We expect the markets to become more circumspect than they have been. 2010 was characterised by the stockmarkets lurching between 'risk on' and 'risk off'.
We think this year will be more of a 'sideways grind' as the world slowly, and occasionally painfully, rebalances.
Oil
The price of oil is up over 20% so far in 2011, making it one of the best performing assets worldwide.
Equities and bonds are broadly flat year to date. Whilst it is galling to have our carefully-constructed fund soundly outpaced by a bucket of dinosaur remains, we think there are powerful investment forces at work here and some of the themes are worth reflecting on.
Stronger for longer
I am no expert on Middle Eastern affairs, and I am not sure how all this is going to play out. However, it does look like a whole new 'can of worms' has been opened up and I would be surprised if there are any quick answers here.
I think it is entirely likely that the oil price will now be stronger for longer. The risk to supply is now at the forefront of peoples' minds and I would expect a 'risk premium' to be imputed to the oil price for some considerable time to come.
The fundamentals for oil are already reasonably strong. Growth in emerging economies is driving demand and the supply side remains relatively squeezed. OPEC still has the power to turn the taps on, but the only OPEC player that has any spare capacity is Saudi Arabia, so the system is potentially quite fragile.
It is quite conceivable that the oil price trades above and beyond its fundamental value because of persistent geopolitical tensions.
Oil stocks: nothing discounted
If you had told me last Christmas that the oil price would be up 20% in the first quarter of this year, I would have been asking Santa for lots of shares in BP (BP.) and Royal Dutch Shell (RDSB).
What is amazing is that, so far this year, these stocks are broadly unchanged. So the market is presumably not imputing a higher long-run oil price now than it was before. It is not our style to chase the latest bit of news, but surely something has really changed here? I think the market is giving us a chance to buy these stocks.
We have 5.4% of the PSigma Income fund in BP, 5.9% in Royal Dutch Shell, and 2.2% in BG Group (BG.), a low-yielding stock which has been a long-term favourite of the PSigma UK Growth fund. We also hold 1.1% in the French stock, Total SA. This means we have over 14.5% in the sector.
The question we grapple with is whether we should have more.
The oil sector is 17% of the All-Share Index, dominated by the 'super majors' of BP and Royal Dutch Shell which make up 12% of the whole index between them. To express a positive view on the sector, we would have to own more than this and be, say, 5% overweight. This would mean that we would have 22% in the sector.
Is it really right to have nearly a quarter of the fund in one sector? Is that really a sensible thing to do on a risk-reward basis? Given all the uncertainties in the world, given the scope to be blown off course by "Black Swan" events, given that even big companies can go very wrong, is it really sensible to park so much of the fund into one corner of economic activity?
My considered answer is 'no'. So even though we like the oil sector we have no more than 15% of the fund in it. There is no particular science behind this number, but it does ensure that we continue to run a reasonably balanced fund.
It also means that if the oil sector does do well, we will do well on an absolute basis, on a risk-adjusted basis, but not necessarily on a relative basis against those competitor funds that are heavily over-weight in the oil sector.
Our thinking is similar in pharmaceuticals. We are very excited about the opportunities here, as discussed in my last note. But for similar prudential reasons, we are not keen to have more than 15% of the fund in the pharmaceutical sector. In this case though, that makes us around 8% overweight.
Another blow for consumers
The strong oil price has knock-on effects for us all as consumers. Unleaded petrol is now 140p a litre. That is over £6 a gallon in old money.
We wrote last time of 'inflationary deflation' in the UK. Rising prices are being swallowed by consumers and are not being wholly offset by rising incomes. The rise in the oil price is exacerbating this further. Disposable incomes are getting pinched. Anyone who has filled their car up lately will know what I mean.
We are sticking with our negative view on the outlook for sectors exposed to the UK consumer. We own no general retailers, no consumer-facing media stocks, and are underweight the leisure sector. We still do not own any housebuilders.
The return of risk
The terrible events unfolding overseas, be it in New Zealand, Japan or Libya, should remind us all how fragile our grip on the future is.
Some of these catastrophes are, to borrow Dick Cheney's terminology, "known unknowns": the Japanese know they live on unstable foundations and have made massive strides in architecture to mitigate the impact of seismic events. The disaster would have been much worse if they had not made such advances. If it were totally unforeseen, it would have been multiple times worse.
This is obviously not to belittle the human cost of the earthquake. But to expand Cheney's thinking, the set of "unknown unknowns" is unknowably large. As managers of other peoples' money (plus an important chunk of my own), we should adopt a stance that minimises our vulnerability to the unforeseen.
It has been my view that the markets have been too optimistic about the outlook for synchronised global growth. The effects of the financial crisis of 2008 have yet to be fully unwound. We are all "lab rats" in the "largest financial experiment in history": interest rates have never been so low, "special measures" so prevalent and public finances are uncomfortably stretched. It is not a given that governments and central banks can steer us back to normality.
I am not expecting a double-dip recession, but I do foresee a very long haul for the global economy to rebalance. And the possibility that it is worse than my central case - either by slipping into the gutter of deflation or by over-steering in the other direction, unleashing inflation - is something that I have my full focus on.
The good news is that equity valuations are reasonable and many sectors look very cheap to us. As we go about the day-to-day business of meeting companies and assessing valuations, we are struck by how many good opportunities we can find.
After all, the corporate sector is not where the problems are. The consumer is under the cosh, governments are over-stretched but the corporate sector, on average, is in relatively good health. Obviously companies are connected to and reliant upon the broader economy, but it is not a bad time to be a fractional owner of the UK corporate sector.
Source: www.iii.co.uk
We think this year will be more of a 'sideways grind' as the world slowly, and occasionally painfully, rebalances.
Oil
The price of oil is up over 20% so far in 2011, making it one of the best performing assets worldwide.
Equities and bonds are broadly flat year to date. Whilst it is galling to have our carefully-constructed fund soundly outpaced by a bucket of dinosaur remains, we think there are powerful investment forces at work here and some of the themes are worth reflecting on.
Stronger for longer
I am no expert on Middle Eastern affairs, and I am not sure how all this is going to play out. However, it does look like a whole new 'can of worms' has been opened up and I would be surprised if there are any quick answers here.
I think it is entirely likely that the oil price will now be stronger for longer. The risk to supply is now at the forefront of peoples' minds and I would expect a 'risk premium' to be imputed to the oil price for some considerable time to come.
The fundamentals for oil are already reasonably strong. Growth in emerging economies is driving demand and the supply side remains relatively squeezed. OPEC still has the power to turn the taps on, but the only OPEC player that has any spare capacity is Saudi Arabia, so the system is potentially quite fragile.
It is quite conceivable that the oil price trades above and beyond its fundamental value because of persistent geopolitical tensions.
Oil stocks: nothing discounted
If you had told me last Christmas that the oil price would be up 20% in the first quarter of this year, I would have been asking Santa for lots of shares in BP (BP.) and Royal Dutch Shell (RDSB).
What is amazing is that, so far this year, these stocks are broadly unchanged. So the market is presumably not imputing a higher long-run oil price now than it was before. It is not our style to chase the latest bit of news, but surely something has really changed here? I think the market is giving us a chance to buy these stocks.
We have 5.4% of the PSigma Income fund in BP, 5.9% in Royal Dutch Shell, and 2.2% in BG Group (BG.), a low-yielding stock which has been a long-term favourite of the PSigma UK Growth fund. We also hold 1.1% in the French stock, Total SA. This means we have over 14.5% in the sector.
The question we grapple with is whether we should have more.
The oil sector is 17% of the All-Share Index, dominated by the 'super majors' of BP and Royal Dutch Shell which make up 12% of the whole index between them. To express a positive view on the sector, we would have to own more than this and be, say, 5% overweight. This would mean that we would have 22% in the sector.
Is it really right to have nearly a quarter of the fund in one sector? Is that really a sensible thing to do on a risk-reward basis? Given all the uncertainties in the world, given the scope to be blown off course by "Black Swan" events, given that even big companies can go very wrong, is it really sensible to park so much of the fund into one corner of economic activity?
My considered answer is 'no'. So even though we like the oil sector we have no more than 15% of the fund in it. There is no particular science behind this number, but it does ensure that we continue to run a reasonably balanced fund.
It also means that if the oil sector does do well, we will do well on an absolute basis, on a risk-adjusted basis, but not necessarily on a relative basis against those competitor funds that are heavily over-weight in the oil sector.
Our thinking is similar in pharmaceuticals. We are very excited about the opportunities here, as discussed in my last note. But for similar prudential reasons, we are not keen to have more than 15% of the fund in the pharmaceutical sector. In this case though, that makes us around 8% overweight.
Another blow for consumers
The strong oil price has knock-on effects for us all as consumers. Unleaded petrol is now 140p a litre. That is over £6 a gallon in old money.
We wrote last time of 'inflationary deflation' in the UK. Rising prices are being swallowed by consumers and are not being wholly offset by rising incomes. The rise in the oil price is exacerbating this further. Disposable incomes are getting pinched. Anyone who has filled their car up lately will know what I mean.
We are sticking with our negative view on the outlook for sectors exposed to the UK consumer. We own no general retailers, no consumer-facing media stocks, and are underweight the leisure sector. We still do not own any housebuilders.
The return of risk
The terrible events unfolding overseas, be it in New Zealand, Japan or Libya, should remind us all how fragile our grip on the future is.
Some of these catastrophes are, to borrow Dick Cheney's terminology, "known unknowns": the Japanese know they live on unstable foundations and have made massive strides in architecture to mitigate the impact of seismic events. The disaster would have been much worse if they had not made such advances. If it were totally unforeseen, it would have been multiple times worse.
This is obviously not to belittle the human cost of the earthquake. But to expand Cheney's thinking, the set of "unknown unknowns" is unknowably large. As managers of other peoples' money (plus an important chunk of my own), we should adopt a stance that minimises our vulnerability to the unforeseen.
It has been my view that the markets have been too optimistic about the outlook for synchronised global growth. The effects of the financial crisis of 2008 have yet to be fully unwound. We are all "lab rats" in the "largest financial experiment in history": interest rates have never been so low, "special measures" so prevalent and public finances are uncomfortably stretched. It is not a given that governments and central banks can steer us back to normality.
I am not expecting a double-dip recession, but I do foresee a very long haul for the global economy to rebalance. And the possibility that it is worse than my central case - either by slipping into the gutter of deflation or by over-steering in the other direction, unleashing inflation - is something that I have my full focus on.
The good news is that equity valuations are reasonable and many sectors look very cheap to us. As we go about the day-to-day business of meeting companies and assessing valuations, we are struck by how many good opportunities we can find.
After all, the corporate sector is not where the problems are. The consumer is under the cosh, governments are over-stretched but the corporate sector, on average, is in relatively good health. Obviously companies are connected to and reliant upon the broader economy, but it is not a bad time to be a fractional owner of the UK corporate sector.
Source: www.iii.co.uk
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