of active members entering the Scheme from new employers.  However, the trend can only accelerate in the future.  In the near term, investment income (1.7% in aggregate) will comfortably cover the gap but not forever - now is the time for funds to plan for that eventuality. Finally, I turn to governance.  With less than a year until April 2018, when funds are supposed to turn their investment implementation over to the pools, governance arrangements will need to change.  Because Funds will effectively be outsourcing a large part of the investment management, they will need to put in place a clear framework to monitor and govern the arrangements between the various parties, including the Pools, the Section 101 committee, any connected body which has delegated responsibilities, the Pension Board, and outsourced service providers such as actuarial and investment consultants.    In my view, rather than trying to carve up the work between the 101 Committee and the Pension Board, clearer accountability will come from giving them separate functions.  The Section 101 Committee should be responsible for all functions including the governance of the various relationships, while the Pension Board’s role should be one of scrutiny and challenge.  They should ensure that appropriate governance processes are in place and followed, and provide challenge where they believe there are gaps. I haven’t even mentioned the General Data Protection Regulation, which comes into force in exactly a year’s time on 25th May 2018 but, while there is plenty of work to do, from a funding perspective the LGPS is not in a bad place.  Private sector schemes are reaping the consequences of de-risking: investing in low risk assets results in low returns and, except where schemes are sufficiently well funded or mature, sponsors are having to increase their contributions.  In contrast, the LGPS is beginning to look more sustainable in the long term.   * Source: Purple Book 2016, p. 42  

WILLIAM BOURNE ATTENDS JPMAM INFRASTRUCTURE BREAKFAST

On 10th May 2017, William attended the JP Morgan Asset Management Infrastructure Breakfast at their offices in London.

rising chinese producer inflation and capital inflows add up to higher us bond yields

Our colleagues at CrossBorder argue that World government bond markets are risky because of Chinese reflation and the progressive recovery of the Eurozone economies. This threat is only partially explained by rising inflation pressures. The bigger risk comes from a prospective ‘re-normalisation’ of bond term premia; this is largely a capital flow story. Some US$3 trillion poured out of the Chinese and Eurozone economies into ‘safe’ (largely US) government bonds between 2012-15 – it now seems to be heading back. US 10-year governments could test 4% yields and the US dollar could fall 10% over the next 12 months.​  For more information click here.

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