A “risky trinity” of productivity growth, high levels of debt and limitations on monetary authorities means that investors need to tread carefully, according to Troy’s James Harries (pictured), who has the task of launching a fund against this backdrop. 
The manager, who recently joined Troy after running Newton’s Global Income fund for more than a decade, says we are coming to the end of a “mightily benign” period for markets which first began in 1981 at the start of the equity and bond bull run.
While bonds are still performing well and are offering yields at historic lows, he believes that the equity bull run is finally coming to a head.
Performance of indices since start of data
Source: FE Analytics
“They say that knowledge of the past allows one to look forward and this is a case in point. By stretching one’s time horizon back decades and understanding the structural forces that have been prevailing one can rationalise the current backdrop,” Harries said in his first newsletter as manager of Troy Global Income.
“The authorities have been fighting an uphill battle by arguably over-emphasising the short term as well as their own ability to control events without fully appreciating (or perhaps conveniently overlooking) the structural problems in economies. It appears that these are now becoming acute.”
One concern that has been mentioned frequently by investment professionals over the last few months is that central banks are running out of steam.
In an article published shortly after the European Central Bank (ECB) announced it would expand its quantitative easing (QE) programme in March, a number of industry commentators warned that continuing to implement loose monetary policy will not fix long-term headwinds.
There is also the concern that, given how low interest rates are and how expansive bond buying programmes have become in some regions, that central banks are gradually running out of tools and may struggle to bolster economic growth.
Ian Kernohan, economist at Royal London, said: “Since [the end of 2015] we have seen a major spike in financial market volatility, a fall in eurozone inflation, some weakness in the main eurozone business surveys and cuts to global growth forecasts.”
“The initial reaction of markets was very clear. Draghi’s comment at the press conference that he thought further rate cuts were now unlikely, reversed this initial reaction. Looking through these very short-term reactions, however, the proof of the pudding will be a rise in eurozone inflation expectations and a further pick up in lending growth.”
Harries refers to the Bank of International Settlements’ recent annual report, which warns of a “risky trinity” of global debt, authority limitations and low growth. It then says this is exacerbated by continual economic booms and busts caused by the intervention of central banks over the years.
Performance of index since start of data
Source: FE Analytics
“[The report] is effectively acknowledging that all the efforts of the central banks, most obviously via quantitative easing, may have actually been responsible for the problems we face via well-meaning but mistakenly short-term policy,” he explained.
“They have helped the cyclical backdrop but at the cost of damaging the underlying fabric of economies by furthering the misallocation of resources and attendant booms and busts. Greater indebtedness has been encouraged. The ‘risky trinity’ sums this up well.
“Until now one could argue that the cyclical effect of increasing confidence and consumption by raising up asset prices was in some way offsetting the structural problems we have; no longer.”
The manager says that a combination of oversupply caused by QE, a large amount of debt, technological disruption and aging populations are all headwinds that can’t be overcome using monetary policy alone.
“The policy of dragging forward demand from the future has reached its limit and tomorrow has become today. Such a backdrop at a time of elevated valuations is a dangerous mix for investors,” he added.
The key to navigating such a challenging backdrop, according to Harries, is to focus on attractively-valued, high-quality businesses that generate high returns on capital employed. Not only this, he says that attractive dividend yields mean he is able to produce a healthy stream of income as well as strong risk-adjusted returns.
“It is worth remembering that in fixed income markets high yield equates to high risk but in equities that isn’t necessarily the case,” he pointed out.
“It may be that we are being offered the chance to secure an attractive future income stream funded by a high quality business for any number of reasons; temporary problems that are often mistakenly seen as permanent, a high profile issue that is actually pretty immaterial, an inefficient capital structure or, and perhaps best of all, an underappreciation of the long-term attractions of a business leading to structural undervaluation.
“For this reason, even in a world characterised by a so-called ‘reach for yield’, opportunities for income will likely be available somewhere if you have a sound investment process and a global remit.”
That said, Harries points out that there are four ways he could potentially get this process wrong.
Firstly, a company can suffer a permanent loss of earnings power. To overcome this, he focuses on businesses that have consistently generated income over long periods of time although, of course, bearing in mind that past performance is no guide to future returns.
Secondly, he says there is the risk of overpaying for an asset, which will reduce the return generated from the investment at least over the short term.
“It is worth remembering however that the return from an investment over the long term will converge on with the return on capital of the underlying business,” he said.
“Buying such a business when out of favour should make a good investment better still. It is key to realise though that time is the friend of the excellent business as its inherent qualities will prevail even if we get the timing of the purchase wrong. This is not the case for a lower quality business.”
Another pitfall to avoid, according to Harries, is buying into business with too much debt as it means they become inflexible and are higher-risk. Not only are they more susceptible to bankruptcy, the manager says they are at risk of being taken over by another company which, while not as damaging as going bust, will still negatively impact returns.
The fourth way he says an investment process could go wrong is if the team overtrades as this can affect the fund’s ability to compound its capital and income earned from that capital over time.
However, he believes that he has designed an investment process for Troy Global Income, which launches on 1 November, that can mitigate these potential pitfalls.
“The portfolio is likely to have four key attributes,” Harries continued. “The core of the portfolio will be very similar to the equities held across the other Troy funds. That is high quality businesses that are likely to compound capital and income over the long term.”
Other attributes will include his belief that inflation expectations will remain low, that some good businesses have limited downside due to low valuations and that emerging markets will continue to suffer.
In an article published earlier this year, the manager said that there was indeed “trouble ahead” for emerging markets despite their recent surge in popularity, as it is the end of a credit boom in the process of unravelling.
Performance of index in 2016
Source: FE Analytics
“At a time when there is much to be concerned about we believe that the right strategy, with the right process at an investment house known for a conservative approach, with the preservation of capital at the core of the investment offering, should form a part of many investors’ portfolios,” he added.