The manager of the £727m M&G UK Growth fund says markets have been responding in an overly optimistic way to a host of economic and geopolitical threats to financial stability, and current valuations are not reflecting the risk these pose as a result.
A high cash level will enable investors to buy in cheaply following a sharp correction or worse, he says.
“It feels right for investors to exercise an elevated degree of caution at this time,” he said.
“The risks attached to both the near-term macro-economic outlook and to global geo-political instability appear especially acute, but it is not apparent that these risks are being adequately reflected in prevalent extended valuations.”
“In such a widely diversified UK equity market, select investment opportunities will always arise and a little more cash at a time when we think prices generally should be a little lower offers increased option to act quickly as those opportunities surface,” Felton said.
“We hope for all our sakes that this results from the bubble in complacency deflating slowly rather than bursting suddenly.”
In a recent article FE Trustnet questioned the markets haven’t sold off despite strife in the Middle East and Ukraine, the Banco Espirito Santo crisis and an imminent rise in interest rates.
The level of complacency is evident by near historical lows in volatility, as measured by the VIX index, Felton says.
According to FE Analytics, volatility in the S&P 500 has fallen more than 10 per cent since the beginning of the year, having a huge effect on volatility in other markets.
Performance of index over 1yr
Source: FE Analytics
“UK and US central banks are in the process of removing the punchbowl and after a monetary experiment of such unprecedented size, there can be little conviction as to what happens next, nor in the omnipotence of central bankers given their failings ahead of the global financial crisis,” said Felton.
Felton says that the market has reacted more positive to negative economic news in recent months, which is a very worrying sign in his eyes.
“In this topsy turvy world in which we live, weak economic news is interpreted as good news for equity investors as it will help ensure that monetary policy remains ultra-accommodative for longer,” he explained.
“This cannot surely be right though. It is counter-intuitive at least to observe that the UK equity market has been one of the poorer performing equity markets in the West so far this year, despite an economy that appears to be performing the strongest.”
The S&P 500 and the FTSE All Share have gained 144.94 and 126.03 per cent since the market bottomed out in March 2009.
Performance of indices since March 2009
Source: FE Analytics
Psigma’s fund of funds manager Tom Becket, believes the same complacency is also evident amongst bond investors, especially those exposed to high yield debt.
“Despite already having the lowest yields in its history, the asset class formerly known as 'high' yield credit has been one of the best performing asset classes, as yields have gone from very expensive to eye-wateringly expensive,” he said.
“There appears to be almost unrivalled levels of complacency and whenever anything is so popular it causes me great nervousness and as the 'quiet' summer period is upon us we have time to reappraise our allocations in corporate debt markets. It is an underestimated risk which stalks all asset markets, not just corporate credit markets.”
The global high yield market, which bottomed out in October 2008 just after the crash of Lehman Brothers, has risen at equity like pace, only slightly underperforming the FTSE 100 and S&P 500.
Performance of indices since Mar 2009
Source: FE Analytics
Becket, also chief investment officer at Psigma, says the complacency of managers reminds him of property managers before the financial crisis.
He commented: “The majority of the corporate credit managers that we speak tell us that this is unlikely to be a problem, mostly because it hasn’t been a problem before. I’m pretty sure that UK commercial property managers were saying something similar at the start of 2007. That all turned out really well, didn’t it?”
Becket believes that over complacency in bond markets could spell a coming liquidity crisis in the asset class in the event of a market sell-off.
“The conditions might not even need to be that extreme to create issues,” he said.
“All you would need is a marginal mismatch of sellers and buyers, which could create a negative feedback loop, worrying investors who start to see losses from an asset class they have been programmed to only ever see going up.”
“That could lead to further downward pressure on prices and amplify the negative sentiment.”
While he admits that such a shock may not happen, he is reallocating credit exposure to mitigate its risk nonetheless, including a greater weighting to cash.
“Experience has taught us that it is best to repair the roof when the sun is shining and we have taken great lengths over the last eighteen months to prepare portfolios against a potential dislocation in credit markets,” he said.
“Of course, there is a decent probability that such a shock will never come and the relaxed attitude of many credit managers might well be justified.”
