Miton’s Anthony Rayner: How to Preserve Capital?

• The absence of a gain is not a loss in capital preservation
• Forecasting which assets will be best for capital preservation is futile
• Currency is a way to manage risk rather than generate returns

Anthony Rayner, manager of Miton’s multi-asset fund range, comments:

“One of the most frequent questions we’re asked at the moment is how we will preserve capital in the event of a market downturn. This is always a relevant question, but especially so given the current cross currents which are, to some degree or another, influenced by the massive and unprecedented global quantitative easing programme. These forces combine to create a unique context for this question.

“We are currently experiencing a very extended bull market, so the question feels particularly front of mind. Despite having spiked of late, yields are still at very compressed levels in major economy government bond markets and so the degree to which bonds can act as a ballast to equities, or indeed financial markets more generally, is limited. Also, major central banks are on the journey to exit QE, and there are a number of data points which point to pockets of rising inflationary pressures.

“Importantly, these last two points are much more recent in nature and add to the complexity of the task facing central banks. In short, central banks are surely much less confident that they can manage financial market stability, specifically to minimise the threat to economic stability, if inflationary pressures start to build more widely.

“Whilst the current environment is indeed unique, so are most situations, whether pre-crisis or not. This soon becomes apparent when you look at how safe havens have behaved in the past in different crises.

“Crises can be broadly grouped into economic, financial and geopolitical, while safe havens conventionally include US Treasuries and gold, and then currencies. The first thing to note about these safe havens is that they are dominated by the US dollar, either directly or by their denomination, and this is particularly relevant for non-US dollar investors.

“Looking back at how asset classes behave has drawbacks, however the behaviour of asset classes, in isolation and in relation to each other, is rarely consistent for extended periods. Applying that to safe havens means that there isn’t a consistently excellent safe haven. Each situation is unique and the journey each asset class has taken is unique too, think of US Treasuries currently.

“So what can we apply to how a portfolio should be positioned now? Firstly, it’s worth stating that whilst we know there will be a crisis, we don’t know when it will occur and we don’t know its nature. That’s not to say it isn’t worth scoping out some scenarios.

“If it’s an economic crisis in the next few months, it will likely be inflation driven rather than recession driven, given the momentum for economic activity is so strong. If that’s reasonable, then it’s likely that US Treasuries won’t be the first port of call, as higher rates, or the anticipation of higher rates, will likely see them struggle.

“Even though US TIPS (Treasury Inflation Protected Securities) can provide some inflation protection if held to maturity, they can be very sensitive to increases in interest rates, remember they are real yields and so any benefit from higher inflation can be overshadowed by the impact of higher rates. Turning to equity, resources might be a relatively better safe haven, counter-intuitively perhaps, than the traditional defensive stocks (the bond-proxies) which tend to move with the bond yield.

“Of course, our base case might be wrong, the next major crises might be geopolitically driven. Our sense is that gold has tended to be a fairly decent geopolitical safe haven, take its response to the numerous North Korean episodes of late, but how useful is that information, even if it is repeated?

“Geopolitical events are notoriously difficult to forecast, both their starting point and how they evolve by their very nature. Think of the Cuban Missile crisis for example. Yes, it was at the height of the cold war but that specific event came out of nowhere, genuinely threatened world peace, and was then resolved in an unpredictable fashion.

“We believe that forecasting is unhelpful. Even assuming you get the timing and the nature of the event right, which are massive assumptions, how do you know how the crisis will evolve and how assets will behave? Take Brexit, not a crisis in the purist sense of the word but a shock to markets nevertheless. Clearly the timing wasn’t difficult but, whilst the minority of forecasters got the result right, an extremely small number of those that got it right forecasted the correct reaction from markets, i.e. that gilts and equities rallied sharply.

“We think it makes sense to be pragmatic rather than pre-emptive. That’s not to say we’re ‘flying blind’ but we’re looking at what’s in front of us now, not into the future. To allow us to be pragmatists, we remain in liquid investments and continue to be as open-minded as possible.

“It might be that once a crisis hits, cash could temporarily be the best way to preserve capital. That then begs the question as to which currency should be used to denominate this cash. We would argue sterling, as we think of currency as a way to manage risk rather than generate returns, and we are sterling based investors. Sterling is unlikely to be the headline safe haven currency but the absence of a gain is not a loss.

“The current situation is unique but that, in itself, is not unique. This means that forecasting which asset classes are going to be the best way to preserve capital is probably as futile as trying to forecast the event itself.”

• The absence of a gain is not a loss in capital preservation
• Forecasting which assets will be best for capital preservation is futile
• Currency is a way to manage risk rather than generate returns

Anthony Rayner, manager of Miton’s multi-asset fund range, comments:

“One of the most frequent questions we’re asked at the moment is how we will preserve capital in the event of a market downturn. This is always a relevant question, but especially so given the current cross currents which are, to some degree or another, influenced by the massive and unprecedented global quantitative easing programme. These forces combine to create a unique context for this question.

“We are currently experiencing a very extended bull market, so the question feels particularly front of mind. Despite having spiked of late, yields are still at very compressed levels in major economy government bond markets and so the degree to which bonds can act as a ballast to equities, or indeed financial markets more generally, is limited. Also, major central banks are on the journey to exit QE, and there are a number of data points which point to pockets of rising inflationary pressures.

“Importantly, these last two points are much more recent in nature and add to the complexity of the task facing central banks. In short, central banks are surely much less confident that they can manage financial market stability, specifically to minimise the threat to economic stability, if inflationary pressures start to build more widely.

“Whilst the current environment is indeed unique, so are most situations, whether pre-crisis or not. This soon becomes apparent when you look at how safe havens have behaved in the past in different crises.

“Crises can be broadly grouped into economic, financial and geopolitical, while safe havens conventionally include US Treasuries and gold, and then currencies. The first thing to note about these safe havens is that they are dominated by the US dollar, either directly or by their denomination, and this is particularly relevant for non-US dollar investors.

“Looking back at how asset classes behave has drawbacks, however the behaviour of asset classes, in isolation and in relation to each other, is rarely consistent for extended periods. Applying that to safe havens means that there isn’t a consistently excellent safe haven. Each situation is unique and the journey each asset class has taken is unique too, think of US Treasuries currently.

“So what can we apply to how a portfolio should be positioned now? Firstly, it’s worth stating that whilst we know there will be a crisis, we don’t know when it will occur and we don’t know its nature. That’s not to say it isn’t worth scoping out some scenarios.

“If it’s an economic crisis in the next few months, it will likely be inflation driven rather than recession driven, given the momentum for economic activity is so strong. If that’s reasonable, then it’s likely that US Treasuries won’t be the first port of call, as higher rates, or the anticipation of higher rates, will likely see them struggle.

“Even though US TIPS (Treasury Inflation Protected Securities) can provide some inflation protection if held to maturity, they can be very sensitive to increases in interest rates, remember they are real yields and so any benefit from higher inflation can be overshadowed by the impact of higher rates. Turning to equity, resources might be a relatively better safe haven, counter-intuitively perhaps, than the traditional defensive stocks (the bond-proxies) which tend to move with the bond yield.

“Of course, our base case might be wrong, the next major crises might be geopolitically driven. Our sense is that gold has tended to be a fairly decent geopolitical safe haven, take its response to the numerous North Korean episodes of late, but how useful is that information, even if it is repeated?

“Geopolitical events are notoriously difficult to forecast, both their starting point and how they evolve by their very nature. Think of the Cuban Missile crisis for example. Yes, it was at the height of the cold war but that specific event came out of nowhere, genuinely threatened world peace, and was then resolved in an unpredictable fashion.

“We believe that forecasting is unhelpful. Even assuming you get the timing and the nature of the event right, which are massive assumptions, how do you know how the crisis will evolve and how assets will behave? Take Brexit, not a crisis in the purist sense of the word but a shock to markets nevertheless. Clearly the timing wasn’t difficult but, whilst the minority of forecasters got the result right, an extremely small number of those that got it right forecasted the correct reaction from markets, i.e. that gilts and equities rallied sharply.

“We think it makes sense to be pragmatic rather than pre-emptive. That’s not to say we’re ‘flying blind’ but we’re looking at what’s in front of us now, not into the future. To allow us to be pragmatists, we remain in liquid investments and continue to be as open-minded as possible.

“It might be that once a crisis hits, cash could temporarily be the best way to preserve capital. That then begs the question as to which currency should be used to denominate this cash. We would argue sterling, as we think of currency as a way to manage risk rather than generate returns, and we are sterling based investors. Sterling is unlikely to be the headline safe haven currency but the absence of a gain is not a loss.

“The current situation is unique but that, in itself, is not unique. This means that forecasting which asset classes are going to be the best way to preserve capital is probably as futile as trying to forecast the event itself.”