Q1 2015 - The Maleficent Seven

By Stephen Black 8 February 2015

Although the seeds of the credit crunch were sown many years previously, the public awareness that something was, to say the least, not quite right within the financial system occurred in 2008. A full seven years later, a period long enough to encompass an entire ‘normal’ economic cycle, and you will notice if you stand back that the markets have pleasantly risen for six years in a row despite people being fearful along the way.

So things are going well surely? Unfortunately, it's not quite as easy as that and this is a classic case of the more you know, the more concerned you have cause to be.

Ongoing fear continues to be justified and to find support of this you need look no further than the fact that virtually all central banks and governments around the world are still taking consistently necessary action to avoid a sharp return to the heady days of seemingly limitless financial ruin and instability. The ECB has just pumped in the princely sum of €1 trillion for this exact purpose and in the archives of history you will note that €1 trillion stimulation packages are never called for when everything's rosy in the garden.

In the main, the eminently worthy efforts of the central banks and governments continue to achieve their goal of financial stability with the result being that markets continue to muddle along in a limbo of artificially delivered calm where the risks are all too eerily to the downside at a time where the added threat of mass debt forfeiture is growing. 

So in the acceptance of the fact that forecasting is indeed a mugs game, we once again throw caution to the wind to partake…


The ultimate intended exit plan to the varying degrees of stimulus is always the same whether it is within the UK,  US, Europe, Japan or any of the emerging markets and the rationale in each case goes thus; the central bank will support growth in the economy until it can exit at a point where the private sector is able to cope with stimulus being withdrawn. This was a solid theory in the beginning however after many layers of stimulus across many intricately linked economies, the ability of private sector growth to step up and fill what is now a truly massive level of support is as fanciful a notion as would be claims that boom and bust are simply two friends who have at last learned to get along.

2.      THE KING OF THE MOUNTAINS                                               NEVER WINS THE TOUR DE FRANCE

The S&P 500 is an index constituted of the largest companies in the largest economy in the world yet is has grown at a pace over the past twenty four months that small to medium companies in emerging markets would be thrilled at. The pace of this growth is a real concern and, whilst the American economy is undoubtedly experiencing an uplift in its internal economy, we are naturally cautious when the gradient of a graphs growth becomes clearly unsustainable as what goes up inevitably comes down. This is especially so when the cold facts of history state that the S&P 500 has risen for six consecutive years and, whilst it may not be this year, we are inescapably due a negative year soon. Equally, even though the FTSE 100 has not experienced the strong surge upwards of its American cousin, the FTSE 100 is currently trading around 15 times forecast earnings against a long term average of 12 so a case can still be made for caution. The use of secondary market structured products comes into its own at a time like this where clients can lock in protection on the downside whilst still maintaining some exposure to a continued upside perhaps fuelled by the economic boost of an extended low cost of oil should such a scenario play out.


The permanence of a market at times can be misunderstood. History shows us many companies who failed to understand their market correctly and were caught out in the cold as their industry moved on; HMV thought they had a permanent market with music but whilst the music industry is indeed permanent, how people listen to music changes. Energy will go through similar changes in our lifetime but the changes will not be as drastic as the sharp fall in oil prices seen in recent weeks. The ongoing need for oil will inevitably be replaced as renewable technologies continue to make faster and faster strides in all areas of the energy market such as cost efficiency, stability, longevity and transferability but oil is by no means superfluous yet. We are therefore going overweight oil to take advantage of a rebound we strongly feel will come through much sooner than the large oil companies are suggesting to the markets at the moment. We feel there is a massive vested interest in large caps pumping such a negative message out to justify large cost cutting through redundancies and closures at the same time as making it easier to drive a harder bargain for sweeping up a wave of smaller companies at bargain basement acquisition prices compared to only six months ago. The natural laws of supply and demand must kick in and will at some point react to a huge number of rigs being shut down - including 90 rig closures in one day recently which is the highest mass turn off since the early eighties.


The Banking industry is another sector where fundamental changes in the way people bank is already upon us whilst the industry sleeps. Few can argue that the quality of a bank in ten years is far more likely to be driven by the quality of its app and digitally led client service than it is by the number of branches or length of its cues at lunchtime is. Few can suspect that the ten years will in all likelihood turn out to be less than five and such likelihood is far more aptly described as inevitability. Terms such as ‘ping it’, ‘contactless payment’ and ‘peer to peer lending’ weren’t even on the radar five years ago so we’re closely watching which banks are adapting quickest and which are contenders for the next HMV…


The fashionable French economist Thomas Piketty has suggested that where there exists limited capital mobility caused by a large percentage of someone’s wealth being tied up in their home, there can be large domestic asset bubbles which can reach incredible levels and be sustained over long periods such as seen in Japan, UK, Italy, France, Spain – currently being seen strongly in London. These higher asset prices have the effect of pushing down income levels from capital assets unless wage growth keeps pace with asset growth. Therefore we are set to experience more and more capital chasing less and less income. Our modest contribution to Piketty’s work is to also note that when this dynamic is added to by the fact that attractive income based opportunities are currently in short supply due to such factors as the high entry levels of the bond markets at present and the inefficient costs of holding property for income through buy to lets (which typically strongly underperform people’s expectations from an income perspective), the attractiveness of income derived from the onset of functional peer to peer lending is a rare beacon of expanding light in a darkening area. We are averaging 8.2% per annum income net of fees from our peer to peer projects and to date have experience no bad debt whilst maintaining a 100% delivery record across over 15 projects to date. We regard the high quarterly income these projects produce as highly attractive as a stabiliser to market volatility and for this reason peer to peer finance is by far the fastest growing part of our proposition at the moment which, whilst not explicitly predicted by Picketty, is certainly there in between the lines if you look hard enough!


The next election is the closest thing to a political poison pill you will ever find. Regardless of who wins, there are austerity cuts coming through of such severity that the incumbent party is going to have to perform extraordinarily well to avoid being found guilty by association for overseeing these cuts. Our house view is that even if strong gains are experienced in the markets beforehand, these gains are likely to be given back as the economy copes with a massive retraction in public sector spending. This means we are unfortunately not moved to move our long term house view that the likeliest scenario remains an extended plateau where volatility takes us up and down but over the next three to five years we will do well to be materially ahead of where we are currently.


An individual can be reasoned with but a mob cannot. A mob responds only to fear, assertiveness or great leadership. The economic effects of austerity in countries like Portugal, Ireland, Italy, Greece and Spain is biting in the electorate and the protest vote is starting to come through. The election of Syriza on a clear mandate to negotiate a reduction in the agreed debt means that someone has to lose face here; either the radical Greek government sticks to the strict terms of the bailout package despite vowing not to or the EU ‘troika’, primarily led by Germany, agree to write off some of the debt. The problem with the latter is that this really isn’t an option when the global economy has added $57 trillion of debt since 2007/08 and the queue of debtors who would be happy to follow Greece in having some of their debt written off is a long one. The US ambassador to Greece has stated that Greece ‘should continue to make administrative and structural reforms and exercise fiscal prudence’ but the fact of the matter is that if the Greek people were that way inclined naturally then they wouldn’t have gotten into this mess in the first place. A Greece exit from the Euro, or ‘Grexit’ as it is being referred to, is now increasingly likely with unknown repercussions in the bond market and banking sectors. We are therefore wary of a sharp fall in bonds and in banking shares if any meaningful departure from the agreed terms is allowed or if an exit is played out and we are overweight in equity based synthetic zeros (which are a type of structured product which takes on board conditional equity risk based on particularly low performance levels) as a way to generate a bond type return over the next three to five years of 4%-5% per annum without direct exposure to a potentially slowly rising base rate over the same period.


We are long:

  • An oil recovery
  • Peer to peer finance
  • Defensive secondary market structured products

We are cautious about:

  • A pullback in global markets
  • Greece defaulting on its debt and/or exiting the euro
  • Austerity cuts following the election

In light of what remains a challenging economic environment, we continue to strive find new and innovative ways to achieve the 6% to 9% annual return our clients are generally looking for and through opportunities like the Lakes Distillery, our Peer to Peer finance and our offering within secondary market structured products we are pleasingly performing well towards this common goal.

Onwards and upwards!