Uncertainty around the global vaccine rollout, the price insensitivity of passive ETFs and changing perceptions around the price of risk all pose a threat to financial markets, according to Troy Asset Management’s Charlotte Yonge.
Global vaccine rollout
As the vaccine rollout continues in major developed markets, Yonge – who is assistant manager of the £5.4bn Trojan fund and lead manager of the £261m Trojan Ethical fund – is concerned about the progress in emerging markets.
“This is something that's not only a humanitarian risk, but it's a global economic risk that hasn't perhaps fully been appreciated,” she said. “I think our immunity against this is probably only as secure as the weakest link would be.
“We still live in a very connected world and if we want everyone to return to that on a physical basis then we really need immunisation on a global scale. I think there are going to be huge challenges to that.”
Yonge worries investors are too focused on the optimism around the vaccine rollout in developed markets and are overlooking the difficulty of the vaccine rollout in the rest of the developing world.
“This is a risk to global growth,” she explained. “For many multinational companies - some of which we invest in - a huge amount of their sales, in many cases the majority, are from markets such as Asia, Africa, Latin America and areas where they will be facing big challenges on the vaccine.”
Another risk this poses is that the relative strengthening of the US economy, which has had roughly 15 per cent of its population vaccinated, could further weaken developing nations struggling with vaccine rollouts.
Yonge said: “If we get a strong US economy whereby the vaccine provides some sort of return to normal and the lockdown ceases, then you could see a much stronger US dollar.”
A stronger dollar means the developing countries with dollar-denominated debt will see their liabilities increase in local currency terms as dollar strength increases.
“That certainly threatens to exacerbate the economic pain that is being felt in a lot of those countries where the vaccine rollouts are not happening,” Yonge explained. “That is a real risk for the world at large, one that's not being talked about enough.”
Passive ETFs
Yonge is also concerned about the amount of money that is in passive vehicles, which could be adding to the fragility of the whole market.
She said: “So there's been a lot of a huge amount of flow into ETFs and, frankly, investors that are quite a few steps removed from what the underlying companies that they own are doing.
“They are price insensitive on the way up, definitely price insensitive on the way down. We saw that in the market sell-off last year and also in the fourth quarter of 2018.
“There's this sort of momentum in both directions. You can get that avalanche of selling in just the same way that you can see a melt-up, as inflows into ETFs help markets.
“Someone buying an S&P 500 tracker isn't really looking at like what the cash flows are of that underlying basket of stocks that they’re buying.”
Performance of S&P 500 from 2018 to today
Source: FE Analytics
Yonge continued: “It's just getting more equity exposure without really considering what you're going to get in return. So there's just this dislocation between the fundamentals and the price.
“There is a basket stocks that people are buying, so they're not really discriminating between Alphabet - which is in my opinion good value - and something like Tesla, which, who knows, but certainly on a kind of cash flow basis today, is very, very expensive. People are just buying the lot.
“The risk is: for investors like us who are discriminating between those two or between the many options out there, everything can sell off at once.”
Indeed, markets sold off indiscriminately in March last year as investors rushed into cash.
“In the short term, there's kind of nowhere to hide,” Yonge said. “All the correlations move to one.
“If there is another market sell-off, which I think there is certainly a considerable risk of, ultimately the only thing that will hold up is cash.”
People are forced to own more risk than they realise, in her view: “They are holding these assets which have done really well but ultimately, can fall at the same time that those known-to-be risky assets are falling.”
The price of risk
Given the economic uncertainty that still looms, Yonge believes the discount rate, or the price of risk, is not as high as it should be.
She pointed to how markets wobbled during the taper tantrum of 2013 and similarly in the last quarter of 2018, when investors feared the US Federal Reserve was going to raise the risk-free rate.
“Remember all of these recent scares were very much issues of perception,” she said. “Ultimately, the Fed was in the end there, and very much prepared to backstop the market.
“So are we going to see the risk-free rate rise higher on a permanent basis? I would be very surprised. I think there's a very clear commitment from the Fed to keep rates low.
“Ultimately, there's so much debt in the world, we can't afford to raise interest rates. I think the risk-free rate, as much as central bankers can control, there is a very clear commitment to being there to suppress that risk-free component.”
However, a change in perception around the equity risk premium – which Yonge said can move independently of the risk-free rate - could be a very underappreciated threat to markets.
“That completely comes down to confidence,” she explained. “It's what premium are you prepared to accept, on top of that risk-free rate. We have a lot of confidence right now in the markets, which is at odds with the uncertainty.”
She believes the premium that investors should be demanding for the wide range of economic outcomes should be higher: “We really don't know how long this virus is going to be with us, that's incredibly uncertain. On top of that, you've got fundamentals that we know that we can be very sure of.
“The corporate sector has taken on a lot more debt, we’ve taken a huge economic hit from Covid and the ramifications of that are going to be here for some time to come.
“You've got the fact that in the corporate world margins in many cases have expanded to levels that are probably unsustainable, a prioritisation of wage inflation from the Biden administration could put pressure on margins, and we also know that tax rates certainly in the US have a risk of rising.
“All these things should today command to higher risk premium for a lot of equity prices. I think there are lots of areas of the market where the confidence and that sort of certainty in the future cash flows is way too high. The discount rate needs to rise.”
Since launch in March 2019, Trojan Ethical has generated a 19.38 per cent return, versus a 19.6 per cent return from the average fund in the IA Flexible Investment sector and 3.65 per cent from the UK Retail Price Index benchmark.
Performance of the fund versus sector and benchmark since inception
Source: FE Analytics
The fund has an ongoing charges figure (OCF) of 1.02 per cent.