Many parts of the market are looking overvalued and investors need to start preparing for an eventual global recession. 
This is the view of a number of managers in the IT Flexible Investment sector, after the Association of Investment Companies (AIC) surveyed those running trusts with multi-asset and capital preservation strategies about their outlook and positioning.
AIC communications director Annabel Brodie-Smith said: “Recently, it’s been a turbulent time for markets and it’s useful to know about the investment companies whose objective is to protect investors’ capital and limit volatility, come rain or shine.”
As Brodie-Smith noted, markets have experienced an uptick in volatility in 2018 on the back of concerns such as a potential trade war between the US and other major economies as well as rising bond yields and fears of slowing global growth.
Performance of indices in 2018
Source: FE Analytics
As the chart above shows, progress has been difficult in markets this year with the US making just over 8.6 per cent but the other major equity regions posting losses. This month has been especially challenging as global equity markets were hit with a significant sell-off that left investors nursing heavy losses.
The IT Flexible Investment sector is home to investment trusts that have the ability to invest in a range of asset classes. Like the Investment Association’s sector of the same name, it is home to funds that aim to protect investors’ capital through cautious positioning as well as those that are fully invested in risk assets.
When asked for his outlook on markets, Ruffer Investment Company investment director Hamish Baillie said: “We are very worried about the outlook for equity markets. There are pockets of value, but many parts of the market are overvalued and the combination of structural fragilities in markets, lower levels of liquidity and the rise of unthinking passive strategies means that the next downturn is likely to be particularly vicious.”
However, this does not mean that Baillie sees the bond market as a source of comfort amidst these conditions. Indeed, he is even more worried about this asset class given the high valuations being seen here after a decade of ultra-loose monetary policy from the world’s central banks.
“Perhaps most worryingly, bonds may not provide the offset that they have done for the last 25 years and so a typical balanced portfolio will find that both sides of the fear/greed strategy fall in value,” Baillie said.
Reflecting these concerns, the £409.8m Ruffer Investment Company has a “relatively low” exposure to the equity market at around 40 per cent of assets, with a focus on cyclical and value stocks as well as some special situation growth businesses. The investment director added that Japan has been a “particularly productive hunting ground” and 15.4 per cent of the trust is invested here.
Performance of trusts in 2018
Source: FE Analytics
Furthermore, the trust has one-third of assets in UK and US index-linked bonds so it can benefit from an increase in inflation greater than any rise in interest rates while there is another 7 per cent in gold and gold equities. Baillie added that the trust is holding options to protect against rising bond yields and falling equity prices, which should help it in the event of a correlated sell-off in both bonds and equities.
Giving his outlook, Seneca Global Income & Growth chief investment officer Peter Elston said: “Economies are in the late stage of their cycle and low or falling unemployment is translating into rising wages. This means tighter monetary policy, which is putting pressure on financial asset prices. A global recession is not imminent, but one should be preparing for it. Brake ahead of the bend, not when you reach it.”
Seneca Global Income & Growth has been trimming its equity exposure for some time, moving from an overweight in the asset class to an underweight. In June, the managers said they expect a global bear market in equities in 2019 followed by a global recession in 2020; they also expect to continue to move further underweight equities as the cycle matures over the coming years.
The trust currently has 29.21 per cent of assets held in UK equities, such as BT Group, Marston’s and Babcock, and other 23.54 per cent in overseas stocks through funds like CIM Dividend Income and CC Japan Income & Growth. There’s 30.94 per cent in ‘specialist assets’ like International Public Partnerships and Fair Oaks Income and 9.76 per cent in fixed income, from products such as Royal London Short Duration Global High Yield Bond and TwentyFour Select Monthly Income.
Katy Thorneycroft, co-manager of JPMorgan Multi-Asset Trust, is less bearish in her outlook and expects global growth to continue above trend. However, she conceded that the global trade tensions prompted by the Donald Trump administration and higher US interest rates have increased risks to this outlook.
“We expect US policy rates to continue steadily tightening over coming quarters, but even then monetary policy will remain accommodative and supportive for risky assets into early 2019,” she concluded.
“Within asset classes, we have a preference for US stocks over most other regions. We are more cautious on emerging markets and we see further headwinds from trade tensions, a stronger US dollar and rising US rates. We continue to see opportunities for returns and diversification within infrastructure.”
JPMorgan Multi-Asset maintains a pro-risk tilt in anticipation of an economic and earnings environment that would be consistent with equity outperformance but is looking to trim equity allocations “a little”.
But Capital Gearing manager Alastair Laing is another investor who agrees there is a growing consensus that the current macroeconomic and financial environment is ‘late cycle’.
“Some indicators are relatively simple to observe, namely that the current US economic expansion and equity bull market are both the longest since the second world war,” he explained.
“Other indicators are based on historic echoes such as the Federal Reserve embarking on a tightening cycle resulting in a flattening yield curve. These all point to a cliff edge out there, shrouded in the mist that is the future.”
Capital Gearing has the majority of its portfolio in short duration high quality bonds and takes “restrained” exposure to equities, through investment trusts such as North Atlantic Smaller Companies, Ground Rents Income and GCP Infrastructure Investments.
“The cost of timidity is forgone opportunity today. However, the cost of greater courage is all too often forgone opportunity at the time it really matters,” Laing added.
“The best returns across the cycle come from increasing equity exposure after a bear market. In order to exploit those golden opportunities you need to make sure you are not fully-invested when you discover where the cliff edge is.”