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Dickie Hodges: Why there is “great potential” for a collapse in risk assets this year

05 April 2017

Hodges, who runs the Nomura Global Dynamic Bond fund, tells FE Trustnet why markets are prematurely pricing in Trump positivity and why he believes inflation assets have peaked.

By Lauren Mason,

Senior reporter, FE Trustnet

There is now greater potential for a future collapse in risk assets near the end of this year, according to Nomura’s Dickie Hodges (pictured), who warns that inflation expectations and Trump positivity are prematurely priced into markets.

As more and more investors pile into the riskiest areas of the market, he says even the smallest disappointments from Trump’s policies will lead to hefty drawdowns across capital markets.

As such, the manager of the Nomura Global Dynamic Bond fund is utilising put options and currently holds more than 7 per cent of the fund in cash, which he plans to put to work when investor sentiment changes.

“All you have to do is look at the VIX [Wall Street’s volatility index – a key measure of market volatility expectations] and you see that, in 2008, the increase in volatility after the Lehman Brothers default lasted 12 months,” Hodges said.

“In 2011 during the European debt crisis, it lasted about nine months. During the Taper Tantrum of 2013, it was six months. Greece 2015 was two months, the commodity price scare in 2016 was five weeks, Brexit volatility lasted five days, Trump lasted five hours and the final Italy referendum lasted two hours.

“You can see that, because we can’t generate enough return out of income alone, we all have to sit here and wait for areas of increased volatility so we can deploy the cash. We cannot generate the returns that meet investors’ expectations out of investing for income in isolation.”

Performance of index since 2008

 

Source: FE Analytics

As such, the manager explains he is holding cash, not because he is concerned about the market, but because he anticipates a future spike in volatility resulting from macroeconomic disappointments.

However, he says a significant capitulation into high-risk assets will pre-empt this, which will be based on expectations for Trump’s pro-growth policies, such as his plans to return US investors’ untaxed foreign earnings from overseas.

“The fact is that [the repatriated money] is going to be spent on equity markets and dividends, which is great for those markets, but it won’t be spent on capex or anything that will be beneficial long-term to the economy,” Hodges said.

“This has happened in the past. The last time was 2004 and that resulted in all the money that was bought back into the US being spent on shareholder-friendly activities, buying back equity and increasing dividends.

“From a bond perspective and growth perspective, it did nothing to stimulate a measure of growth coming through in the US.

“If we get this tax repatriation coming back and everyone views it as a positive, I think that money will be ploughed back into shareholder-friendly activity. That in itself will drive equity markets and all risk assets higher still.”


The manager isn’t the only investment professional to voice concerns about toppy market valuations. In an article published last month, Fidelity’s Nick Peters explained that he is reducing his equity exposure across his portfolios due to overly-optimistic expectations for global growth.

Hodges is aiming to mitigate the impact of any potential market disappointment through holding put options, two of which are currently on US equities.

This is a technique he often employs when markets are pricing in a certain outcome, given that they are so attractively valued by this point. For example, he took out put options in the run-up to both Brexit and the US elections because he deemed hedging against a ‘leave’ result or a Trump victory so to be immaterial in terms of cost.

This technique has stood the fund in good stead. Over the last year, Nomura Global Dynamic Bond has returned 25.09 per cent compared to its sector average’s return of 13.19 per cent. It has done so with a top-quartile maximum drawdown (which measures the most potential money lost if bought and sold at the worst possible times) relative to its average peer.

Performance of fund vs sector over 1yr

 

Source: FE Analytics

“People bought puts on equity markets to protect against downside at the beginning of this year. Post the Trump election, we’ve had a significant rally in equity markets,” Hodges said.

“I don’t think there’s anyone in the world who seriously thinks we’re going to have another 5-or-10 per cent sustainable fall in equity markets. But we all own a put, we’re all waiting for markets to catch.

“However, the longer that opportunity takes to come, the more investors will be inclined to let their hedges roll off to claw back some of the premium.

 “I can just see it, everyone is just going to invest, everyone is going to lift their puts or their puts will expire out of the money and, at some stage over the course of the next two-to-three months, I think we will get very close to a stage where everyone ends up being unhedged and into the riskiest assets.

“That will lead to even the smallest of disappointments being reflected in larger moves or drawdowns in capital markets.”

 One market theme that Hodges believes has run for too long across risk assets is the expectation for a significant rise in inflation.

While he says it won’t be a surprise if inflation does rise in the immediate term, he says this has already been discounted across asset classes.

“We now need to see that inflation is going to be meaningfully higher than is already priced in, but I don’t think that’s realistic,” the manager said.


“I am sure inflation is going to be higher over the next two or three months but I have absolutely no confidence that inflation will be higher over the next two or three quarters.

“The only way of making any money out of inflation or inflation assets is if market expectations change.”

Given that rallying market areas depend on a Trump-induced inflationary environment that is yet to materialise, Hodges believes we will see a significant market correction over the medium term. He also says there is very little in the way of tailwinds for fixed income at the moment and, as such, is utilising individual high-conviction positions to maximise returns.

“There is nothing, in my opinion, to drive this market significantly higher, and there is very little in regard to a risk event that is going to suddenly cause a material sell-off in fixed income.

“Any evidence that comes through from Trump, you won’t get to see the effect this has on the economy until 2018.

“Essentially, I’m looking for, not necessarily a very similar move to what we saw in January and February 2016, but certainly I can see towards the end of the year we have a great potential for real disappointments in equity market returns. There is certainly now greater potential for a future collapse in risk assets.”

 

Since Hodges launched Nomura Global Dynamic Bond, it has returned 25.9 per cent compared to its sector average’s return of 18.48 per cent.

Performance of fund vs sector since launch

 

Source: FE Analytics

It has a clean ongoing charges figure (OCF) of 0.82 per cent.

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