Opinion

Mixing it up

Finance | William Jensen | 1 Feb 2008

William Jensen does not see enough evidence to justify wholesale equity disinvestment. 

The uncertain tone that haunted markets through the latter half of last year has characterised the first trading days in January. With the exception of small caps, equities delivered positive returns over the last 12 months and emerging markets performed exceptionally. The consensus is that 2008 will be challenging and is unlikely to develop into a vintage year for easy gains. Endowments, however, are generally investing for the very long-term and are able to think in multiple market cycles. Although it is possible to talk oneself into some very gloomy forecasts, there are also factors such as emerging economies, lower US and UK interest rates and the influence of sovereign wealth funds to persuade investors with a capacity to withstand volatility to remain invested.

Increasingly, UK endowments have embraced the US model of total return, pursued through diversified asset allocation policies, with which has come a polarisation within equity allocations to a blend of passive index tracking and active hedge fund strategies. Equity hedge funds, it is argued, are indifferent to the direction of the market. This was definitively not the case last August when many hedge funds with a history of positive monthly returns came unstuck.

What threatens to undo the equity investor in 2008? One concern is whether the fourth quarter write-down of impaired debt assets has removed the canker that could escalate into a terminal cancer. Recent easing of three-month LIBOR rates implies improving confidence among those with the best information on how much more off-balance sheet asset value may yet crumble to dust. Central banks are committed to financial stability, and the scale of pump-priming in the interbank markets is a clear indication of how fragile the banking infrastructure is believed to be. So, we have conflicting signals.

Second is the issue of inflation. Oil has breached $100 per barrel, the gold price is continuing to hit new highs and the latest report on private sector pay awards in the UK confirms that increases are running at an average rate of 4 per cent. Incipient inflation was defeated a generation ago using the bitter medicine of tight fiscal and monetary policy. With the monster slain, central bankers became the guardians of both economic and market stability. This included using short term policy rates to cushion the impact of financial shocks and stimulate demand when nerves faltered. The harnessing of cheap labour in emerging markets undoubtedly contributed to the viability of the Greenspan magic. This cycle may now be drawing to a close as emerging economies develop in depth and ambition. Just when markets most crave the stimulus of easier lending rates, central banks may find that their capacity to deliver is limited by the need to impede inflation.

A continuing and deepening degradation of toxic financial instruments and an escalation in margin calls forcing leveraged investors to liquidate better quality assets would have a deflationary effect; for many, value would be lost never to be recovered. A persistent increase in inflation causing rates to rise would squeeze corporate earnings and drive prices down until equity yields reflected an acceptable risk premium to higher bond yields; in time, however, public equities recover their price levels as the cycle turns.

There are too many challenges to stability to dismiss a cautious approach to equity investment, but not yet enough evidence to justify wholesale disinvestment. Remaining invested requires a careful consideration of the appropriate balance between passive exposure to market beta and active management that can navigate any combination of a rout precipitated by capital market degeneration and economic retrenchment. Part of the answer may lie in the neglected domain of traditional long-only active investment. Strong corporate cash flow that translates into dividends has great attraction in lean times. As ever, the eggs in baskets argument has much to commend it and with the headwinds to equity increasing in ferocity, trustees might take a moment to evaluate the mix of active managers in their portfolios. 

William Jensen is a fellow of Exeter College, Oxford   

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