A “highly fragile market structure” means that investors should prepare their portfolios for more volatile conditions such as those seen at the end of 2018, Troy Asset Management’s Sebastian Lyon warns. 
During the final quarter of 2018, markets were hit by two significant sell-offs sparked by the trade tensions between the US and China, the Federal Reserve’s moves to tighten monetary policy and concerns over the health of global growth.
As the chart below shows, most parts of the equity market fell hard over the three-month period, with some of the strongest falls coming towards the very end of the year (followed by a big Boxing Day bounce).
Price performance of indices in Q4 2018
Source: FE Analytics
Lyon, manager of the £4bn Trojan fund, said: “The shocking experience of the last three weeks of 2018 should not necessarily be viewed as an anomaly.”
The manager argued that this is down to a “very material change in markets” over the past 10 years: the decline in secondary market liquidity, which makes them more vulnerable to shocks.
Regulatory changes brought in after the global financial crisis have led to investment banks withdrawing their capital from equity and bond markets; as their capital requirements rose, their inventory of assets fell.
“Combined with an increased prevalence of exchange-traded funds, the holders of which expect continuous trading, and after a strong rise in algorithmically-driven strategies, this makes for a highly fragile market structure,” the FE Alpha Manager said.
Against this backdrop, Lyon argued the stock market ‘relief rally’ that was witnessed in the opening quarter of 2019 appears to be disproportionate to fundamentals, which are little changed from the end of 2018.
He noted that talk has recently turned whether there will be an equity market ‘melt-up’ – or a momentum-driven rally that is sudden and substantial – although the return of volatility in recent days on the back of an escalation in the US-China trade war might have put a dampen on this.
The Trojan manager pointed out that there were also forecasts of a melt-up in January 2018, just before the market was hit by a severe contraction.
Price performance of global equities in 1999/2000 in US dollars
Source: FE Analytics
“Today it would mark a further divergence from fundamentals. The most recent equity market melt-up was in 1999, during the technology bubble,” Lyon said. “A repeat of this cannot be ruled out but it is worth noting that this has occurred within living memory for the majority of stock market participants.”
The manager maintained that one factor investors cannot ignore is the direction of US interest rates. The Federal Reserve was in the process of normalising rates but has put this on pause; some now expect rates to go down again in the US but the Troy manager cautioned investors against seeing this as definitely positive news.
Failure to lift interest rates towards more normal levels would mean that the world’s central banks remain stuck in “a world of unorthodox monetary policy”, he added. A consequence of this might be that monetary policy is forced to become even more unorthodox when it is needed to fight the next downturn.
“Falling rates are not necessarily good for equities. Cast your mind back to 2002 or 2008 when interest rates were being cut aggressively; these were dreadful years for equity returns,” he continued.
“For now there are few firm conclusions that can be drawn but relying on the ‘Fed put’ to save the day in all conditions may prove a thin reed to lean on. Whilst the ‘pause’ has been cheered, a future cut will not necessarily offer cause for celebration.”
In the meantime, investors face “an invidious choice” between overvalued quality stocks or cheaper stocks that tend to be cyclically or structurally challenged. Lyon warned that high yields are all too often an indication of poor future returns rather than bargains and as a result he prefers to “eschew these murkier parts of the market”.
The fund manager concluded that risk continues to be seen in stocks that have seen their values pushed higher by central bank liquidity. He noted that stocks rose in 2019’s opening quarter without decent improvement in earnings, which is a sign that investors are overlooking valuation risk.
“For those investing for short-term outcomes that may be all well and good. For the prudent, long-term investor, the prospective rewards look somewhat less compelling when compared with the risks,” he said.
“Our preference will remain for companies which invest to sustain good returns rather than those which endanger their franchises for short-term gains. We also seek to avoid structurally challenged business which are struggling to progress in a rapidly changing world.”
Performance of fund vs sector and index since launch
Source: FE Analytics
Lyon has managed the Trojan fund since its launch in May 2001, of which time it has outperformed both its average IA Flexible Investment peer and its FTSE All Share benchmark with a 238.58 per cent total return. This makes it the sixth-highest returning member of the 28-strong sector.
The fund – which priorities capital protection and is built around quality global blue-chips, index-linked bonds, gold and cash – also has the peer group’s lowest maximum drawdown and annualised volatility as well as its best Sharpe, Sortino and Treynor ratios.
Trojan has an ongoing charges figure (OCF) of 1.02 per cent.