Hefty levels of debt, geopolitical uncertainty and extended rallies in both equity and bond markets mean 2017 is not the time to make big portfolio bets, according to Brooks Macdonald’s Niall O’Connor.
The deputy manager, who works alongside Jonathan Gumpel on the five crown-rated Brooks Macdonald Defensive Capital fund, says investors shouldn’t rule out a significant market correction at some point as we continue through the year.
He says the biggest headwind of 2017 is likely to be geopolitical, given the forthcoming elections within the European Union this year and the impending triggering of Article 50.
“We’re looking at markets at the moment and the S&P 500 is pretty much at an all-time high, the FTSE is at an all-time high, the MSCI World is an all-time high, bond yields are still relatively close to all-time lows. We can see that asset prices are very stretched, that’s the first point,” O’Connor said.
Performance of indices since start of FE data
Source: FE Analytics
“The second point is we’re still seeing very high debt levels. Sovereign debt is getting to a high level; Chinese debt is at a very high level. Tech valuations are very high as well, so there are a lot of things that are stretched. 
“On the other side of the equation, we have a huge amount of event risk coming up this year, there are obviously the Dutch, German and French elections – potentially an Italian election. Article 50 should be triggered soon.
“Those are just the events we know about. There are other events that might turn up to surprise us, so there are a lot of things that could trip us up.”
As such, the manager (pictured) doesn’t feel as though there is enough downside risk being priced into markets.
O’Connor warns that realised volatility across markets is also unusually low, which he believes to be inconsistent with the current macroeconomic backdrop.
“It seems that all good news makes markets go up and most of the bad news just seems to be ignored by markets,” he continued. “Again, one of the things we’re looking at is global growth and certainly western world growth, which seems to be coming in ahead of consensus.
“European PMIs are coming in strong, German IFO survey data is still strong, and yet equity markets are rallying on that news. That feels a little bit funny at this stage in the cycle when employment is relatively full and inflation is starting to rise.
“Generally speaking, when you see stronger growth, that’s bad for bonds and, at this stage, generally bad for equities. Yet we’re seeing positive correlation there. It seems slightly strange to us.”
In terms of fixed income, the manager notes that yields are also at historic lows, despite the fact they have started rising over recent months off the back of expectations for fiscal loosening.
In fact, he argues that unprecedented levels of market intervention from central banks have distorted the fixed income market so much, that current government bond prices are now entirely artificial.
Performance of indices over 20yrs
Source: FE Analytics
The Brooks Macdonald Defensive Capital Management team has therefore hedged against a big tail risk event in its portfolio through buying hedges, such as put options on both the S&P 500 and Euro Stoxx 50 indices.
These put options were significantly ‘out of the money’, which means its strike price (the price the derivative can be exercised at) was much lower than its market price.
O’Connor says this is because implied volatility at the end of last year was significantly low, despite ominous levels of event risk.
“One of the themes we’re running with this year is that it’s a bad year to make big bets because we have plenty of binary outcomes coming up,” he said.
“I think the lesson we learned from last year and what we should apply to this year is that we should be conservative in our allocation, and that’s again why we skewed our portfolio to protect itself on the downside.
“I think this year, certainly more than last year and more than the year before, we could get a big drawdown in markets, although I’m not saying there necessarily will be.
“It has only taken the S&P 500 one year to get up to 20 per cent. A 15 per cent drawdown in markets wouldn’t be inconceivable and I think it would be quite easy to post-rationalise a drawdown of this size, given all of the good news would have been priced in and some bad news could set this off-balance.”
The £277m Brooks Macdonald Defensive Capital fund – which has no specified benchmark – aims to achieve positive absolute returns over rolling three-year periods.
While it must be noted that the IA Targeted return sector holds funds with a wide range of performance aims, it has more than doubled the returns of its average peer over one, three and five years.
Performance of fund vs sector over 5yrs
Source: FE Analytics
It has done so with a five-year maximum drawdown – which measures the most money lost if bought and sold at the worst times – of 4.41 per cent.
The fund has a clean ongoing charges figure of 0.82 per cent.