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Mundy: How to protect your capital if the market does enter panic mode

30 August 2016

The popular manager of the Temple Bar Investment Trust says that a focus on value is the best way to protect investments over the medium term, given the extraordinary market trends of late.

By Alex Paget,

News Editor, FE Trustnet

There is a growing likelihood that inflation levels will rise which would wipe out the bond markets and much of the equity market, according to star manager Alastair Mundy, who says in such uncertain times taking a long-term value approach will be the best form of protection.

A recent poll found that 25 per cent of FE Trustnet readers have no idea whether there will be a significant correction in global equities – and it’s easy to see why so many are confused about the future direction of markets. 

Equities have clearly rallied a long way over recent months, despite the perceived negative implications of Brexit and the numerous headwinds on the horizon.

However, in a world where growth is anaemic, inflation is stubbornly low and central banks remain as accommodative as ever by keeping interest rates low (and even negative) as well as buying up most of global bond markets via quantitative easing (QE), many say there is no real catalyst for a sustained period of weakness for equities.

Performance of indices in 2016

 

Source: FE Analytics

Pictet’s Andrew Cole said: “Bond yields are going to remain low and in a tight trading range for the time being. We would agree that they are not cheap (they are pretty damn expensive), but in the current environment, why wouldn’t equities get as expensive as bonds?”

However, Mundy – manager of the Temple Bar Investment Trust – says that following consensus can often be a dangerous path to take.

“To highlight how misleading ‘obvious’ first-look conclusions can be, it is interesting to look back at the introduction of quantitative easing during the global financial crisis,” Mundy (pictured) said.

“Once again, this was a time of great uncertainty, but, despite this, there was a strong consensus that QE would ultimately prove inflationary, and so long gilt yields increased. This conclusion was totally incorrect (on an eight-year view); instead of rising, gilt yields have fallen to all-time lows.”

10yr gilt yields and CPI since QE was introduced in 2009

 

Source: FE Analytics

As such, the manager questions the viability of the recent the relative value trade (the idea that because bonds are expensive, equity valuations should rise) especially as he believes investors are wrong to write-off the idea of inflation returning.

“One can easily imagine reasons why gilt yields might move higher. With the budget and current account deficits still significantly sizeable, a funding crisis could easily occur.”

“Meanwhile, weak sterling clearly increases import prices, and, if the UK becomes a less hospitable place for foreign labour, wage rises could become an issue too. Rumours of the death of inflation may well prove to have been exaggerated.”


There are numerous industry commentators who have warned about the need to buy inflation-protection within a portfolio while it is cheap and Mundy says that if, for whatever reason, inflation does tick up it will have a profound effect on markets.

“If gilt yields were to rise, the knock-on effects could be significant. They would presumably take all other bond yields with them as well as any other assets whose prices seem to be benchmarked off bonds (the much-loved ‘bond proxies’).”

Mundy admits, certainly for the time being, that inflation doesn’t look likely to make a roaring comeback. However, he says this highlights the state in which financial markets have found themselves in following eight years of extraordinary monetary policy from central bankers.

“Of course, there are always good arguments in both directions, and bond bulls might suggest we are in a period of long-term deflation and/or that the financial authorities will continue to pursue financial oppression and thus keep bond yields low,” Mundy said.

“But the flatness of the bond yield curve suggests the market believes this financial oppression will never have the desired reflationary effect. And, if that is the case, the outlook for economic growth and corporate profitability is surely worse than what is currently baked into share prices.”

He says this, along with other factors, means financial markets are now in highly precarious position.

“Typically, markets can only worry about one thing at a time – and Brexit has clearly been that ‘thing’ in the past few weeks,” Mundy said.

“Perhaps, bear markets occur when investors worry about a number of factors simultaneously and consequently discover there are few, or no, hiding places. It is worth reviewing what else there is that could worry investors over the next year or so.”

“In no particular order – and certainly not a complete list – we have: a very expensive US equity market, extraordinarily low bond yields worldwide, central banks finding their actions having increasingly little reflationary impact, significant political uncertainty in the US, a global debt mountain looking as high as ever, a Chinese economy with far lower economic growth than expected a few years ago and still being at least partly sustained by unnecessary government-funded infrastructure projects, populist politics gaining traction around the world and Europe under significant pressure both economically and politically.”

Mundy has long held a negative view on the direction of equity markets, which is largely due to his contrarian approach to investing.

This focus on value (and a fairly chunky weighting to cash) has hurt his performance over recent times, though, as the market has favoured defensive growth companies due to loose monetary policy and an overarching sense of negativity among investors.

Performance of indices over 3yrs

 

Source: FE Analytics

However, he says that if the market does start to panic about any one or more of those headwinds he mentions, then focusing on companies with low valuations will be the best way to shield capital.

“What would be the stocks to own in a market that decided to worry about some (or all) of these? For value investors, that answer is straightforward: the cheapest and most beaten-up stocks plus, a little bit of cash.”

“Those parts of the equity market already priced for very negative outcomes may paradoxically offer the best protection to investors eager to position their portfolios for a very different future.”


While Mundy is renowned within the industry for being a straight-talking and self-deprecating manager, many investors may not be overly surprised to hear a value manager talking up his own investment style.

However, there are other more independent commentators who are upping their exposure to value funds now – such as City Financial’s Peter Toogood.

“That opportunity set works either way – value is not going to go down as much (in a recession) and if the bond yields go roaring they outperform relatively by some distance,” Toogood said.

While Mundy’s trust has struggled of late, the manager has a decent long-term track record.

Performance of trust versus sector and index under Mundy

 

Source: FE Analytics

According to FE Analytics, Temple Bar has returned 320.33 per cent since Mundy took charge in October 2002 meaning it has beaten the IT UK Equity Income sector and the FTSE All Share by 61 and 90 percentage points, respectively.

It has also outperformed in difficult market conditions. The best example was in 2008 as, despite its closed-ended nature, it fell just 13 per cent during the crisis compared to the index’s losses of 30 per cent and the sector’s plunge of 36 per cent.

Nevertheless, thanks partly to its underperformance relative to the index in 2014, 2015 and so far in 2016 has left Temple Bar trading on a wide 9.21 per cent discount to NAV – which is one of the widest levels it has traded for a number of years.

The trust has dividend yield of 3.4 per cent (and good record of growing its distribution), gearing of 5 per cent and ongoing charges of 0.49 per cent. 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.