A wise colleague once said to me “once you read about it in the financial press you want to do exactly the opposite of what you read”. The current debate raging is about performance of active management vs. passive management, and the argument has merit empirically in the fact that passive management has outperformed active management over the past five years – if you adjust for fees

In classic behavioral science analysis, once you read about it, do the exact opposite. If everybody is recommending the same investment strategy, it probably makes sense to be very cautious about believing what you read, and be critical of the mass consensus.

In fact currently we believe that you want to do exactly the opposite, this is the time to increase your allocation to active management, and significantly decrease your allocation to passive management. In order to substantiate this argument let us look at what has been going on in financial markets over the past few years.

Central-bank action– central banks have been actively purchasing fixed income securities, flooding the market with liquidity, and limiting bank lending to only higher quality borrowers, IE selectively modifying the transmission mechanism that banks use in terms of distributing capital on their balance sheet. This has had a significant positive effect on government bond yields, investment grade spreads and corporate high yield and has been the driving force in the equity market rally

Central bank lending has been the key determinant leading to a prolonged equity rally by reduced borrowing cost significantly for the larger corporations that banks regularly lend to. The freely available capital and low borrowing rates mid-and large-cap corporations have enjoyed over the past 10 years has led to a prolonged equity rally.

The abundance of inexpensive debt financing has shifted the relationship between equity and debt financing increasing the CAPM efficiency of debt relative to equity. What this boils down to is cheap funding via debt issuance has replaced or displaced increases in equity funding, secondary IPOs, dilution and increases of equity for most large corporations. This has led to a rally in equity as a result of the supply of equity not increasing as quickly as the supply of debt.

My premise is that all of this is about the change. The US yield curve has begun to shift upwards in anticipation of the Fed raising rates, the Fed has begun to communicate that it will be raising rates albeit gradually (for now) , government bond yields curves have steep and in the 10 and 30 year by a significant proportion, and we are beginning to see the effects of full employment in the US causing wage inflation.

Combine these already inflationary forces with, reduced imports via import duties, reduced immigration via labor policies, and massive fiscal stimulus (the Mexican border wall will be the biggest construction project ever undertaken) that the Trump administration has promised.

If we move to Europe I am concerned about the dispersion and the difference between the growth rates of various countries in the euro zone. If one looks at Italy and France, we see zero growth, unemployment rates above 10% and a real problem with immigration social unrest, isolationist polices becoming law, and disenfranchisement.

If I look at the UK and Germany we are seeing inflationary tendencies similar to the US manifest themselves with growth rates of between 2 – 2.5%, full employment, the beginning of wage inflation, and not dissimilar to the US immigration policy shifting towards isolationism and selective targeted immigration policies.

So my concern at this juncture is that the ECB will be caught between a rock and a hard place, they will have to consider raising rates to combat inflation in Germany and other productive European countries with growing growth and falling unemployment.

On the other hand the ECB will have to be stimulative keep rates low and continue pumping money into the economy in order to stimulate growth in France Italy and the other countries throughout Europe that are not performing well in terms of GDP growth, which have sustainability high unemployment and which show no sign of growth nor inflation.

My underlying argument is that there will be major shifts in central bank policy, coming in the next 6 to 12 months, that will be significantly detrimental to fixed income investing. There will also be potential volatility entering into the equity market due to the fact that loose monetary policy bond purchases and ultra low rates are the key drivers of the equity market and have been over the past 10 years. The equity markets have not grown because of GDP growth, underlying industrial and sectoral growth, or increasing demand from the general public, on the contrary growth rates price inflation and wage inflation have all been moderate.

Equity market price appreciation has been a direct result of freely available cash and sustained ultra low interest rates

Therefore now is the time for active investing, now is the time for an increase or decrease in risk based on macroeconomic changes, policy changes from government, and technical and fundamental factors. You have had a directional low volatility environment in which both bond and equity markets rallied significantly since 2008 or so globally, with the exception of Europe in 2011, however that will not continue.

Investors should position themselves with managers who have the flexibility to hedge, be short, have relative value trades, and interpret when to be in or out of the market … the very definition of active investment.

Please feel free to reach out with comments, criticisms, and/or feedback.

Louis Gargour – Founder of LNG Capital T +442078393456 E lg@lngcapital.com