Investors need to realise that the valuations in many parts of the market are “divorced from reality”, Troy Asset Management’s Sebastian Lyon warns, as he reiterates his view that a cautious approach is now essential given the expensive state of most assets.
In his latest update to investors, the manager of the £3.2bn Trojan fund said that the UK’s vote to quit the European Union is likely to be a “watershed moment” that has the potential to fundamentally transform the continent for decades to come.
He warns against rushing to forecast what the Brexit result will mean for markets and asset prices but is also cautious against reading too much into the fact the FTSE 100 rose after its initial sell-off and is now higher then when it started the year.
Performance of index over 2016
Source: FE Analytics
Investors should not get used to the feeling that everything is okay just because markets took the Brexit vote in their stride, he adds.
“The enormity of the UK’s decision to end its participation in European political integration means that it is easy to be consumed by domestic affairs. But just because there is a temptation to ignore problems further afield does not mean that they have gone away,” he said. 
Among the issues highlighted by the FE Alpha Manager (pictured) are the lack of robust growth in the global economy, the increasing reliance on debt for what growth there is and a significant fall in the growth of world trade, as well as the risk the UK is on track for recession.
Compounding these problems is the fact that central banks will now find it difficult to use interest rates to tackle recessions, given that they have been sat at historic lows for a number of years. Indeed, the fallout of the Brexit vote saw the Bank of England last week cut the base rate in half to 0.25 per while expanding its quantitative easing programme but many wonder how effective this will prove to be.
Lyon says this situation will ultimately end in pain: “Low interest rates and quantitative easing have led to ballooning asset prices. Over $12trn of government bonds now offer buyers a negative nominal yield. This is not even an example of ‘picking up pennies in front of a steam roller’. Instead, it is throwing your own pennies in front of one – courting danger with the deliberate intention of losing money.”
“Amazingly, not a single Swiss government bond carries a positive yield. The heights of absurdity continue to be pushed upwards. Paying to save (in nominal terms at least) has not occurred in 5,000 years according to David Roche of Independent Strategy. Paying someone to borrow your money is, he argues, the equivalent of the ‘monetary loony bin’.”
Likewise, Lyon says that bond-like equities – which have been immensely popular with investors as loose monetary policy forced down fixed income yields – are looking to be on very stretched valuations. He notes that the strong returns of recent times have been driven by multiple expansion rather than revenue and earnings earning.
FTSE All Share and gilt yields over 5yrs
Source: FE Analytics
“Bonds and bond-like equities are increasingly looking like bubbles in search of a pin,” he said. “Very low (or even negative) bond yields should not necessarily lead to higher risk assets. Equities and bonds are giving mixed messages. If bond markets are right in indicating lower growth then risk should not be rewarded.”
“We repeat our warning that in an environment of near-universally overvalued asset markets it is unlikely to be easier to navigate the post-market falls than to avoid the falls themselves. This is because, with both equities and bonds looking vulnerable, traditional asset diversification may not protect to the same extent that it has in the past.”
Lyon has built his Trojan fund with this viewpoint very much in mind. Its portfolio revolves around four ‘pillars’ of blue chip equities, index-linked bonds, gold and cash that are designed to enhance capital preservation.
It counts the likes of British American Tobacco, Philip Morris, Microsoft, Altria and Coca-Cola as its top equity holdings, but there’s also 22 per cent in UK and US index-linked bonds, 11 per cent in gold and 27 per cent in cash.
This cautious positioning has paid off over the fund’s 15-year track record. Since launch in May 2001, Trojan has made a 221.46 per cent total return – beating the FTSE All Share by around 100 percentage points and ranking its second in the IA Flexible sector.
Performance of fund vs sector and index since launch
Source: FE Analytics
Added to this, the fund has the peer group’s highest Sharpe ratio – which measures risk-adjusted returns – as well as its lowest annualised volatility and maximum drawdown.
However, Lyon is not the only market commentator to be vocal about the distortions they see ultra-loose monetary policy creating in financial markets.
Jim Wood-Smith, head of research at Hawksmoor Investment Management, is another that has been vocal about the effect this has had on valuations and has warned on a number of occasions of the huge risks being created as asset prices become increasingly separated from their fundamentals.
“I really do not want to be a party-pooper. But this is a party we would be better off without. The music is rubbish, most of our friends aren’t here, the toilets are awful and worst of all, the prices at the bar are extortionate. But there are no exits and the only way to rave is to keep drinking and keep paying. And the louder the music gets, the darker and hotter the club gets and every time you need another drink, the price has gone up,” he said recently.
“As Don Henley sang ‘last thing I remember, I was running for the door. I had to find the passage back to the place I was before’. The time will come when the latest new paradigm comes to an end. The world in which 5 per cent growth can justify p/e ratios of 20 or 25 times is unstable and impermanent.”
