Merricks (pictured), head of investments at Skerritts, says that, according to BCA Research’s Geopolitical Report, the world is experiencing “three paradigm shifts” that explain the volatility and confusion which has characterised markets since the financial crisis.
He says these three transformations, which we will cover in the article below, mean investors cannot simply rely on the model of portfolio construction that has worked so well over recent decades otherwise they will be hit with significant problems in the future.
“I think the main lesson that will be learned is that just because something goes down, it doesn’t mean it will go up again sharply afterwards,” Merricks (pictured) said. “It all means that buy-and-hold probably isn’t going to work anymore – investors will have to change their portfolios more quickly.”
The decline in the US’s influence on the world
“The first is the transformation from US dominance to multi-polarity [through] the emergence of at least one secondary power in the shape of China to challenge the position that America has held on the world stage,” Merricks said.
“Contrary to what one may suspect, the main beneficiary in market terms has been the one belonging to the diminishing power – the US. Faced with uncertainty, investors still prefer familiarity and the sense of security offered by the US over the less developed emerging power.”
“How long will this continue? We would guess for quite a while yet.”
Merricks admits that he is playing this shift in a relatively odd way as he hadn’t bought a US fund within his portfolios since 2000 but started to do so last summer.
As more investors are looking to the perceived safety of the dollar and US equities, he has recently bought an S&P 500 tracker and the £700m Old Mutual North American Equity fund – which has beaten both the IA North America sector and its benchmark since Ian Heslop, Amadeo Alentorn and Mike Servent took charge in December 2004.
Performance of fund versus sector and index since Dec 2004
Source: FE Analytics
However, Merricks says there will be a shift as the performance of US assets over recent years has been largely been because investors have been hunting for safer assets and he will therefore be looking for other opportunities in the not-so-distant future as they are likely to lose their “safe-haven” characteristics.
On this theme, he says there is no coincidence that geo-political tensions are increasing in eastern Europe, Asia and the Middle East at the same time the US is losing its position as the sole super power in the world.
Merricks also warns that protectionist tariffs on foreign products will only increase in the US in the future.
The end of the debt super-cycle
The second shift is the end of the debt super cycle, according to Merricks, who warns that there will be a lot of potential pain for investors who think the market conditions of the last 30 or so years will be repeated.
“We have long said that the period from the 80s through to mid-2000s will be seen as a freak, and yet to all of us who lived through that time, it was the norm,” Merricks said.
“Many a portfolio will be wrecked by investors and their advisers doing what they think should be done, rather than by facing the current and future conditions and acting in the present. Many theories and models born in the debt super-cycle era will simply not work in the lower growth/lower return world that we appear to face.”
A classic example, Merricks says, is the expectation that fixed income assets will continue to act as a hedge against risk following the phenomenal performance of government bonds over recent decades and given that yields are now at ultra-low levels.
Performance of sector since December 1989
Source: FE Analytics
Our data on the IA UK Gilts sector spans back to December 1989 and over that time the average fund has returned 335.82 per cent with a maximum drawdown, which measures the most an investor would have lost if they bought and sold at the worst possible times, of just 14 per cent.
“There is a risk to the fixed interest market and the safety element of gilts and corporate bonds, especially at their current levels,” he said.
“People have been saying this for ages, of course, and yields have kept falling. However, while many think yields will stay lower for longer, over the coming years inflation will start to pick up and interest rates will start to rise at some point.”
“That will be a source of calamity in portfolios especially those geared towards assets deemed ‘safe’. At some point, there will be a disastrous situation in these types of lifestyle funds which move more into gilts as investors reach retirement. Expectations need to change.”
The end of the emerging markets decade
Like a number of experts, Merricks is bearish on the prospects for emerging markets over the coming years and he says investors can no longer buy a global emerging markets fund anymore.
“Many of the emerging markets have wasted what was, in hindsight, a once-in-a-lifetime opportunity provided by the commodity explosion fuelled by Chinese growth,” Merricks said.
“As we’ve said before, you can only build scores of cities and umpteen airports once. This demand for commodities is on the retreat and any country that has not used its commodity windfall wisely will hear its electorate loudly asking ‘what have commodities done for us?’”
“We anticipate that, for some emerging markets, things will get progressively worse before they get better and so we will continue to avoid investing in them per se.”
Though funds within the IA Global Emerging Markets sector have had a tough period recently, our data shows the MSCI Emerging Markets index has returned more than 300 per cent over 15 years, while the developed world MSCI World index is up 79.83 per cent.
Performance of indices over 15yrs
Source: FE Analytics
However, linking back to the previous paradigm shift, Merricks says the likelihood of emerging markets repeating those returns is very slim. He therefore says investors need to change their mentality.
“Reward is much more likely to be found in identifying single countries rather than lumping them together as has been the fashion. With concentration, however, comes risk, but then doesn’t the world look a riskier place as we propel ourselves further into 2015?”
For the moment, Merricks is avoiding all the developing world economies at this point in time due to various concerns over the outlook for Latin America, Africa and Asia. He says the only area which looks promising is the Chinese ‘A Shares’ market.
