There is no ‘magic pudding’

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“The common theme of market strategists over the past 6 months – basically since the Credit Suisse & Silicon Valley Bank March events- is that the global economy will face a credit crunch that causes a recession. Even though this has been subsequently and self-evidently shown to be an incorrect forecast the same strategists are still clinging to their strategic approach of switching from assets that are traded with daily liquidity like equities, senior debt and major bank subordinate debt  into ‘alternative asset class ‘  investments like private equity and private debt. It is important to understand what is meant by ‘alternative asset class ‘ investments. These market strategists are switching into alternative asset class investments because:

  • The assets are not marked to market. If there is an equity market or credit/bond market sell off sometime in the next 6 months at a total asset level investors will not see a change in value. This helps advisors maintain their asset based fees…in the short term.
  • They are claiming that this will broaden and diversify the investment risk and at the same time provide a higher return.
  • It is apparently some sort of ‘ magic pudding’?

So we feel compelled to point out that:

  • There is no ‘magic pudding’;
  • The market strategists and advisory groups recommending alternative asset class investment are often receiving  high fees sufficient to compensate them for the lack of liquidity that are not passed onto the investors and often not disclosed sufficiently. The high fees require investment in higher risk assets;
  • While it is true that investing in private equity and private debt does broaden out the investment universe, it comes with a considerably higher risk and a lack of liquidity that many investors in equities and repo eligible bonds may not fully comprehend. The actual value of private debt or equity funds may not be truly revealed until the debt matures and the funds are repaid. Until then investors have an opaque black box on their balance sheets.

The mistake that these strategists are making is that they are assuming that any equity or credit market sell off  will be a short term event and not a signal of a recession. Here again, they are clinging to the history since the GFC where the central banks have rushed to the rescue with Quantitative Easing (QE)at the first sign of asset price weakness and there has been no recession.”

“Firstly, it needs to be understood and acknowledged that Central Banks got away with QE ( really Modern Monetary Theory) since the GFC only because we had stable prices – no inflation –  and this miracle was because we were successfully exporting our industrial production to China and more recently SE Asia. Now that inflation has returned the Central Bank Put option for all those households, businesses and government with high levels of gearing is dead.

Secondly, when not ‘if’ a recession occurs it will not be mild it will not be short but it will be severe and prolonged because of the extreme levels of debt held by government, household and corporates. In a recession investors in the opaque private equity/debt funds and investments will see large losses from these higher risk investments because they are far more reliant on an ongoing economic expansion than the more liquid listed market traded securities. Alternative Assets may avoid a short term fall in market prices, but only if a recession does not occur.

Given that the investment risks are currently rising all investors should remember that Goldilocks and The Magic Pudding are just fairy tales. Inflation will not be brought under control without an economic contraction – no Goldilocks outcome- and that investors cannot just move into alternative assets and expect a Magic Pudding outcome. Now is the time to move towards investments that are low credit risk and liquid or fund managers that understand and have room within their mandates to avoid the rising inflation risks and the risks of a recession. Cash is King!   Private Equity and Private debt are very poor investments in a recession because they are exposed to smaller companies (85% of PE funds are invested in companies with fewer than 500 employees) that don’t have the balance sheet strength to survive a recession or the market power to pass inflation onto customers.

One of the more disturbing forms of private debt we have seen being marketed to retail investors as ‘secure’ but with very high mid teen returns has been from funds that lend to property developers of residential real estate. Australia has an unsustainable level of household debt linked to ownership of residential real estate assets.”

“Over the past 6 months consistent readers of our Weekly and Monthly updates will be able to acknowledge that we have consistently forecast that inflation and higher rates will occur and that accordingly duration should be minimised. As an Absolute Return manager we are not biased to either fixed or floating rate bonds because we can alter duration, unlike a fixed rate or credit fund manager.

 Arculus Funds Management and formerly GCI Australia first pointed out, in the midst of the pandemic lockdowns, that an inflationary breakout would occur for the first time since the 1980’s by mid-2021.  Inflation is not something understood by many economists (anymore) and even fewer market strategists and apparently, disgracefully, by no asset managers that have been advocating for investors to increase duration by purchasing fixed duration bonds since 2022. They were wrong then, they are wrong now and they may well be very wrong over the next 12 months given the underlying economic strength in the US, Australia and perhaps even the global economy (not withstanding we now have raised Europe – inclusive of the UK – to a high risk of suffering a material economic contraction within the next 12 months). It is flabbergasting that given the potential capital loss on a long duration bond holding that investors don’t retain a tight stop loss when they have been gambling that that economy will magically still grow and at the same time inflation will conveniently fall to the central bank target level. Goldilocks is a fairytale!”

Renny

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