Taking Profits

Unchartered territory?

Regular readers will be aware of my long held view that, in order to help pay down their huge debt mountains, governments have been attempting to engineer an element of inflation. Part of the plot has been to keep interest rates artificially low at both ends of the yield curve.

This is achieved at the short end because it is the politicians who pay the central bankers – ‘forward guidance’, such as 7% unemployment rates, being nothing more than a smokescreen. It is achieved at the long end by forcing the big players, the banks and pension funds, to be buyers of government bonds – capital adequacy ratios and asset-liability balancing being some of the tools. Such are the means of ‘Financial repression’.

Massive money-printing by governments, or quantitative easing (QE),is also part and parcel of the process.

This policy of engineering inflation has been practiced before by governments after WW2 when faced with huge debts.And it seemed to work – at least for a while. It was not until the 1960s that inflation began to really rear its head. Once out of the bag, governments struggled to contain it. Having pursued the policy, governments thought they could take corrective action when it was necessary – but the full complexities of this ‘dark art’ were hard to master.

Now I do not doubt that today’s governments and central bankers are very capable. They have the benefit of history upon which to reflect. More is understood today as to how economies work and interconnect with each other. Massive strides in technology assist their decision-making. But it is sometimes a want of mankind that history is ignored – that past lessons are ignored. Just as previous governments believed they could master their art, present governments believe likewise.

They may be right. They may be able to time interest rate rises correctly to stop inflation taking hold. They may be able to scale-back QE in such a way as to cause minimum disruption to markets. We are certainly reaching a tipping point. The policy has been ongoing now since the financial fallout in 2007-08 when markets made it very clear that there was a limit to the amount of debt that could be tolerated. The moment of truth is now approaching.

All eyes are on policy-makers to get the exit strategy right. If the policy of low interest rates and QE was the answer to all our economic woes, then governments would have pursued it long ago. Having believed since first writing this column five years ago that interest rates would remain low, I now believe there is a growing risk that policy-makers will overshoot – that inflation will be allowed to progress too far before corrective action is taken.

The threat to investors is two-fold. First, the longer such a policy is pursued, the greater the threat of financial imbalances as capital continues to migrate to ‘high’ yielding assets and away from those offering quality or liquidity. As time passes and corrective action is delayed, the chances build of a setback in certain markets.

Second, if I’m wrong and interest rates rise soon, then this will come as a surprise to markets which certainly believe, after initial scepticism, that rates are set to remain low. Bond yields remain near or at record lows. The S&P 500 is now entering its sixth consecutive year of positive returns – not a common occurrence. Artificially low interest rates and money-printing has lifted most markets and assets.

Equities generally cope with tighter monetary policy. But the extent of central bank support this time around, together with debt levels remaining stubbornly high, suggests the retreat from liquidity will not be an easy one. Better messaging and corrective, if gradual, action is now required.

Portfolio strategy

Both portfolios will continue to be relatively fully invested. Trying to time the markets is often a mug’s game – it is best left to wiser investors. But, given my growing caution, I am being even more diligent in taking profits and more demanding when seeking value, even if this means the portfolio’s cash balance rises a tad. Accordingly, during July I sold the Growth portfolio’s holdings in Schroder UK Mid Cap Fund (SCP), and top-sliced Scottish Oriental Smaller Companies (SST) and International Biotechnology (IBT).

SCP has done well. But given my caution in recent months as to the extent to which smaller companies can continue to outperform their larger brethren, and with the discount having narrowed to around 4%, better value exists elsewhere.

Despite being excellent trusts, SST and IBT were top-sliced as both were up 20 per cent since last purchasing them in January and April respectively when sentiment was depressed – SST having narrowed to within 2 per cent of NAV. My introduction of Fidelity China Special Situations (FCSS) in May and the extent of the portfolio’s continuing exposure to biotechnology, testifies to my remaining commitment to both sectors.

With some of the monies raised, I continued in July to increase the portfolio’s exposure to larger companies within the UK by adding to existing holdings of Murray Income Trust (MUT) when on a small discount, and Finsbury Growth & Income Trust (FGT). The larger UK blue-chips have been looking decent value relative to smaller companies in recent months.

By contrast, I have increased the portfolio’s exposure to European Assets Trust (EAT). Smaller companies on the continent have significantly underperformed their UK counterparts in recent years. A period of catch-up is due which we may now be seeing. More initiatives by governments, especially those within the Eurozone with youth unemployment rates of 50 per cent, will assist their progress. A 6 per cent yield, as measured by the NAV at the beginning of each year, adds to EAT’s attraction.

All in all, I have adopted a slightly more cautious approach for the Growth portfolio. I felt this was unnecessary for the Income portfolio given its relatively defensive positioning – accordingly, once again, there were no changes to this portfolio.

Readers may also wish to note that, because of holidays, all portfolio figures are as at 20 July. My next column is due on the first Friday of September and will contain the usual end of month figures for August. Otherwise, may I wish you a happy – and relaxing – summer break.

View John Baron's updated Investment Trust Portfolio