Wealthy Nations Daily Update - Flight to Quality

Last week Royal Bank of Scotland issued a note to its clients telling them 2016 could be a ‘cataclysmic year’ where equity markets could fall up to 20%, global commodities could continue to suffer and insisting the world has far too much debt to be able to grow well. The overview of the note makes for very bearish reading, it states:

“We think investors should be afraid that the ominous outlook for the world in our Year Ahead has been borne out (ex-ECB cuts) over the past six weeks. This hardens our ‘anti-goldilocks’ and deflationist views. Rather than fade, we say follow - and be cautious in 2016. We have been warning in past weeklies that this all looks similar to 2008. We dust off our old mantra: this is about ‘return of capital, not return on capital’. We suspect 2016 will be characterised by more focus on how the exiting occurs of positions in the 3 main asset classes that benefitted from QE 1) EM, 2) credit, 3) equities. We stick to our -10 -20% equity downside call. In a crowded hall, exit doors are small. Risks are high.”

Andrew Roberts, credit chief at RBS says the FTSE 100 is at particular risk due to its high weighting of commodity companies “London is vulnerable to a negative shock. All these people who are long oil and mining companies thinking that the dividends are safe are going to discover that they’re not at all safe” Roberts also reckons the tightening cycle by Anglo-Saxon central banks is over already.  He believes that there will no rate rise by the Bank of England before the downturn hits and that the next action by the FED could be a reversal of December's 25 basis point rise. RBS is not alone with this view on the FED. Lawrence Summers, the former U.S. Treasury Secretary, said in an interview last week that there was a “significant risk” that within the next 2 years, FED rate policy will have to reversed.

Whenever there is heightened global stress there is always a flight to quality. Investment grade bonds perform better than other credits in these times due to the issuer’s ability to pay its debts. We only hold investment grade bonds and at present have an average credit rating of A3 across the portfolio’s. We feel that in times of stress it's vitally important to invest in investment grade bonds from countries and companies that have the greatest ability to pay back their debts.  We invest in bonds based on fundamental credit basis.  Countries are screened by their ability to repay debt, using our net foreign assets (NFA) model, and then credits are evaluated based on value for money and fundamentals of that credit. We see this as a return to fundamentals of credit analysis for fixed income, rather than the indexed approach used by most other funds. The major downside to index weighting means having to buy more of a country or company’s debt as it becomes more indebted, therefore the weighting of that country or company’s debt becomes greater. No country has ever defaulted on its debt while it was a net creditor, while those that have defaulted are indebted countries.

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