Q2 2018: The World Cup
It’s July 2018 and for a blissful, short while, only one thing matters: the World Cup. Trade wars, civil wars, cyber wars; as a potential new client told me last week, “the world is terrifying”, but for now we can lose ourselves in o jogo bonito, Pele’s “beautiful game”. Can we find in football a useful metaphor for portfolio construction?
Last quarter I wrote about gathering clouds over unusually placid financial markets – and how your portfolios are appropriately structured to withstand a change of weather. In this letter I will consider how we ensure particular elements of your portfolio are going to do the job required of them when the time comes.
Look at the spine of England’s World Cup-winning side : Pickford, Stones, Henderson, Alli and Kane each have a clearly-defined role. It is not just about throwing the eleven best players on to the field. (If it were, Argentina and Spain would still be in the competition.) It is about how they fit together. Each player is chosen to provide a particular blend of attack and defence. Take Henderson and Alli: both midfielders, but if we were to split their roles, we might say Henderson is 70% defence, 30% attack, while Alli is the other way around. Gareth Southgate has to consider which combination of players works best to achieve the specific goals of the next match.
Building the perfect first XI. Every holding in your portfolios is considered in a similar way. What is its purpose in the portfolio – its blend of attack vs defence? How does it work with other parts of the portfolio?
Defensive holdings are a particular focus for us right now. We need to know they will protect your wealth when it really matters. Bond funds, for instance, have historically been less volatile and suffered smaller losses in times of market stress than equity funds; for the past 33 years they have been the perfect defensive midfielder, shielding the back four yet also contributing to attacking moves.
However, in the 1980s and 1990s we did not have trillions of dollars of QE  in the system. What if that colossal liquidity causes surprise inflation and unexpected, sharp interest rate rises? Bond prices would be hit hard – at exactly the same time as equity prices. Indeed, as QE turns to QT  in the US, yields have been creeping up across the globe, not just in America.
Public infrastructure funds also look great on paper (just like the Germany team): long track records of high and steady income flows and stable capital values, backed by government contracts. Those contracts are rock solid, right…? Post-Brexit, post-Trump and (perhaps) pre-Corbyn, the threat of a new government tearing up old contracts no longer seems impossible. Assets considered “safe” may in fact expose you to hidden and highly damaging risks.
We need to try to uncover these and find ways to mitigate against them. These are the true “risks”; after all, everyone already knows about the trade wars, civil wars and cyber wars of my first paragraph. Our challenge is to test holdings against scenarios that are not already priced into markets. When we propose changes to all-weather, lower risk portfolios in the months ahead, expect them to be focussed primarily on improving defensive characteristics.
For now, whatever the outcome, I know I will relish every minute of the final stages of what has been a glorious, memorable World Cup, and I hope you do, too.
(1) I am an optimist. At the time of writing, we have not, in fact, won the World Cup, but reached the Semi-Final stage.
(2) Quantitative Easing: the printing of electronic cash by central banks to purchase government bonds with the goal of forcing long-term interest rates to remain low.
(3) Quantitative Tightening: the process of central banks gradually selling the government bonds acquired during QE with the goal of allowing interest rates to rise and for bond markets to return to ‘normal’ functioning with less central bank intervention.