Huge levels of sovereign debt across the globe mean a full-scale crisis is inevitable, according to Artemis’ William Littlewood, who says he is preparing his portfolio for this eventuality.
Littlewood (pictured), manager of the £1bn Artemis Strategic Assets fund, says it is impossible to call exactly when the crisis will occur, but is holding a significant portion of his assets in cash and shorting government bonds to protect against the downside. “My view is that a sovereign debt crisis in the developed world is inevitable at some point,” he said. “But it is not necessarily going to happen this year and it is hard to offer any view on timing or potential catalysts.”
“I expect Japan to be at the epicentre, as its colossal and rising government debt overwhelms its diminishing and ageing population. This is where we have the majority of our bond short positions.”
FE data shows that 15 per cent of Littlewood’s portfolio is invested in government bonds, almost predominantly in short positions. The fund's gross bond short position was -95.8 per cent at the end of December, predominantly in Japanese government bonds with the remainder in France, the UK, Italy and the US.
Around a quarter – 23.9 per cent – of Artemis Strategic Assets is in cash, which some investors may raise their eyebrows at given that money in the bank has a negative real yield at present.
The manager understands these concerns, but insists cash is a useful asset class in its own right because there are so few attractive alternatives.
“I sympathise with those investors, and our large cash pile looks anomalous given that we expect higher inflation as a result of an eventual sovereign debt crisis,” he explained.
“It would be preferable to own equities and commodities in an inflationary environment. However, while a sovereign debt crisis is occurring, those assets are not likely to hold their value in the short-run. So we view our cash as a means to profit from the future buying opportunities that we expect.”
“Also, our significant bond shorts protect the portfolio against higher inflation,” he added.
Littlewood does have exposure to equities, however. Net equity exposure is at 50 per cent – 65.3 per cent gross long and 15.3 per cent gross short. While a sovereign debt crisis could likely cause a sharp decline in equity prices, he says that investors cannot afford to be out of risk assets entirely with market sentiment so positive.
Given his significant cash exposure and short bond positions, Littlewood thinks the portfolio is diversified enough to cope.
“The All Share is trading on a prospective price/earnings ratio of 13 times – an inverted earnings yield of 7.7 per cent,” he said. “This valuation looks ‘cheap’ compared with bonds and other alternatives.”
“Investors are now generally bullish and, in the short-run, markets are fully capable of rising further. However, we are cautious for two reasons.”
Performance of indices over 3yrs
Source: FE Analytics
“First, profits as a percentage of GDP are high versus historical averages and we expect this ratio to fall in time. Valuation multiples look much less attractive on normalised margins, interest costs and tax rates.”
“Second, our long-held concern about sovereign debts in the developed world prevents us from having a higher equity exposure.”
“A debt crisis would hit equities very hard if it were to happen. But in the mean time, ongoing quantitative easing is a beneficial force for equities. So it would be foolish not to have any equities in a portfolio provided they can be bought on reasonable valuations.”
Most of the fund’s equity exposure is in multinational UK and US companies where Littlewood and his team have the most expertise. He says he is beginning to see more value in emerging markets given their recent poor run though, and Korean and Russian equities now have a 4 per cent weighting.
Within the UK and US, banks have a major weighting in Artemis Strategic Assets, at 10 per cent. Both Barclays and Lloyds are top-10 holdings.
“In the absence of a sovereign debt crisis, I would expect the shares to carry on re-rating upwards for two reasons,” Littlewood said.
“First, the UK economy is growing again, albeit slowly. Second, the barriers to entry in banking are substantial which, in the past, caused good banks to be valued at more than twice book value. A dividend from Lloyds would be a strong signal of its successful transformation into a ‘dull’ utility bank.”
“Banks will fare poorly in the event of a sovereign debt crisis, but in this instance our bond shorts will protect the portfolio.”
Littlewood has run the Artemis Strategic Assets fund since its launch in May 2009. Sitting in the IMA Flexible Investment sector, its broad objective is to perform well when markets are favourable and preserve capital when markets are poor.
Officially, it attempts to beat both cash and equities over rolling three-year periods.
On this measure, the fund has failed to keep up with rallying equity markets over the past three years, although it is well ahead of cash.
Performance of fund, sector and indices over 3yrs
Source: FE Analytics
The fund has been less volatile than equities, though. It has an annualised volatility of 10.33 per cent over three years, compared with 11.7 per cent from the FTSE All Share.
Littlewood accepts that his significant short position in bonds has worked against the fund for much of his tenure, but remains confident that it will come good eventually.
“Not being fully invested has hampered our ability to participate in a rising market,” he said.
“With hindsight, it would have been better to have owned more shares throughout the market rally and to have held on for longer to those that we sold.”
“Nevertheless, I am confident that we made the right decision in view of the risks and our mandate to protect the downside while offering upside.”
“The decision to short government bonds has held back the fund significantly. However, we remain convinced that this investment position is early, not wrong, and that it will prove invaluable in future.”
“If anything, our view has become more entrenched given the ongoing deterioration in government solvency while yields remain near record lows,” he added.
Littlewood previously worked at Jupiter and has significant experience in running hedge fund strategies.
This article was written in collaboration with and is sponsored by Artemis Fund Managers.
