may 2019 a perspective on returns...lower long-term returns, but with shorter-term booms and busts....

For professional investors only. This document is for Australian and New Zealand wholesale clients only. Newton claims compliance with the Global Investment Performance Standards (GIPS®). Please read the important disclosure at the end of this document. Originally published February 2019.

May 2019

A PERSPECTIVE ON RETURNSFrom the Newton Real Return team

Meet the Real Return team

Suzanne Hutchins Suzanne is a global portfolio manager of the Real Return strategy and leader of the Real Return team. She chairs the formal weekly team meeting and, together with Aron and

Andy, Suzanne is responsible for the final capital allocation decisions on the strategy. Suzanne started her career at Newton in 1991 as a global research analyst before working directly with Stewart Newton on multi-asset and RPI-based strategies and leading on the UK and Intrepid team. In 2005, Suzanne joined Capital International, before returning to Newton to focus on the Real Return strategy.

Andy Warwick Andy is a global portfolio manager of the Real Return strategy. Together with Aron and Suzanne, Andy is responsible for the final capital allocation decisions on the strategy.

Andy started his career at Mercury Asset Management in 1993 as a unit trust dealer before joining the quant & derivatives team to focus on managing synthetic portfolios for clients and trading equity derivatives for the firm. In 2006, Andy joined the multi-asset team at BlackRock, where he was responsible for managing absolute and relative return mandates, as well as head of research specialising in equity thematic views and risk premia strategies.

Philip Shucksmith Philip is a global portfolio manager and has responsibility for managing corporate debt, convertible bond and precious metal holdings in the Real Return strategy. Philip

works closely with the credit team and research analysts, combing through the recommended securities for those that best fit the characteristics which we are seeking in the Real Return strategy in combination with the risk and return characteristics of the existing portfolio. Philip joined the Real Return team in 2008, is a CFA charterholder, and is a co-lead manager of the Newton Sustainable Real Return strategy and of the sterling offshore Real Return portfolio and Australian-dollar mandate.

Brendan Mulhern Brendan is a global strategist and a member of the Real Return team. He attends the global strategy group, and has responsibility for analysing trends in financial markets and

helping to develop the long-term themes that form the basis of Newton’s investment framework. Prior to joining Newton, Brendan was a member of the investment team at Axa IM and Iveagh ltd, managing multi-asset portfolios. Brendan holds a degree in international business economics and statistics and has completed the CFA program.

Aron Pataki Aron is a global portfolio manager, and is the risk strategist for the Real Return portfolios, with a particular focus on the use of derivatives and hedging. Together with Suzanne and Andy,

Aron is responsible for the final capital allocation decisions on the strategy. Aron joined Newton in 2006 as a member of the portfolio analytics risk team, where he was responsible for risk analysis and portfolio construction across Newton’s portfolios. Previously, he worked as a quantitative analyst at Lacima Group.

Iain Stewart Iain is responsible for providing investment insight, thought leadership and influencing the overall strategic direction of the Real Return strategy, working closely with Brendan

and the rest of the team. Iain joined Newton in 1985 and specialised in the management of multi-asset and global equity mandates, developing the Real Return strategy from its launch in 2004.

Matthew Brown Matthew is a global portfolio manager, and has been a member of the Real Return team since the strategy was launched in 2004. He provides strong input at the security level,

and in particular works closely with Newton’s team of global research analysts on new ideas and existing portfolio holdings. Since joining Newton in 2000, Matthew has acquired varied experience in a range of mandates, including multi-asset, global equity and absolute-return portfolios. He is a member of Newton’s Finance and Policy themes group, and a CFA charterholder.

Lars Middleton Lars joined the Real Return team in 2015 and has specific responsibility for alternative investments in the strategy. Lars also assists the team on risk management, portfolio analysis

and scenario-testing of the strategy. He also works closely with Newton’s independent risk team, which monitors and provides challenge to the overall portfolio construction of the strategy. Lars joined Newton in 2007 as a member of the investment performance measurement team, taking on responsibility for the analysis of the Real Return strategy.

Catherine Doyle Catherine joined Newton in 2008 and is an investment specialist within the Real Return team. She began her career as a global equity analyst before moving into a client-facing

role in the institutional area, more latterly focusing on the investment needs of defined-contribution schemes. Catherine is a CFA and CAIA charterholder, holds an MBA from Profingest Business School, Bologna, and graduated from King’s College, London with a BA in French.

Note: CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

2 A perspective on returns

3A perspective on returns

Contents

Executive summary 4

Introduction 6

Why lower returns?

Why more volatility in returns? 7

The last cycle seemed to fit with the ‘Perspective on returns’ model

Where do we think markets are now? 8

What are the arguments against this cycle being a rerun of the last? 10

Why is boom-bust still a reasonable probability? 12

Here we go again? 18

Conclusions 20

Investment strategy 21

A PERSPECTIVE ON RETURNS

Note: CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

In February 2018 we published this paper in which we explained why, despite the extended nature of the current market cycle, we continued to see the potential for low returns to combine with considerable volatility. We believe the increased volatility experienced by markets in 2018 has served to highlight the relevance of the arguments we made, and we are therefore happy to continue to share the paper, which follows in this document. Please note that the data used in the paper only covers the period up to the paper’s original publication date in February 2018, and is for illustrative purposes only. No further analysis has been undertaken.


In the early part of this decade, we discussed a qualitative idea for the post-millennial world, which we called ‘A perspective on returns’. Our view was that the death of the long secular bull market (dating from 1982) had marked a transition to a different kind of financial environment, one characterised by lower long-term returns, but with shorter-term returns following a pattern of alternating booms and busts.

� The bull market has been extended for much longer than we had envisaged.

� We would argue that the longer risk-asset prices rise and volatility is suppressed by persistent interventions, the more risk there is that apparent ‘stability’ ultimately breeds instability.

� There are arguments against this cycle being a rerun of the last:

– Until the market volatility seen at the start of February, the S&P index had broken out convincingly above its previous peak.

– Post-crisis regulation has made the banking system safer.

– There is simply not enough euphoria for this financial-market boom to be thought of as a bubble.

– Where is the conspicuous leverage?

– Policy is finally working!

– Central banks will not let markets fall.

� However, we continue to see boom-bust conditions as probable for the following key reasons:

1. Monetary policymakers’ thinking hasn’t changed since the last crisis.

2. ‘Inflation’ targeting in an era of structurally low inflation is distorting the financial world.

3. Debt growth continues to outpace economic growth globally.

4. Investors of all kinds have been displaced into risky and much less liquid assets.

5. Economies have become increasingly ‘financialised’.

� With incentives to take risk having never been greater, investors and speculators have pushed many measures to extreme levels which have seldom been seen before. Equity valuations are at levels which we regard as eye-watering, particularly in the US.

� Timing is, as always, uncertain. What is certain to our minds is that expected returns for longer-term investors do not currently compensate for the risks. However, searching, or indeed waiting, for a catalyst may be a fruitless distraction.

Executive summary


� Conclusions

– Despite the extended nature of the current cycle, we continue to see the potential for low returns to combine with considerable volatility in economic and capital-market cycles.

– This derives from the fact that we believe expected returns from current valuation levels are very low. Potential economic growth is also diminished at a time when debt levels have never been higher.

– Policymakers appear increasingly to have been caught in a trap of their own making; loose policy incentivises more leverage and higher asset prices, which in turn restricts authorities’ ability to tighten. This cycle, then, has a very significant chance of ending with a bang rather than a whimper.

� Investment strategy

– Our convictions about the high probability of subsequent boom-bust cycles influenced the development of our Real Return strategy, and have guided its management.

– If booms and busts are indeed an inevitable consequence of having both too much debt and interventionist policymaking, an investment made at any particular point now has a significantly increased chance of returning to its starting value, or indeed of being worth less than that value, than during the great bull market phase where the ‘trend was your friend’.

– Our simple assumption has been that, with this new kind of backdrop, investors should not chase market upside to make a decent longer-term return.

– Armed with these views, our strong emphasis on capital preservation over recent years has seen our Real Return strategy produce stable but unspectacular returns, particularly in the context of booming stock and credit markets.

– Despite this, we strongly believe that an approach which balances participation in risk-asset markets with the use of stabilising assets in a relatively transparent and traditional fashion can produce attractive risk-adjusted returns, particularly if some sort of return to normality in terms of volatility is overdue.

– In the context of an historic long-term return for equities of 5-6% in real terms, the returns experienced by investors in recent years are decidedly supernormal. At the current valuation juncture, it is our contention that, in many markets, expected returns do not compensate for the risks being taken.

– While the Real Return portfolio remains largely in capital preservation mode, it also remains active and focused upon opportunities. Its flexible approach enables us to be highly selective in terms of the underlying securities owned across geographic areas and asset classes.

– The strategy is diversified, but at the same time it is focused on characteristics that we believe improve our odds of successfully navigating a highly distorted financial landscape.

– Where policy has encouraged investors variously to chase yield, lever up and look for ‘alternatives’ (which often involves illiquidity, complexity, counterparty risk and leverage), we have sought to resist this pressure.

– Our approach has been to attempt to keep the strategy relatively simple, liquid and transparent.


Introduction

In the early part of this decade, we discussed a qualitative idea for the post-millennial world, which we called ‘A perspective on returns’ (POR). Our view was that the death of the long secular bull market (dating from 1982 and only interrupted temporarily by the 1987 stock-market crash) had marked a transition to a different kind of financial environment, one characterised by lower long-term returns, but with shorter-term booms and busts. A stylised representation of the two contrasting periods is shown in Exhibit 1.

Exhibit 1: A perspective on returns

The idea underlying the POR was that the period from 1982 to the 2000s had had unique characteristics which were unlikely to be sustained indefinitely. Indeed, the two-decade period may well have been an anomaly, starting as it did with a spike in interest rates and inflation – both of which progressively subsided.

The period was further associated with an even longer stretch of extraordinarily low economic volatility (extending up until the global financial crisis) in the developed world, which became known as the ‘Great Moderation’.

What caused this dampening of the business cycle is still open to debate, although policymakers on both sides of the Atlantic were keen to stress that it was their measures to target inflation that enabled greater control over economic cycles.

In our view, policy was indeed an important factor in this apparent economic stability, but perhaps not in the way policymakers might think. As well as providing the motive force for the bull market, the inexorable downward trend in interest rates catalysed a giant credit super cycle which overpowered any cyclical shortfalls in demand, but also masked growing imbalances.

Why lower returns?

The primary reason for believing that post-millennium returns would moderate was that investors’ starting point (in terms of valuations, interest rates, corporate margins and various other measures) had become progressively less attractive, as interest rates fell and markets rose, compared with those that were available in the early 1980s. The starting point is important because one of the very few reliable relationships in finance appears to be between the price investors pay (for risk assets like equities) and the returns they subsequently receive. In the jargon, equity valuations tend to mean revert; put simply, when you pay an above average valuation, you should expect a below average longer-term return (and vice versa).

A quick glance at Exhibit 2 illustrates why early-1980s prospects were so attractive: valuations were extremely low (and struck on low corporate margins), and the equity dividend yield was high – in keeping with interest rates at eye-watering levels (15% in the US) by today’s standards. With hindsight, these factors combined to make 1982 one of the most auspicious times in history to invest – although investors did not realise it at the time, with sentiment having been pummelled by the inflationary 1970s. As it turned out, mean reversion expanded the price-to-earnings multiple on equities, and falling interest rates lowered the discount rate on future cash flows. What is more, household savings rates were also elevated and demography highly favourable as the ‘baby boomers’ entered their peak spending years.

“Our view was that the death of the long secular bull market had marked a transition to a different kind of financial environment, one characterised by lower long-term returns, but with shorter-term booms and busts. ”

Re

turn

TimeFor illustrative purposes only.

1980-2000s trendcharacterised by high returns andlow volatility

Our outlook – trend characterised by more volatility and lower returns

“The starting point is important because one of the very few reliable relationships in finance appears to be between the price investors pay (for risk assets like equities) and the returns they subsequently receive. ”


The conclusion of the POR was that these valuation and interest-rate tailwinds had been one-offs which would inevitably fade and/or go into reverse. Our conclusion was that investors should not continue to expect high returns from elevated valuation levels, particularly if ever-lower interest rates increasingly seemed to imply weaker future economic activity.

Why more volatility in returns?

The short answer was debt, which via the credit ‘super cycle’ had ballooned to levels unprecedented in peacetime. Debt weighs on growth, and strongly suggested that some kind of deleveraging was overdue. How such a debt reduction would occur (i.e. via restructuring, default, more growth or monetary debasement) was uncertain, but to our minds was unlikely to be a smooth process. Furthermore, structural headwinds appeared to count against economies growing their way out of their indebtedness.

We did, however, recognise that the pain of deleveraging was likely to prove unacceptable to policymakers and lead them to opt for yet more financial repression, liquidity injections and money printing. However, this route seemed likely only to add to the distortions and imbalances already apparent in the financial system and real economy. We concluded that using monetary policy to encourage asset inflation and incentivise even more debt in an environment widely recognised as having ‘too much debt’ was ultimately likely to be a destabilising, rather than a steadying, influence.

The last cycle seemed to fit with the ‘Perspective on returns’ model

As we noted in our previous piece on this subject:

In May 2007 the then Bank of England Governor Mervyn King stated, “ it is the stability of the UK economy which appears to be the most marked contribution of the MPC”, at the same time as UK Chancellor Alastair Darling was lauding the death of boom and bust with the “longest unbroken economic expansion on record”. A few months later Northern Rock collapsed.

The boom-bust cycle which ended so spectacularly in 2008, and subsequent crises in the eurozone, emerging markets and commodities, appeared to confirm this model of a more boom-bust backdrop.

Moreover, the pronounced weakness of economic recovery since 2008, and record-low levels of short-term interest rates and government bond yields (which in some economies even turned negative), further seemed to imply that we were indeed living in a low-return world.

Although the global financial crisis had represented a major turning point in financial markets, the gigantic monetary and governmental response truncated potential adjustments in the real economy. Although Lehman Brothers was allowed to fold, fear that the payments system was too embedded in the banking system meant that policymakers chose to ‘socialise’ the bad debts of the previous cycle with widespread bailouts. With the exception of some defaults in US housing, the expected deleveraging and Schumpeterian ‘capital destruction’1 often seen as the prelude to a new cycle of productive investment did not take place. For good or ill, policymakers short-circuited capitalism. The price of doing so was that rates could not normalise, and the credit super cycle simply carried on where it had left off.

In writing about the POR in the aftermath of the financial crisis (in 2012 and 2014), we concluded that, with interest rates and bond yields still at their lows, and corporate margins and valuations having recovered (see Exhibit 2), we were certainly not faced with a 1980s-like opportunity set. Thus it seemed unlikely to us that we were on the cusp of another 1982-style secular (as opposed to cyclical) expansion in financial asset prices. In addition, potential triggers for volatility, such as extreme and experimental monetary policy interventions, debt levels around the world resuming their inexorable upward trend, rising income and wealth disparities and other distortions produced by monetary policy were becoming ever more marked.

1 A concept most readily identified with the Austrian-American economist Joseph Schumpeter.


Exhibit 2: Then and now – a different world

Start of 1982

Start of 2012

Start of 2014

Start of 2018

Fed funds rate 12% 0.25% 0.25% 1.5%

10-year bond yield 14% 1.9% 3.0% 2.4%

Monetary base US$149 billion US$2.6 trillion US$3.7 trillion US$3.9 trillion

Profit margins (national accounts) 10.7% 17.5% 17.3% 16.1%

S&P 500 P/E ratio (1-year trailing) 7.7x 14.0x 18.6x 22.3x

S&P cycle-adjusted P/E ratio* 7.8x 20.5x 24.9x 32.3x

MSCI USA dividend yield 5.80% 2.17% 1.9% 1.9%

Average age of baby boomer 27 56 58.2 61.7

For illustrative purposes only.Source: Bloomberg, Bureau of Economic Analysis, Thomson Reuters Datastream, US Census Bureau, Newton, January 2018.*10 years of earnings used to remove the effect of the economic cycle from the P/E calculation.

In both 2012 and 2014, we concluded that the POR idea was still valid, and that the strong returns seen in risk-asset markets could easily be consistent with the boom phase of yet another boom-bust cycle (such as in Exhibit 1).

Where do we think markets are now?Notwithstanding the market volatility experienced during February 2018, the bull market has clearly been extended for much longer than we had envisaged, and our expectation that the distorting side effects of ever more policy intervention would inevitably prove destabilising (rather than the reverse) has not yet come to pass.

In our defence, we did stress in 2012 that the POR was more about setting the ‘context’ for investors, and that it did not constitute a forecast of nominal returns, which ‘could appear elevated if monetary debasement took hold’, which it certainly has.

That said, just because the current boom is shaping up to be one of the longest on record does not necessarily mean that its underpinnings are any sounder than those we have experienced in recent cycles. Indeed, one could argue that the reverse is true, that the longer risk-asset prices rise and volatility is suppressed by persistent interventions, the more risk there is that this ‘stability’ ultimately breeds instability (a theory famously described by the economist Hyman Minsky).

This is particularly the case because it has quite clearly been monetary policy (via the ‘hunt for yield’, stock buybacks etc.), rather than ‘fundamentals’, which has been the principal driver of financial asset appreciation until very recently when we have seen some cyclical uptick in economic activity. In the case of equities, this means it has largely been valuation expansion rather than earnings growth that has been the main determinant of returns for much of this cycle. In the meantime, market participants have become increasingly conditioned to the idea that money will remain cheap and that central banks will always be there to provide support – the so-called central bank ‘put’.

This is not of course what central banks originally intended; extreme monetary policy in the US, UK and elsewhere began as temporary responses to domestic crises. The intent of quantitative easing (QE) was to lower borrowing costs and inflate asset prices (not just government bond prices, but also the prices of equities, credit and real estate too) as a means of boosting the real economy, which, via ‘wealth effects’, would be bounced back into its sustainable trend.

In practice, of course, ‘recovery’ in this cycle has not reverted to its pre-crisis trend – indeed, one wonders whether this would have been desirable given that the reason for the crisis was that the trends leading up to it were unsustainable; and, rather than being temporary, central-bank asset purchases have become a permanent feature globally (with US$15 trillion or so of injections having taken place during this cycle), with central banks, such as the European Central Bank (ECB), the Bank of Japan and the People’s Bank of China taking up the running from the US Federal Reserve and the Bank of England (see Exhibit 3). It is worth noting also that central-bank acquisitions have not been restricted to government bonds. Asset purchases have also included corporate bonds, and even equities and real estate investment trusts.

What is noticeable is that periods in which central-bank liquidity injections have receded have tended to be associated with weakness in financial markets and economic expectations (note the dynamics in 2015/2016 in Exhibit 3), and, each time markets have exhibited signs of stress, the authorities have seemed compelled to act.

“Our expectation that the distorting side effects of ever more policy intervention would inevitably prove destabilising has not yet come to pass. ”

“The longer risk-asset prices rise and volatility is suppressed by persistent interventions, the more risk there is that this ‘stability’ ultimately breeds instability. ”


In this context, it should come as little surprise that investors become conditioned to policymakers’ asymmetric responses, nor that the underlying belief becomes that there is indeed a central bank ‘put’ which reflects the fact that asset prices cannot be allowed to fall. This is clearly some way away from traditional market capitalism. Indeed, without periods of capital destruction, financial markets struggle to do their job in allocating capital efficiently. With the price of money persistently manipulated to keep asset prices high and borrowers solvent, it is hard to see how markets can price risk effectively. Indeed, the fact that debt has persistently grown faster than GDP provides strong evidence that capital is being misallocated on a grand scale.

Exhibit 3: Central-bank net asset purchases

For illustrative purposes only. Source: Bloomberg, September 2017.

A glance at Exhibit 2, showing measures for the start of 2018, indicates that valuations have become even more elevated (and therefore expected returns lower) on the back of even higher corporate margins. Indeed, a cyclically adjusted price-to-earnings ratio (based on an average of ten years’ earnings) of 32, which has only been higher in the late 1990s bubble, implies an expected return over the next 10 years of approximately zero percent per annum (Exhibit 4). If one takes out the effect of corporate margin, looking at the price/sales ratio of the S&P index, the market is now at its most expensive in history. As it has previously in this expansion, this expected return profile continues to suggest to us that this is yet another extended cyclical bull market rather than a sustainable secular expansion.

Exhibit 4: What you pay influences future returns

Observations over 100 years S&P valuation level (cycle-adjusted) vs. 10-year average annual returns

For illustrative purposes only. Source: Professor Robert Shiller, Yale University, http://www.econ.yale.edu/~shiller/data/ie_data.xls Newton, 30 September 2017. Chart depicts 100 years of monthly data points.

In terms of timing, we must bear in mind that “in the long run the equity market is a weighing machine, in the short run it is a voting machine”.2 So, while equity valuation may indeed be the main determinant of returns in the long run, sentiment matters in the short term, and investors’ ‘voting’ has been overwhelmingly bullish. Such euphoric expectations certainly suggest that investors see little prospect of this boom turning to bust any time soon.

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“The underlying belief becomes that there is indeed a central bank ‘put’ which reflects the fact that asset prices cannot be allowed to fall. ”


3 http://time.com/3207128/stock-market-high-1929/

What are the arguments against this cycle being a rerun of the last?

1. Until the market volatility seen at the start of February, the S&P index had broken out convincingly above its previous peak

The first argument is technical, and therefore somewhat subjective. It is that, in November 2016, – coinciding with the Trump presidential victory – the US equity market (in the shape of the S&P 500 index) moved above its previous high in real (inflation-adjusted) terms. In the minds of some in the market, this signified the beginning of a secular bull market. If this is the case, given the stretched valuation levels, it would be a clear break with history. This brings to mind Irving Fisher’s declaration that stocks had reached a new “permanently higher plateau” just nine days before the crash in 1929!3

2. Post-crisis regulation has made the banking system safer The most popular reason cited in official circles and among commentators to dismiss the idea of the current cycle leading to a bust is that the banking industry has been ‘fixed’, so a crisis of the order of 2008 could not happen again.

Indeed, Mrs Yellen, previous chair of the Federal Reserve, herself recently declared that a crisis of the type seen in 2007/8 would be highly unlikely to recur in her lifetime. One does need to remember, however, that central bankers broadly did not fully comprehend the mechanics of the last crisis, and continued to believe it could not happen (according to their models) even when it was upon us. What is clear is that banks have indeed now been forced by regulation to take much less risk and carry higher capital buffers, such that they are not the likely source of the next downturn. What is also clear is that leverage has, in aggregate, continued to grow at a pace, and this has been mediated by the markets (through non-bank lending and shadow banking activity). Furthermore, the financial ‘innovations’ in this cycle have been largely seen in asset management (complex strategies, exchange-traded funds, etc.).

Whereas the problems of the last cycle related to bank liquidity and solvency, we believe that risks in this cycle are likely to have been transferred to the stock and credit markets, and ultimately to unsuspecting investors (via the use of capital markets in place of banks).

3. There is simply not enough euphoria for this financial-market boom to be thought of as a bubble.

It is true that the kind of popular exuberance seen in past stock and credit-market booms may to date have been missing. Euphoria/overexuberance is one way that investors can end up taking too much risk; another is that they simply feel that they have no other choice (with interest rates so low) in seeking to fulfil their objectives. The key, however, is whether investors have been seduced into taking more risk than they should, not how they came to do so. We would argue that in this cycle ‘TINA’ (there is no alternative!) has replaced euphoria as the motive force compelling investors to move up the risk curve. Indeed, that is exactly what QE was designed to do.

All that being said, signs of increasing exuberance have been building in recent months, causing some high-profile investors to suggest that markets may well be entering a ‘melt-up’ phase which is often characteristic of bubble-type market peaks. As this can be one of the strongest phases in a bull market, this tends to stoke investors’ fears about missing out.

Given that such phases are also, by definition, the most speculative, it can be hard to apply any kind of investment discipline to taking risk in this kind of scenario. What one can say though is that, while these parabolic periods are indeed common features of a bubble’s final phase, they tend to be wiped out relatively quickly (and often completely) when the market turns.

4. Where is the conspicuous leverage? Indebtedness may be less conspicuous, but we calculate that the world has over 40% more debt today than in 2007. Indeed, in what has remained a slow-growth world, borrowing has been rising much more quickly than our ability to service it. Today’s credit cycle, the largest ever seen, has developed via different conduits, and is distributed differently compared to the last

“Whereas the problems of the last cycle related to bank liquidity and solvency, we believe that risks in this cycle are likely to have been transferred to the stock and credit markets, and ultimately to unsuspecting investors. ”

“Indebtedness may be less conspicuous, but the world has over 40% more debt today than in 2007. ”


cycle. In the run up to the global financial crisis, credit excesses were focused in areas such as US real estate and the peripheral economies of Europe. This time, the growth in leverage also has hotspots (most notably China), but at the same time is much more widespread – among governments, in corporate credit, and in emerging markets – as well as being embedded in the gigantic pool of derivatives and investment structures.

5. Policy is finally working! Throughout the post-crisis experiment in monetary stimulus, the expectation has been that policy measures would eventually gain traction, and that improvements in economic growth would justify elevated financial asset prices.

Cheapening money to encourage further borrowing can generate growth – in the sense that it brings forward consumption from the future (particularly in sectors that employ above-average levels of financing) while simultaneously increasing debt, rather like spending on a credit card. Although creating growth at the expense of looking after balance sheets, and accelerating tomorrow’s demand, would seem a questionable route to sustainable growth, this has been the story of much of the western world for decades, and it explains the inexorable growth in debt.

The other channel by which monetary policy is expected to boost growth is through ‘wealth effects’ (via what academics call the ‘portfolio balance channel’). This encourages extra consumption, and therefore profits, which creates the confidence for investment, which in turn prompts further spending and so on – in a virtuous cycle.

The obvious flaw with this idea is that inflating paper wealth does not increase the net wealth of the economy, because the financial assets owned by one party are at the same time the liabilities of another. So, if there are ‘wealth effects’, they will tend to accrue to one segment of the population at the expense of another. Such effects represent transfers of wealth, not gains, and thus are unlikely to provide a sustainable boost to economies. Moreover, given that asset inflation primarily accrues to the already wealthy, who have a lower propensity to consume, the direct effect on economic activity is likely to be limited.

Certainly, the world is currently experiencing more economic activity, in the sense that almost all economies are growing, if somewhat moderately compared with the past. Since 2009, according to the World Bank, global growth has averaged 2.4% a year in nominal terms – well short of the rate seen before the global financial crisis.4 However, given that equities are a claim on a long-term stream of future cash flows (and that that stream does not change just because investors choose to pay a higher price for it in the short term), the longer-term outlook for growth is important.

We do not anticipate higher real growth in the longer term, for the simple reason that real economic output is a function of the size of the working population multiplied by its productivity. With demography relatively intractable (working populations are growing only very slowly, or not at all) and productivity trends weak, transformation in the world’s growth trajectory doesn’t seem likely.

With regard to whether or not we are in a bubble, it would seem to us that the presence of shorter-term growth momentum neither justifies sky-high valuations, nor precludes the attainment of market peaks. Indeed, US Nobel Laureate Professor Robert Shiller noted in a recent study of post-war bear markets:

“The US stock market today is characterised by a seemingly unusual combination of very high valuations, following a period of strong earnings growth and very low volatility... a lot like it did at the peak before all 13 previous price collapses”.5

If further proof were needed that synchronised global growth is not a sufficient foundation for the continuation of a bull market, the IMF comments below seem to provide it:

“Favourable global economic prospects, particularly strong momentum in the euro area and in emerging markets led by China and India, continue to serve as a strong foundation for global financial stability”.6

Note that this quote is dated not in 2018 (although it could well be), but in 2007; and we all know what happened next.

4 http://databank.worldbank.org/data/home.aspx

5 https://www.project-syndicate.org/commentary/us-stock-volatility-bear-market-by-robert-j--shiller-2017-09?barrier=accessreg

6 IMF Global Financial Stability Report, April 2007.

“Inflating paper wealth does not increase the net wealth of the economy, because the financial assets owned by one party are at the same time the liabilities of another. ”

“The US stock market today is characterised by a seemingly unusual combination of very high valuations, following a period of strong earnings growth and very low volatility….a lot like it did at the peak before all 13 previous price collapses. ”Professor Robert ShillerUS Nobel Laureate


6. Central banks will not let markets fall A final argument for why the current boom will not turn to bust is that the authorities simply will not let it (the ‘central bank put’). As described above, the belief that central banks have got investors’ backs is very strong and has been reinforced by subsequent waves of official liquidity injections globally, which have appeared as reactions to bouts of economic and market stress (as illustrated in Exhibit 3).

Can this process continue indefinitely? This seems unlikely to us. If printing money to backstop asset prices and keep cyclical downturns at bay was the route to prosperity, human history would have been very different. In practice, we know that cycles are inevitable, that capital destruction goes hand in hand with capital creation and, importantly, that it is in the booms that capital is destroyed. Crashes, busts and crises occur simply when that fact becomes obvious to investors.

Returning to the current cycle of persistent intervention, it is not difficult to discern that the politics of asset inflation are becoming more problematic: huge wealth and income disparities have developed, and financial markets are becoming ever more speculative (witness bitcoin!), exacerbating the negative trends in productivity and encouraging further leverage (more of which below).

In addition, it is clear that the authorities do want to exit these policies – for reasons of credibility, or simply just to create an interest-rate and balance-sheet cushion should further stimulus prove necessary when the cycle inevitable begins to flag.

Despite the arguments that we are not in a bubble, a range of measures have reached levels that have historically indicated speculative excess.

Why is boom-bust still a reasonable probability?

1. Policymakers’ thinking hasn’t changed since the last crisis Given our belief that monetary policy has been central to the evolution of this cycle, we find it hard to overstate the importance of how central bankers think about the world. It is important, we think, to realise that central bankers rely heavily on quantitative models which, while often sophisticated, tend to both simplify how an economy works and make assumptions about the relationships between a narrow range of variables and the behaviour of economic agents. Key to most central-bank models are the dubious assumptions that markets are broadly efficient, investors are rational, and money and financial intermediation (banking and financial markets) are broadly neutral.

Although econometric models provide very useful insights, it is vital to recognise that economies (like all social organisations) are highly complex and adaptive behavioural systems, not simple machines in which relationships between variables are linear. In these systems, there are no fixed laws, such as those which exist in physics or engineering, and the parameters are always changing as the participants adapt their behaviour.

To cut a long story short, this mechanistic, model-driven approach to economy management, which does not take account of skewed incentives, non-linear behaviours and human nature generally, tends to cause monetary policymakers to overstate their influence on the real economy and understate the effects of their policies on the financial economy. Even though monetary policy has its impact predominantly via the financial system (and, in the case of QE, directly so), the idea that money is neutral and the financial system is simply a cog in the machine causes central bankers to believe that their primary influence is on the real economy. Meanwhile, they tend to play down any suggestion that they could be creating, or have created, any distortions in the financial system.

It is this kind of thinking that caused policymakers to be blind to financial speculation in the run-up to the global financial crisis.

“In practice, we know that cycles are inevitable, that capital destruction goes hand in hand with capital creation and, importantly, that it is in the booms that capital is destroyed. Crashes, busts and crises occur simply when that fact becomes obvious to investors. ”


2. ‘Inflation’ targeting in an era of structurally low inflation is distorting the financial world

Perhaps the most glaring area where central banks underestimate the effect of their policies on the financial system is inflation-targeting.

Inflation-based policies are broadly founded on two beliefs. The first is that, because orthodox thinking identifies a predictable trade-off between ‘inflation’ and growth, policymakers can exercise control over the path of economic activity if they can control (target) the level of inflation in a broad basket of goods and services. The second is that engineering stability in economic activity and prices automatically confers financial stability, which seems counter to human nature. In reality, if volatility is suppressed, investors can not resist the urge to speculate with leverage.

In recent years, policymakers have been perplexed that, even after applying more monetary stimulus than the world has ever seen (US$15 trillion or so by the five major central banks – see Exhibit 5), the inflation gauges that they monitor have failed to register rising inflation. Their models tell them that such an absence of inflationary pressure indicates a need to keep up the stimulus.

Exhibit 5: Central-bank balance sheets

For illustrative purposes only. Source: Bloomberg, January 2018.

In practice, of course, there has been no shortage of inflation. But this has been in asset prices (curiously not considered to be inflation in central-bank models!), and was engineered in the hope that it would generate inflation elsewhere (in goods, services and wages), which in turn might drive the economy forward. We say ‘might’ because, in stark contrast to the accepted wisdom, there is, as the Bank for International Settlements (BIS) notes, no evidence of a stable or reliable link between growth and inflation, with the exception of the Great Depression.7

Our contention is that, in attempting to set monetary policy to generate positive CPI inflation in an environment where inflation in goods and services has been restrained both by structural factors – demography, technology and globalisation – and by central banks’ own policies (cheap money has incentivised capacity growth and kept ‘zombie’ companies in business) - policymakers have brought about huge over-stimulation of financial markets and heightened the risk of further asset bubbles. This is important because the BIS work cited above did find clear evidence that “asset bubbles which lead to busts have a profound impact on future growth”.

This point is confirmed in Charles P. Kindleberger’s excellent history of financial crises in which he states:

“One of the stylized facts in monetary economics is that the implosion of an asset bubble is deflationary, the flipside of the economic boom that occurred during the expansion phase of the cycle”.8

Rather ironically then, the surest route to deflation (which policymakers are trying to avoid at all costs) may be to wind up asset prices!

7 See, for example, Bank for International Settlements Quarterly review: A further wave of easing, March 2015.

8 Manias, Panics, and Crashes: A History of Financial Crises, Charles P Kindleberger and Robert Z Aliber, 2005.

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“Our contention is that policymakers have brought about huge over-stimulation of financial markets and heightened the risk of further asset bubbles. ”


3. Debt growth continues to outpace economic growth globallyThe evidence from history is clear that excessive credit growth leads to boom-bust cycles; so the fact that debt has increased by around 44% in this cycle from the levels seen in 20079 (a time when it was universally agreed that many economies had a debt problem) to over 300% of GDP would seem concerning. While ‘magic money trees’ should not exist, monetary policy has been the next best thing; consumer, corporate and government debts have ballooned without any apparent consequences. The US government, for example, has expanded its debt since the last crisis, but its debt-servicing cost has only risen by 20% (Exhibit 6). Perhaps this somewhat unrealistic view of the costs of running government explains why the latest unfunded US tax cuts, which will see the country piling on more debt at an ever-increasing rate, passed with little resistance.

Exhibit 6: US government debt and interest costs

Data rebased to 100 at 31.12.07

For illustrative purposes only. Source: Bloomberg, January 2018.

US corporate sector leverage has also never been higher, and monetary policy has encouraged borrowers offshore to access super-low dollar credit costs to the tune of US$11 trillion (roughly the size of China’s economy), as indicated in Exhibit 7. There is still a belief in some circles that increasing debt does not matter, but not all debt is created equal, and debt growth that is persistently greater than increases in GDP implies increasingly unproductive debt, and thus misallocation of capital. Put simply, if a credit cycle is manufacturing ‘bad debts’ at an ever increasing rate, we believe this has to be a cause for concern.

Exhibit 7: US dollar credit to borrowers outside the US

Source: Bloomberg, January 2018.

9 https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-january-2018

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“The evidence from history is clear that excessive credit growth leads to boom-bust cycles; so the fact that debt has increased by around 44% in this cycle from the levels seen in 20079 to over 300% of GDP would seem concerning. ”


Some economies, particularly those that escaped recession in the last cycle (China, Australia, and Canada for example), are vying with previous bubble measures (Exhibit 8).

Exhibit 8: Household + non-financial corporate debt as % of GDP

For illustrative purposes only. Source: Bank for International Settlements to 30 June 2017.

China’s outgoing central bank chairman Zhou Xiaochuan seems to agree and has been warning about “excessive debt in the financial system” and stating that latent risks are accumulating, including some that are “hidden, complex, sudden, contagious and hazardous”.10 Given that around half of the world’s credit growth is occurring within China’s somewhat opaque financial system, it is surprising to us that investors remain so sanguine (Exhibit 9).

Exhibit 9: Global sources of credit growthGlobal growth by region1

Misallocated capital is not a subject that investment banks, which largely mediate the credit cycle and merger and acquisition activity, like to address. The Macro Strategy Partnership, however, has estimated that the US economy may have misallocated 10.5% of GDP (roughly US$2 trillion) since 2009.11 In economies such as China and Australia, where credit growth has been fastest, the potential misallocation is much larger.

The most obvious areas where capital is likely to have been misallocated in recent years are in Western housing markets, the massive boom in stock buy-backs by corporations, energy-market debts, retail, auto and student loans, and chunks of China’s vast real estate and infrastructure boom. One might also argue that at the nexus of cheap money and technology, such as for the ‘FAANGS’ (the largest technology companies) and various ‘unicorns’ (start-ups which have a stock-market valuation or estimated valuation of more than US$1 billion, but are yet to build an established performance record), money is currently so cheap that it is unlikely to be invested productively.

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10 https://www.bloomberg.com/news/articles/2017-11-04/china-s-zhou-warns-on-mounting-financial-risk-in-rare-commentary

11 The Macro Strategy Partnership LLP, The Productivity Tipping Point, 25 July 2017.

US Bubble – global financial crisis

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For illustrative purposes only. Sources: Citi Research, 31 March 2016. Bloomberg, Newton, Q3 2016 (quarterly data).

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4. Investors of all kinds have been displaced into risky and much less liquid assets

At the heart of the financial system’s distortions created by years of manipulating the price of money is the ‘hunt for yield’. The movement out of low-yielding cash, near-cash instruments and government bonds has set up momentum in almost all riskier assets that have yield, growth potential or rarity value. That price momentum creates, in turn, more demand and fear of missing out (or of underperforming index benchmarks).

What makes this cycle different is the sheer scale of the migration into riskier assets. The combination of cash holdings being unappealing to individuals and almost impossible for most professional investors to hold means, we believe, that most market participants will have become displaced in the hunt for yield (or be taking more risk than they imagine). Those whose natural home might have been cash are likely to have assumed some kind of credit or equity risk. Many erstwhile savers have become property speculators, and those who operate with leverage are likely to be using more debt or more complex derivative structures than previously to achieve their required return.

It is important to note that, in this cycle, rising risk appetite and migration into risk assets have been more a feature of the capital markets and asset management sector rather than the banking system, where regulatory pressure to de-lever balance sheets has constrained institutions’ ability to take risk. Moreover, tighter capital requirements and lower risk appetites in the banking system have meant that, although capital markets are much larger than they were in 2008 (particularly in the emerging world), inventory held by market-makers has fallen, and thus underlying liquidity has shrunk.

Financial innovation within asset management has also been important in facilitating rising risk appetite and the hunt for yield. Developments in quantitative finance mean that investment has increasingly become ‘deconstructed’. Rather than appraising and holding underlying assets, many asset management approaches now invest by gaining exposure to various indices, asset classes or esoteric ‘factors’. What this means in practice is that modern investment management has become increasingly intermediated, and many investors access their investments via structures that are once (or more times) removed from underlying assets. This trend has supported the explosive growth in so-called ‘delta-one’ derivatives like specialist mutual funds, exchange-traded funds (ETFs) and structured products. Many of these structures may include complex derivatives that imply underlying leverage.

The number of mutual funds in existence overtook the number of common stocks some time ago, and the Financial Times notes that ETFs now number over 7,000, with the number of indices standing at a remarkable 3.1 million – a figure 70 times greater than the number of common stocks!12

It is important to note that the trend towards this style of investing has developed from the growth of passive investing, which is itself a response to a monetary regime that promotes asset inflation. Stripping out the need to analyse underlying securities has opened up investment to a vast array of quantitative approaches which have in aggregate created a cost-effective and efficient way of channelling investors into risk assets.

A side effect has also been to magnify the importance of stocks with large market capitalisations and/or strong momentum, which has exacerbated the risk that markets are littered with ‘crowded trades’.

What is also key from a risk perspective is that these structures rely heavily on the normal (i.e. liquid and continuous) functioning of the financial system, and daily pricing implies a degree of liquidity that is often far in excess of that actually characteristic of the underlying assets.

In economist-speak, these instruments can attain a degree of ‘moneyness’, on which a broader financial architecture rests, that belies their potential for volatility; think, for example, of high-yield credit funds whose underlying securities are very illiquid.

In buoyant policy-driven markets, derivatives like ETFs can be created at the click of a mouse; time will tell whether the reverse transaction can occur as smoothly if the herd wants to sell into a thin market.

The key point we would make is that in this cycle, as never before, investors are en masse taking more risk in order to achieve their required returns, and they are increasingly doing so in ways that have not been tested in an environment of market stress. Market liquidity could well be the greatest risk if nervous displaced investors were to choose to sell.

12 https://www.ft.com/content/9ad80998-fed5-11e7-9650-9c0ad2d7c5b5

“Market liquidity could well be the greatest risk if nervous displaced investors were to choose to sell. ”


5. Economies have become increasingly ‘financialised’ As stated above, policies like inflation-targeting, which are likely, in our opinion, to have kept interest rates too low through the cycle, as well as decades of asymmetric policy settings (loosening upon signs of stress in financial markets, but failing to act to manage booms) have led to over-stimulation of financial systems. At Newton, we have aggregated the implications, distortions and unintended consequences of this trend into a theme called financialisation, which we regard as perhaps the most important theme of our time.

Whereas, in the past, the role of finance was to serve the real economy, in a more financialised world it increasingly becomes the driver of activity. This, in itself, has profoundly negative implications for productivity and growth, makes economic activity more fragile, and illustrates why this cycle may be even more dangerous than those in the past.

One could think of recent monetary experimentation as ‘subsidising’ money and therefore finance; financial activities and financial engineering have been privileged over the taking of risks in other parts of the economy. Given that there is plenty of evidence of the distorting effects of subsidies applied to all sorts of industries and prices, it seems remarkable to us that, in fixing the price of money over an extended period, monetary authorities believe they are taking little or no risks with financial stability. In capitalist systems, we need market prices to send reliable signals, or capital allocation and productivity are liable to suffer.

Highly financialised economies are likely to have large financial systems in relation to their GDP, and tend, among other things, to have more leverage, more complex financial products, and more market finance than bank finance (i.e. shadow banking). The key fact is that financialisation has made our systems much more sensitive to interest rates in all sorts of ways, at a time when such rates are some of the lowest in history. This, in our view, creates a significant threat. Veteran central banker William White sees the world financial system today as being “as dangerously stretched as it was at the peak of the last bubble”.13 To illustrate the point, the US Treasury’s Office of Financial Research, in its latest stability report warned that a 1% rise in interest rates would slash USD 1.2 trillion of value from the Barclays US Aggregate Bond index, with further losses once junk bonds, fixed rate mortgages, and derivatives are included.14

6. The financial system has been incentivised to be ‘short volatility’ A consistent thread in the narrative described above is that central bankers do not appear to see that their policies could be directly or indirectly incentivising behaviours in the financial system and wider economy that have non-linear outcomes. To our mind, it is not rocket science to deduce that, if you make excess liquidity available at little or no cost in tandem with what seems like an implicit ‘put’, you will incentivise a giant trading community with an appetite for leverage, which is exactly what we have had!

An important symptom of this is that one of the most popular trading strategies in the market place has been to be ‘short volatility’. This is captured by funds that have an in-built bias which favours extrapolation of the trend in suppressed volatility of financial assets. In essence, such funds gain incrementally from the continuation of stability in a trend, but suffer badly on any significant change (such as regime changes or interest-rate shocks).

The scale of this bet is very large. Artemis Capital Management, a specialist in the subject of financial volatility, suggests that, although only US$60 billion or so may be explicitly shorting volatility, ‘implicit’ short volatility strategies, such as risk parity, risk premia and commodity trading advisers, may total US$1.4 trillion.15 Of course, going short volatility is not just something financial operators do. The corporate sector has been incentivised to emphasise financial engineering in the form of stock buy-backs, and has embarked on an enormous equity for debt swap. This allows company managements to boost the earnings accruing to a smaller pool of shares (and at the same their share options) at the expense of the balance sheet. Rather than use their cash flows to invest in their business activities (research and development spending in the largest companies in the US is still below 2008 levels), they have bought back a whopping US$3.8 trillion of their own stock since March 2010.16

This has had the effect of transforming a modest growth environment into one with significantly more earnings per share. According to Artemis, these transactions account for 40% of the

13 http://www.telegraph.co.uk/business/2018/01/22/world-finance-now-dangerous-2008-warns-central-bank-guru/

14 https://www.financialresearch.gov/financial-stability-reports/2017-financial-stability-report/

15 https://static1.squarespace.com/static/5581f17ee4b01f59c2b1513a/t/59e8a9b0e9bfdfb287faa3d2/1508420022032/Artemis_Volatility+and+the+Alchemy+of+Risk_2017.pdf

16 Source: Bloomberg, 31 January 2018.

“The key fact is that financialisation has made our systems much more sensitive to interest rates. ”

The scale and complexity of the financial system have increased substantially in a relatively short space of time, encouraged by deregulation and financial and technological innovation. There are risks inherent in a situation in which finance dominates, rather than serves, economies.

Newton investment theme


earnings growth and 30% of the stock market gains over the period. The fact that both the monetary authorities and the corporate sector have been ‘price-insensitive’ buyers has also surely contributed to the eerie calm that led S&P 500 realised volatility (as well as stock-market volatility implied by the CBOE ‘VIX’ volatility index) to register recent historic lows.

The reason for stressing the above is that, once again, it illustrates the interconnected fragility of the world’s giant and complex financial system. Should there be any unexpected change in financial-market volatility, interest rates or indeed correlations, there may be very substantial pain for market participants, given that stock-market volatility is at an all-time low while markets are at their historic peaks, and given that record-low debt-servicing costs have emboldened consumers, companies and governments to take on debt.

Here we go again?

With regard to whether or not we are in a bubble, a reading of JK Galbraith’s entertaining and instructive book, A Short History of Financial Euphoria, gives some useful context.

Galbraith points out that speculative episodes have common factors, most of which are visible today. The first is that there is generally some ‘innovation’ that captures the imagination and makes the present appear different from the past. There is often an associated belief in the infallibility or ‘genius’ of some of the protagonists (perhaps, in the current cycle, central bankers or big technology companies?).

A second feature is leverage. As Galbraith notes, “all crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment”.

A further feature of all bubbles is that, when the bust comes, focus turns to the need to find external influences to explain why it happened and who caused it, rather than to the speculation that preceded it. As Galbraith notes,

“The least important questions are the ones most emphasised: What triggered the crash? Were there some special factors that made it so dramatic...who should be punished?” …as always the need was to find a cause apart from the speculation itself”.

This apparent desire to separate the bust from the boom is, in our view, like separating a hangover from the ‘night before’, and was a marked feature of the global financial crisis. It is worth stressing because it highlights that what eventually triggers the market turn does not really matter, and, as such, is very hard to predict.

Bubble-like measures are commonplaceWith incentives to take risk having never been greater, investors and speculators have pushed many measures to extreme levels which have seldom been seen before.

Equity valuations are at levels which we regard as eye-watering, particularly in the US. Although US price-earnings multiples are close to their highest ever, they have of course been hugely distorted by stock buy-backs (as discussed above). Valuation measures that are less manipulated by financial engineering (such as EV/EBITDA and price/book) are close to previous bubble highs, and both the aggregate S&P 500 price/sales and market capitalisation to economic gross value added (i.e. the value of the accumulated capital stock) ratios have surpassed those seen in the speculative phases of 1929 and the late-1990s technology, media and telecommunications bubble.17

As a measure of investor sentiment, the Investors Intelligence survey suggests professional investors are the most bullish they have been for over 30 years, with the index hitting 66.7%, a reading last seen just before the sharp stock-market falls of Black Monday in 1987.18 Supporting this, New York Stock Exchange margin debt (the borrowings by traders to fund their activities) is the highest on record.19 Stock-market volatility has all but disappeared, and, according to Goldman Sachs, until financial markets became more volatile at the start of February, MSCI World indices had had (up until the end of January) their longest spell in history without a 5% correction.20

In credit markets, both the size of the markets and the amount of leverage being employed has ballooned as even the most marginal businesses have been offered funding. The hunt for yield

“This apparent desire to separate the bust from the boom is, in our view, like separating a hangover from the ‘night before’, and was a marked feature of the global financial crisis. ”

“With incentives to take risk having never been greater, investors and speculators have pushed many measures to extreme levels which have seldom been seen before. ”


18 https://www.morningstar.com/news/market-watch/TDJNMW_20180118493/update-why-some-investors-say-stockmarket-euphoria-calls-are-premature.print.html

19 http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&key=3153&category=8

20 http://www.businessinsider.com/goldman-sachs-stock-market-forecast-high-probability-of-correction-2018-1?r=UK&IR=T


has in much of the world rendered ‘high-yield’ debt an oxymoron. Partly as a result of the ECB’s bond-buying antics in Europe, an index of BB-rated bonds yields an astonishingly low 2.5%.21 Out of this, investors need to somehow receive a real return and be compensated for both inflation and credit risk. As if that were not enough, the appetite for paper has seen credit quality deteriorating as borrowers have gained the upper hand and the number of covenant-lite issues has once again soared.

To get a flavour of the speculative appetite of the times, one needs to consider more than just the arcane worlds of cryptocurrencies and modern art. The dubious practices in both China’s official banking system and its vast shadow banking sector, for example, the home to substantial amounts of domestic savings, are well documented and too numerous to mention. A triple-levered exchange-traded note (the snappily named ‘BMO REX MicroSectors FANG+ Index 3X Leveraged ETN) has been launched, which allows investors to gain geared exposure to the so-called ‘FAANGS’ (large technology stocks that are likely to be held in the majority of the planet’s pension funds), if they regard the more-than-50% appreciation in the last year inadequate.

In an even more pointed homage to Galbraith’s “extreme brevity of the financial memory” in Ireland, where house prices are once again on the march, the government has instituted the Rebuilding Ireland Home Loan Scheme, which offers loans at extremely competitive interest rates to low-income first-time buyers, who have already been turned down for a mortgage or cannot raise sufficient funds.

While the majority of professional investors and investment bankers are not apparently put off by any of this, on the basis presumably that the world is truly different this time, we are highly doubtful about such activity.

Timing and triggers

Investors’ obvious questions about how these developments will unfold relate to timing and triggers. Timing is, as always, uncertain. If the current speculative episode has something in its favour, it is that it may not be crazy enough yet! Gauging levels of craziness is, however, not a reliable investment discipline. What is certain to our minds is that expected returns for longer-term investors do not currently compensate for the risks.

As to triggers, we would refer to the comments made above – that searching, or indeed waiting, for a catalyst may be a fruitless distraction. That said, the consensus appears to believe that the primary risk is higher interest rates, which clearly may be the case, although so much growth has been dragged from the future that we still regard further economic disappointment or indeed some more esoteric left-field event as an equally likely scenario.


“What is certain to our minds is that expected returns for longer-term investors do not currently compensate for the risks. ”


Conclusions

Despite the extended nature of the current cycle, we continue to see the potential for low returns to combine with considerable volatility, in terms of the amplitude of economic and capital-market cycles (in other words a boom-bust environment).

This potential derives from the fact that we believe expected returns from current valuation levels are very low (Exhibit 4). Potential economic growth is also diminished at a time when debt levels have never been higher. Meanwhile, financial markets have become highly distorted as policy has been used (and may continue to be used) to fend off inevitable deleveraging and buy time.

Policymakers appear increasingly to have been caught in a trap of their own making; loose policy incentivises more leverage and higher asset prices, which in turn restricts authorities’ ability to tighten. This cycle, then, has a very significant chance of ending with a bang rather than a whimper.

As a final comment, it is worth considering how the public and politicians would react to another financial crisis so soon after the global crisis of 2008. If another crisis were to ensue, the pathology of this bubble should point primarily to the role of state intervention in subverting market capitalism, price discovery and the efficient allocation of capital (however well-meaning that intervention was). That is not how it would be perceived, of course, and the backlash against capitalism (and the financial system in particular) would be likely to be profound.


Investment strategy

Our convictions about the high probability of subsequent boom-bust cycles influenced the development of our Real Return strategy, and have guided its management. As Exhibit 1 illustrates, if booms and busts are indeed an inevitable consequence of having both too much debt and interventionist policymaking, an investment made at any particular point now has a significantly increased chance of returning to its starting value, or indeed of being worth less than that value, than during the great bull market phase where the ‘trend was your friend’. Our simple assumption has been that, with this new kind of backdrop, investors should not chase market upside to make a decent longer-term return.

Armed with these views, our strong emphasis on capital preservation over recent years has seen our Real Return strategy produce stable but unspectacular returns, particularly in the context of booming stock and credit markets. Despite this, we strongly believe that an approach which balances participation in risk-asset markets with capital preservation in a relatively transparent and traditional fashion can produce attractive risk-adjusted returns, particularly if some sort of return to normality in terms of volatility is overdue.

In the context of an historic long-term return for equities of 5-6% in real terms, the returns experienced by investors in recent years are decidedly supernormal. At the current valuation juncture, it is our contention that, in many markets, expected returns do not compensate for the risks being taken. We think the balance of probability and the scale of any potential adjustment favours patience in terms of net exposure to risk assets; expected returns are some of the lowest in history, implying an increasing probability of negative returns in discrete periods, and we have tried to express this view in the strategy.

Although the relentless bullishness and low volatility seen before the change in financial-market backdrop at the start of February has begun to look like ‘Groundhog Day’, opportunity sets are, in reality, always evolving. Changes in market levels can alter expected return calculations very quickly and very significantly. Although markets seem to have gone straight up since the aggressive monetary injections seen in 2016, we find it highly unlikely that stocks, for example, have reached some kind of ‘permanently high plateau’ (the unfortunate phrase coined by the aforementioned Irving Fisher just before the 1929 stock market crash) from which they will never retreat.

Where policy has encouraged investors variously to chase yield, lever up and look for ‘alternatives’ (which often involves illiquidity, complexity, counterparty risk and leverage), we have sought to resist this pressure.

Our approach has been to attempt to keep the strategy relatively simple, liquid and transparent. Third-party vehicles are kept to a minimum, as are leveraged business models. Where we do access yield, this tends to be in areas where we believe the underlying cash flows are sustainable and we can see some margin of safety in the valuation.

While the Real Return portfolio remains largely in capital preservation mode, it also remains active and focused on opportunities. Its flexible approach enables us to be highly selective in the underlying securities owned across geographic areas and asset classes. The strategy is diversified, but at the same time it is focused on characteristics that we believe improve our odds of successfully navigating the highly distorted financial landscape. We strongly believe that such an approach is in our clients’ best interests.

“An investment made at any particular point now has a significantly increased chance of returning to its starting value, or indeed of being worth less than that value, than during the great bull market phase. ”

“While the Real Return portfolio remains largely in capital preservation mode, it also remains active and focused on opportunities. ”


Business development

Sebastien Brown

T: +852 3926 0695 E: [email protected]

Phil Filippelis

T: +61 2 9260 6670 E: [email protected]

Client director

James Mitchell

T: +44 20 7163 2009 E: [email protected]

For more information

Key investment risks

� Past performance is not a guide to future performance.

� Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

� This strategy invests in global markets which means it is exposed to changes in currency rates which could affect the value of the strategy.

� The strategy may use derivatives to generate returns as well as to reduce costs and/or the overall risk of the strategy. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.

� Investments in bonds are affected by interest rates and inflation trends which may affect the value of the strategy.

� The strategy holds bonds with a low credit rating that have a greater risk of default. These investments may affect the value of the strategy.

� The strategy may invest in emerging markets. These markets have additional risks due to less developed market practices.

� The strategy may invest in investments that are not traded regularly and are therefore subject to greater fluctuations in price.

Annualised returns to 31 March 2019

1 year 3 years 5 years

Newton Real Return composite (gross of fees) 7.69 3.06 3.58

Cash (1-month LIBOR) +4% 4.69 4.49 4.49

12-month returns

31 Mar 18 – 31 Mar 19

31 Mar 17– 31 Mar 18

31 Mar 16 – 31 Mar 17

31 Mar 15 – 31 Mar 16

31 Mar 14 – 31 Mar 15

Newton Real Return composite (gross of fees) 7.69 -1.07 2.75 1.89 6.90

Cash (1-month LIBOR) +4% 4.69 4.39 4.40 4.54 4.44

Performance is stated gross of management fees. The impact of management fees can be material. A fee schedule providing further detail is available on request. Please see composite information below. This is supplemental information to the GIPS® compliant information. The strategy aims to deliver a minimum return of cash (one-month sterling LIBOR) +4% per annum over 5 years before fees. In doing so, the strategy aims to achieve a positive return on a rolling 3-year basis.

However, a positive return is not guaranteed and a capital loss may occur.

Source: Newton, composite performance calculated as total return, income reinvested, gross of fees, in GBP, 31 March 2019.

Important information

This is a financial promotion. This document is for professional investors only. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Newton claims compliance with the Global Investment Performance Standards (GIPS®). Newton, the firm, includes all the assets managed by Newton Investment Management Limited and Newton Investment Management (North America) Limited, which are wholly owned subsidiaries of The Bank of New York Mellon Corporation. To receive a complete list and description of Newton composites and a presentation that adheres to GIPS standards, please contact Newton via telephone on +44 (0)20 7163 9000 or via email to [email protected]. The Newton Real Return composite contains fully discretionary portfolios which have an unconstrained multi-asset investment mandate which has an absolute return style performance aim, while seeking to preserve capital, through security selection, diversification and simple hedging strategies and for comparison purposes is measured against 1-month sterling LIBOR +4% per annum. Returns include the effect of foreign currency exchange rates. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. Please note that portfolio holdings and positioning are subject to change without notice and should not be construed as investment recommendations.

This material is for Australian wholesale clients and New Zealand wholesale investors only and is not intended for distribution to, nor should it be relied upon by, retail clients. This information has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person. Before making an investment decision you should carefully consider, with or without the assistance of a financial adviser, whether such an investment strategy is appropriate in light of your particular investment needs, objectives and financial circumstances.

This information is made available by Newton Investment Management Limited and BNY Mellon Investment Management Australia Ltd (AFSL 227865). This information is confidential and is only provided to Australian wholesale clients (as that term is defined in section 761G of the Corporations Act 2001 (Cth)). This is not an offering or the solicitation of an offer to purchase an interest in the Newton Real Return strategy. This document is for general purposes only and should not be relied upon as financial product advice. This document has been prepared without taking into account the objectives, financial situation or needs of any person. Before making an investment decision an investor should consider the appropriateness of the information in this document having regard to these matters and read the disclosure document relating to a financial product. Investors should also consider obtaining independent advice before making any investment decisions. Investments can go up and down and to the extent that this document contains any past performance information, past performance is not a reliable indicator of the future performance of the relevant investment or any similar investment strategy.

Newton Investment Management Limited is exempt from the requirement to hold an Australian financial services licence in respect of the financial services it provides to wholesale clients in Australia and is authorised and regulated by the Financial Conduct Authority of the UK under UK laws, which differ from Australian laws.

Newton Investment Management Limited (Newton) is authorised and regulated in the UK by the Financial Conduct Authority (FCA), 12 Endeavour Square, London, E20 1JN. Newton is providing financial services to wholesale clients in Australia in reliance on ASIC Corporations (Repeal and Transitional) Instrument 2016/396, a copy of which is on the website of the Australian Securities and Investments Commission, www.asic.gov.au. The instrument exempts entities that are authorised and regulated in the UK by the FCA, such as Newton, from the need to hold an Australian financial services license under the Corporations Act 2001 for certain financial services provided to Australian wholesale clients on certain conditions. Financial services provided by Newton are regulated by the FCA under the laws and regulatory requirements of the United Kingdom, which are different to the laws applying in Australia. Newton is providing financial services to wholesale investors in New Zealand in reliance on the

Safe Harbour regime under the Financial Markets Conduct Act 2013, Schedule 1 part 3.

Issued in the UK by:Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA

T: 020 7163 9000

Registered in England No. 01371973Newton Investment Management is authorised and regulated by the Financial Conduct Authority.

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may 2019 a perspective on returns...lower long-term returns, but with shorter-term booms and busts....

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