BFI Infinity InSights: Expect the Best, Prepare For the Worst
The past year was exceptional from an investing point of view. After a very difficult fourth quarter in 2018, with heavy losses in global equity markets, the rebound that started early in 2019 lasted much longer than many expected. In fact, despite the recent volatility caused by increasing fears of the coronavirus spread and the political tensions between the U.S. and Iran over the killing of Qassem Suleimani, the bull run in global equities might have further to go, even though most likely the coming weeks will be challenging.
BFI Infinity InSights
This article was published in the most recent Insights, BFI Infinity’s quarterly newsletter. To read the entire InSights Newsletter, click here.
For many, 2019 began with the assumption that central banks would try to normalize monetary policies by hiking interest rates a number of times. This was particularly true for the Federal Reserve, which at the time, had clearly signaled its intentions to turn to a tighter policy direction. However, it quickly became obvious that this would not happen, especially as the trade tensions between the U.S. and China and the increasing tariffs implemented by both sides created a challenging economic climate. It did not take very long until the outlook for global growth became more pessimistic and growth estimates were repeatedly revised downwards. Central banks responded with more liquidity and lower rates, once again fostering a very positive environment for global stocks.
As a result, investors continued to bid up stock market prices, despite very slow earnings growth. Higher equity prices and flat earnings growth meant that valuation multiples increased further during 2019 and led to the premium of the U.S. stock market recently hitting an all-time high. So, either U.S. stocks are far better in terms of future earnings growth or they are way overpriced, compared to international markets. Our own view on this is very clear: we think non-U.S. equity markets are trading at compelling long-term valuations, especially considering the long-term outlook for the U.S. Dollar, which does not look good at all. In hindsight, we were probably a bit too conservative with our equity investments, as we have been holding hedges against our equity positions throughout the second half of the year. Nevertheless, we still feel that ensuring downside protection was absolutely the right decision at the time and we regard the hedge premium as an insurance cost in a rather challenging environment.
What was exceptional last year was that most other investments were also doing well, with pretty much every asset class showing positive performance. Bonds obviously had a great run, as the Fed started to reverse its course and bond yields around the globe began to fall and bond prices shot up. Despite the fact that most of our bond holdings are by high quality issuers, we experienced compelling returns without really taking on a lot of credit risk in our position.
The market environment last year was also supportive for precious metals, which typically have a strong allocation in our portfolios. Our readers will remember that about a year ago, we were already starting to adopt a more optimistic outlook on precious metals and indeed, the policy reversal of central banks in the second half of the year did provide a very supportive environment for these assets. Of course, some investors feel that gold should have done much better given this sharp monetary policy U-turn, but we mostly still see gold as a hedge against more systemic problems and crises. This became obvious in early January, when the killing of Iranian General Qassem Suleimani stirred fears of a military escalation in the Middle East and when the coronavirus started to spread. These two events were enough to push gold prices towards the USD 1600/ounce level. Other investments, such as global real estate, also performed very well. Asian Speciality REITS had an especially strong year, with most investments going up more than 25% and dividends in excess of 5%.
Somewhat surprising for us was the fact that the U.S. Dollar has been holding up really well, despite the sharp fall in yields. While we feel that the long-term prospects of the greenback continue to be rather challenging, in the short- to medium-term, it could continue to perform relatively well. For now, the factors that support the Dollar in the short-term still seem to be stronger than the long-term concerns. Nevertheless, the long-term case against the USD remains very strong and presents a good reason for investors to diversify internationally.
After a very strong 2019 and a rather volatile start to 2020, we had intense discussions at our latest quarterly investment committee meeting regarding the current market climate and the implications for our investment strategy. From a macro-economic point of view, we remain rather cautious. We think that the first half of 2020 could be disappointing and expect the negative economic trend to continue for the time being. This is somewhat contrarian to most views and expectations of a gradual improvement this year, following the long-awaited trade deal between the U.S. and China. The current economic expansion in the U.S. continues to be late-stage, meaning that after 10 years of growth, a slowdown, and maybe even a recession, is overdue. Thus, slowing growth, coupled with high valuations, make any market more vulnerable and increase the risk of an equity market correction. The main issue here, however, is that the current slowdown and low earnings growth are overlapping with monetary stimulus, which will probably be reinforced by fiscal stimulus soon too. This might prevent the market from correcting and even drive up prices even higher. It is therefore impossible to say at this point how big the risk for an equity market correction actually is. Therefore, we are convinced that in the short run investors need to hedge their bets, but still continue to be almost fully invested. This way, should the markets indeed suffer further losses, the impact on portfolios would be limited. However, if they continue to move higher in the first half of 2020 due to a continued reinflation of asset prices, the hedge premium would only have a small impact on the potential gains. This was the main conclusion from our quarterly investment committee meeting and the core idea behind our current strategy at BFI Infinity.
More specifically, while bonds globally offer very low yields, our overall exposure to fixed-income investments remains moderate. We increased the duration somewhat last year and we are currently not planning to change anything in our approach. We simply see no reason that would justify such a change. Interest rates around the world are low and will remain low for the time being, as consumer price increases are still also very weak and under control. Of course, that’s a very different story from asset price inflation, which is obviously on the rise in equity markets, bonds and precious metals. While this development might be a serious long-term risk in itself, we expect it will take years of asset inflation before consumer prices follow suit. It will probably take a few more rounds of quantitative easing and fiscal stimulus from governments around the world. This, however, is already happening. The Federal Reserve in the U.S. has started to increase the size of its balance sheet again since late 2019 and continues to do so. The Chinese Central bank has also announced new liquidity injections into the financial system to combat the negative effects of the coronavirus outbreak and its negative effects on the Chinese and the global economy. We expect central banks to continue to do what they have been doing for the past few years and that is to keep monetary policies very expansionary. Going forward, this will most likely be combined with stronger fiscal stimulus around the world. The U.S., Europe, the U.K. and China have all started different types of stimulus packages in order to avoid a recession at all costs. This means that the probability for a continued asset inflation remains very high and could in fact get even more extreme in the next year or two.
Our strategic view has also not changed when it comes to precious metals. There seems to be a bit of a risk premium built in the current price levels, so we can’t rule out a short-term pullback. However, we remain optimistic for the rest of the year, as the above-mentioned expansionary policies from central banks and governments will continue to provide ample support for further price gains. We also continue to focus on certain areas within Alternative investments that we think are offering compelling risk/return profiles. This includes hedge funds, especially strategies that are uncorrelated to equity markets, as well as special areas such as Asian REITs.
Our outlook for currencies hasn’t changed much since Q4 2019 either. We think the current geopolitical climate continues to be supportive for the Dollar for the time being, but our long-term concerns remain. The renewed expansion of the Fed’s balance sheet is already an indication that liquidity in the U.S. Dollar market might increase and this has typically been negative for the currency. So, while the USD holds up really well for now, we see possible weakness ahead, as economic growth might disappoint further in Q1 and Q2 of the new year.
We would also like to reiterate a key point that we highlighted in our last InSights too, which still is very relevant: global investments continue to look much more attractive from a valuation point of view than their American counterparts. U.S. markets still look expensive and with the recent earnings revisions, this might be even more true now than it was a few months ago. From that perspective, we feel it is a great time to invest internationally and diversify globally. We are happy to help you with that and with any questions you might have in this regard. Feel free to contact us at firstname.lastname@example.org, we look forward to hearing from you.