How to be a contrarian

This isn’t an underdog we’re talking about. Apple is the largest listed company on earth, with massive international reach and near-unparalleled branding power. As an investment, it has proved a spectacular success, notching up a near-sixfold share price increase since the start of the decade.

Yet contrarianism – when it really does buck the status quo – is hard to ignore, and nor should it be. Investors cannot just get by on the assumption that equity markets will generally go higher. A contention backed by the weight of past examples is one replete with confirmation bias.

Again, for those seeking proof of why a bearish take is also necessary, look no further than the world of hedge funds. Along with its exorbitant fees, and frequently disappointing rates of return, one constant for the alternative investment class (amid its endless obituaries) is that very rich people will pay a lot of money to have their capital tied up for years with hedge fund managers.

That’s right, hedge funds often lose money, and that’s not always a problem for investors. Of course, a catch-all assessment of the sector is complicated by the fact that many hedge funds now compete with other active and passive strategies seeking to maximise returns. But the original philosophy of hedge funds – to reduce overall portfolio risk by taking short positions and bearish calls – holds as much weight as it ever did. Perhaps more so, after multi-year bull markets for equities and bonds, during which time contrarian calls on financial markets have often been left wanting.

Bear raiders

When it comes to equities, ‘contrarian’ investing often amounts to a bullish call on undervalued companies, rather than an insurance policy against a bear market.

Incidentally, such companies dominate the pool of shares in which short-selling hedge funds swim. Followers of UK stocks are given a fairly clear idea of the biggest targets in that pool. Under Financial Conduct Authority rules, funds must disclose any short position equivalent to at least 0.5 per cent of a company’s total stock. This provides a proxy for the biggest short bets, and a list of potential short-selling ideas. But as the 12-month performance column in the table below shows, following the hedge fund herd can itself be a volatile game, particularly if you factor in the negative compounding effects of large dividend yields.

Ask any hedge fund manager and they will tell you it is easier to go long than short. Far larger numbers of market participants want stocks to go up. But from time to time, equities crash, currencies collapse and contagion risk spreads. And while the timing of the next major bearish event is nigh-on impossible to predict with accuracy, investors should nonetheless look to build a hedge-fund-like insurance into their portfolios. Fortunately, it’s possible to do this through exchange-traded funds and financial products, rather than forking out for the ‘two and twenty’ (flat and profit-based) fee structure beloved of Mayfair-dwelling money managers.

Before identifying ways to do this, we first need to look for some of the greater confirmation biases in markets, and unpick how they could unravel.

The great US tax disaster

When the US congress passed the Tax Cuts and Jobs Act at the end of 2017, it was greeted with near-euphoria from equity investors. Although widely trailed, the drop in the US corporate tax rate from 35 to 21 per cent sent earnings estimates for the S&P 500 skyward, causing an avalanche of bids for equities, and turbo-charging the index’s already lofty price/earnings (PE) multiple. While the rating has since peeled back, it remains very bullish at more than 20 times forward earnings.

Ostensibly, the tax cut was meant to encourage capital investment, productivity, job creation and higher wages, by leaving more cash on boardroom tables. Whether dressed as trickle-down economics or unleashing the market’s animal spirits, the act essentially outsources part of the task of economic stimulus to the agency of corporations.

Early signs do not quite support that optimism, or the White House belief that the ground has been laid for 3 per cent GDP growth a year for a decade. Moreover, there are good reasons to believe that the act could lead to economic harm, not least of which because the cuts have suddenly left a $1 trillion hole in the government budget. Instead of investing in capital projects – an option previously smoothed by a decade of rock-bottom interest rates – companies are using the extra profits to buy back shares and hike dividends. M&A activity has been given a boost. And according to analysis by think-tank Just Capital, just 6 per cent of these tax savings have been set aside for workers’ wages and benefits. Out of all of this, the benefits to the real economy are questionable.

Furthermore, as East West Investment Management market strategist Kevin Muir argues, this could have the effect of adding pressure on the Federal Reserve to raise rates, as stocks continue to rise and corporate credit spreads decline. “It’s the worst of both worlds – little actual real growth, which is squashed by a central bank worried about overly easy financial market conditions,” wrote Mr Muir earlier this year. “This combination will only hasten the economic slowdown.”

Why this is of interest to UK investors should be obvious: if the US enters a recession – as a quarterly report from the National Association for Business Economics (NABE) recently suggested could happen in 2020 – the impact will be widespread. By that point, two-thirds of the 45 economists polled by NABE think any boost from the tax cut will have faded.

HEDGES: Two-year put option on S&P 500 (high risk); two-year US bonds (low risk)

China crisis

As any student of investing history will tell you, there are major risks to a bet against the US. That chorus includes Arlington Value Capital partner Allan Mecham, who in a letter to investors in 2008 wrote that “it is important to remember, the American system is a six-sigma event like the world has never seen. In the last 100 years America has enjoyed a seven-fold increase in productivity – unprecedented in modern history.”

But as any student of global politics will tell you, the twenty-first century will not belong to America, but Asia. And although US military power might remain pre-eminent for some time, China is projected to surpass the US to become the world’s largest economy by the end of the next decade.

This rise has been similarly unprecedented. Since the financial crisis, the world has looked on dumbstruck by (and somewhat grateful for) China’s double-digit economic growth. That growth has been accompanied by staggering fiscal stimulus, which in 2017 hit an enormous 14 per cent of gross domestic product (GDP), according to Hayman Capital, the hedge fund run by noted China bear Kyle Bass.

That deficit, which comprises both official government budget and off-balance-sheet infrastructure spending, will be hard to cut. That’s because President Xi Jinping has committed the People’s Republic to a monster infrastructure project in the shape of the One Belt One Road initiative, requiring trillions of dollars of government spending in the years to come.

At the same time, China’s debt levels have exploded, particularly among Chinese companies. Victor Shih, an associate professor at the University of California, calculates that incremental nominal GDP growth has lagged total debt service payments each year since 2012.

You wouldn’t necessarily know this from Chinese monetary policy, which after holding interest rates since 2015 has started to rein in the credit impulse. If the Middle Kingdom is to take the froth out of credit markets, it needs to do this. But herein is the bind: raising rates will add to the pressure on the existing debt pile, particularly for domestic companies and banks. If Beijing is forced to prop up distressed companies – where the debt balloon has really expanded – it may be forced to roll over on its efforts to curtail easy lending. Debt could beget more debt.

Some watchers, professor Shih included, believe that the real threat to China’s economy could come from capital flight. The communist party and its apparatus may be expert at capital controls, but the looser the money supply, the harder it is for the state to keep a lid on wealthy individuals moving their money out of the country. If fears of credit bubbles persist, that could create natural incentive for Chinese investors to diversify, and move their money into dollar-denominated assets.

Hedging against China, like the US, has been a painful trade in the past few years. Some of the most noted China bears, including Mr Bass, Kynikos Associates’ Jim Chanos and former Eclectica Asset Management head Hugh Hendry have either reduced or made losses on their sceptical positions.

But like all investments, could it just be that their moment is yet to come? Until the spectre of a US-China trade war reared its head in February, the renminbi had been strengthening against the dollar for over a year. What happens next remains to be seen, but history isn’t on China’s side here. That’s according to the International Monetary Fund, which in a recent paper compared China’s debt-to-GDP rise to 43 similar past credit booms. All but five ended with a major slowdown or financial crisis.

HEDGE: Short yuan/Long US dollar ETF

http://www.morningstar.co.uk/uk/etf/snapshot/snapshot.aspx?id=0P0000PPPF

A golden era

Ultimately, China will want its currency to weaken, whether or not that happens against the dollar. Indeed, all countries want their currency to devalue with time; a rising or strong currency only raises the cost of (and reduces demand for) a nation’s exports and services. However, for investors, the downside of taking one side of a long-term currency position is that everything tends to come out in the wash. Holding on to cash is an alternative strategy, but one marred by inflationary risks.

But over the long term, one currency that tends to hold its own is gold. As the chart below shows, the yellow metal is worth at least three times what it was 25 years ago, against sterling, the dollar, the euro, the yen and the yuan.

In other words, gold has an enviable track record as a hedge in a multi-polar, multi-currency financial system. The caveat to this is that global markets still sit with the dollar at their core, which helps to explain the apparent loss of momentum in the gold price in recent years. That’s because the Federal Reserve, and other central banks, are supposed to be in the process of normalising interest rates. For investors, the prospect of rising risk-free real yields increases the opportunity cost of holding gold – which is nobody’s liability, but sadly offers nobody a yield, either.

Then again, this assumes that the Fed can both stay ahead of and contain inflation. If it is successful, such environments tend to be bearish for the gold price. But with analysts at HSBC arguing that the threats from tighter global monetary policies “are largely priced in”, several factors point to a supportive environment for the yellow metal.

For one, investors are deeply worried about valuations across financial markets. As we highlighted above, this was widely felt in the US in 2017, despite a rising equity market and a tightening rate environment. After a decade of cheap credit, it’s far from clear whether US corporates will handle the strain of higher interest payments. America’s twin deficits – the shortfall in its current account balance and government budgets – will attract ever-greater levels of investor concern. All of this is bearish for the dollar, and what is bearish for the dollar tends to be bullish for gold.

Added to this is a considerable amount of geopolitical risk. Some investors are happy to treat rising tensions as noise, and argue that negative headlines tend to drown out the wide-frame view of broad global economic growth. But the threat of a trade war and the uncertainties borne of an increasingly complicated world affect investor decision-making. In turn, that provides pulling power to a liquid, low-volatile asset such as bullion.

HEDGE: Gold – physical or ETF

Against the grain, with the grain

As investors in resources stocks will no doubt have noticed, the bear market in commodities that characterised much of the first half of this decade is over. Copper is back up to $3.10 a pound, iron ore is more than 50 per cent off its lows, and Brent crude recently touched $80 a barrel.

However, one corner of the (soft) commodities universe that remains in a rut is the grain market, which after adjusting for inflation is trading at near-decade lows. Judging by the positioning of futures contracts, speculators and traders share little optimism that prices will rise any time soon.

By and large, assuming you aren’t a crop farmer, this is a good thing. Over decades, a combination of global trade, and advances in technology and pesticides have steadily pushed up yields, and pushed down prices.

That trend has been all the more staggering when you consider that the world’s population has increased by more than a quarter since the turn of the century. And with that population growth has come rising income levels, and a greater demand on protein-rich food sources, which in turn require more grains.

Over the coming years, it’s hard to see this bearishness continuing. Growing water scarcity, climate change, topsoil erosion and the prospect of 10bn humans by 2050 will ask ever-trickier questions of farmers, seed developers and the wider agricultural industry.

As with oil, spiking food prices tend to be bearish for the wider economy. A bet on rising grain prices – through exchange-traded commodity funds such as ETF Securities CORN and ETF Securities WEAT – is therefore an insurance policy on a market we all take for granted.

HEDGES: Corn or wheat exchange-traded commodity fund