Next year could be the time when “supposedly ‘safe’ assets” are revealed to be risky investments after years of being bid up, according to Schroders’ Marcus Brookes, who is maintaining a defensive stance on many areas of the market in his multi-manager funds. 
Brookes, head of multi-manager at Schroders and, has been cautious on the bull run that has buoyed markets since the end of the global financial crisis, noting that it has largely been stoked by ultra-loose monetary and arguing that a significant correction could be on the horizon.
One important element of this rally has been inflation consistently surprising on the low side of expectations. This has resulted in a trend within markets for flows to head towards assets that benefit from low inflation such as rate-sensitive investments like bonds and quality-growth equity “surrogates” that benefit from falling bond yields, often known as ‘bond proxies’.
“So stable has been this trend, that such assets now carry an almost irrefutable reputation for being ‘safe’,” he said. “This is the sort of extrapolative thinking that prevails at the mature phase of every major bull market.”
Performance of gilts and a quality-growth sector over 8yrs
Source: FE Analytics
In his outlook for 2017, the co-manager of portfolios such as the £922.3m Schroder MM Diversity fund warns that the uptick in inflation means that this trade is coming under pressure and could unravel in 2017 – with painful consequences for some investors.
“So when is a supposedly ‘safe’ asset exposed as a risky investment? In our view, there’s a good chance the answer is 2017,” Brookes said.
“Our outlook for the coming year is heavily influenced by the likelihood that inflation now surprises on the high side for at least a few quarters.
“This prospect has already instigated a significant rotation within the equity market and a sell-off in fixed income (i.e. bonds). These new trends have accelerated since the election of Donald Trump.”
In an article earlier in the week, FE Trustnet looked at potential reasons why the rotation out of growth stocks towards value – which tends to perform better in a reflationary environment and had endured several years of underperformance – could continue over the long run.
Ian Heslop, head of global equities at Old Mutual Global Investors, told FE Trustnet: “Concentration at style level – which we've had through quality-growth with a bond proxy flavour – has been playing almost uninterrupted for three years. This is a start of an unwind, it's not the finish. It might flip-flop around but there's a long way to go in this rotation.”
“This trade that's unwinding, if you take it back far enough, it goes to the global financial crisis. For eight or nine years, the same trade has through all global markets so 10 weeks of movement is not an 'unwinding'. There’s a huge amount of money to unwind.”
Performance of indices over 8yrs and 2016
Source: FE Analytics
Explaining why he believes the current bull market in bonds and quality-growth stocks looks set to come under pressure, Brookes says the contemporary market cycle has been defined by historically low economic growth and low inflation.
These conditions (combined with historically low interest rates and quantitative easing programmes by the world’s central banks) have been more beneficial to fixed income and ‘bond proxies’, or stocks paying premium dividends with low earnings variability and strong balance sheets.
The bull market has largely been confined to these areas, he suggests. Until recently, more economically sensitive groups like mining and banks have been relatively ignored by investors.
“In our view, this bull market in safety was always likely to climax with a shift in expectations towards better nominal growth,” Brookes said. “With higher inflation pretty well assured for the first half of 2017, Donald Trump’s election has (rightly or wrongly) now given the market a more pro-growth narrative on top.”
This renewed confidence in the outlook for inflation and economic growth that followed the Trump election has spurred “those late to the party” to move away from the market’s incumbent leaders – those assets that appeared best-placed only if the world was secularly stagnating – and towards those that benefit from higher growth, typically value stocks.
“At the risk of being misinterpreted, what we are talking about here is a window of opportunity between now and the next recession to benefit from a period of mean reversion, as the extreme crowding in bonds, bond proxies and yield plays dissipates and owners of those assets suffer drawdowns,” Brookes said.
“Outside of an economic slowdown or crisis (for which there are admittedly a few candidates), we think it is too risky to remain overinvested in many assets that currently bear the safety moniker, but have really just ridden the wave of falling bond yields.”
“This includes commercial real estate, infrastructure funds and alternative financing vehicles. Cumulatively there is massive over-investment in this space. Valuations are historically extreme and the perception of risk is low.”
Fund manager position vs historical averages in Dec 2016
Source: BofA Merrill Lynch Global Fund Manager Survey
In terms of his own positioning, Brookes has the bulk of his equity exposure in value as, given the above, this is the most likely beneficiary of the move away from bond and quality-growth. Value-biased funds held in Schroder MM Diversity include GAM Global Diversified and GLG Japan Core Alpha.
He maintains his bearish stance on bonds, saying: “Quite simply, we believe the short-term losses that investors have suffered in recent months have the potential to build and ultimately become quite substantial.”
The fund’s fixed income exposure is taken through JPM Income Opportunity Plus. Manager Bill Eigen has been very bearish on bonds in the past but has been deployed cash in areas of the market that look undervalued, such as high yield.
Schroder MM Diversity also has close to one-third of its assets in alternatives funds like Majedie Tortoise and Morgan Stanley Diversified Alpha Plus. It also has some gold exposure, through a physical gold exchange-traded commodity, which has been a diversifier during periods of higher inflation.
“We have a number of funds in the portfolios that we believe are set to benefit if the primary trend in fixed income has indeed transitioned from one of falling yields,” Brooke said. “So influential has been this trend that one can benefit from its reversal across multiple asset classes.”