No margin for error in hot markets, says Magellan’s Hamish Douglass

Magellan’s Hamish Douglass has warned of the “speculative frenzy” taking place in some shares and other assets and says now is a time for caution.

Magellan chairman and CIO Hamish Douglass says now is a time for caution in markets. Britta Campion / The Australian

Magellan’s Hamish Douglass has warned on the “speculative frenzy” taking place in some shares and other assets and says now is a time for caution, with no margin for error as the investment community ignores looming risks.

“This is the time to be cautious when others are greedy. I don’t think it’s a time to be fearful, but cautious,” Mr Douglass told an online forum on Tuesday.

“Until we have some clearer scientific evidence around the mutation risk (of the coronavirus), there is no margin for error at the moment in markets. We have no idea if an escape mutant is going to emerge but the risk is foreseeable and there are clear warning signs at the moment.”

Alongside the risk of the virus mutating is the prospect of an inflation event, both of which could hit markets hard, he warned.

“The investment community is almost solely focused on the economic recovery story, and while there’s debate around inflation and the direction of interest rates, there’s a risk that lurks below the surface.

“The economic recovery scenario is complex enough to deal with. If we just had to debate inflation and interest rates and position yourself around that, getting that call right is very important. But you overlay this with the mutation risk of the virus and also with some clear speculative frenzies going in some assets that appear to be getting pretty large and this is a really difficult issue to deal with.”

Homing in on the inflation risk, Mr Douglass said he expected there to be a short-term speed bump but he questioned whether inflation would be higher over the medium term.

“If we ignore the mutation risk, I think it’s very likely at the end of this financial year, and it looks like the $US1.9 trillion) stimulus package will be passed in the US, we’ve got Powell who’s not blinking.

“If everyone gets vaccinated and we reopen economies fairly smoothly, we’re going to get a very powerful period of economic growth at the end of this year and in to 2022.”

Under one scenario, rising bond yields could go with that economic growth, leading inflation to accelerate at the end of this year, he said.

Labelling this “entirely predictable”, Mr Douglass said the big question was whether that inflation rise would be transitory or permanent.

“I think the Federal Reserve is taking the view that it’s very likely to be transitory. (But) if it is the new inflation cycle coming, the US Federal Reserve, at some point, is going to have to change course and start lifting interest rates. That is a disaster for financial markets.”

More likely it would be a short-term inflation “speed bump”, he predicted.

“I think it will prove to be transitory. I think that the fiscal stimulus will pass through the economy and then we‘re going to be looking back into a factual situation of lower long-term structural economic growth.

“But I do think bond markets could be very volatile through the rest of this year,” he warned.

Labelling 2021 “the year of living dangerously”, Mr Douglass said FOMO, or fear of missing out, as well as confirmation bias and oversimplification tendencies were driving the sharemarket higher.

“You have to be prepared to step away from the crowd. And that’s really difficult to do when everyone appears to be making easy money on what appears to be a turbocharged sure bet.

“With what Powell and Yellen are doing, absent this (virus) risk, it almost looks like a sure bet to take risk on. And to some extent the more risk you take on the more you’re going to get rewarded, at the moment.”

Some elements of the market were reminiscent of the dot.com boom of the late 1990s, he said as he warned of the speculative frenzy in certain assets.

“The fear of missing out is extreme, and so the cost of being cautious at the moment can be very high at the moment.

“On one hand you want to have ‘risk on’ because of the stimulus and recovery, and yet there are warning signs that you could have your shirt ripped off if something goes against you.

“People are feeling they need to get on the bandwagon because everyone’s making money at the moment. We’re just saying, have a little bit of caution and remember the sage advice from Warren Buffett: To finish first you must first finish.”

Magellan’s Global Fund has underperformed as markets rallied following the more-than 30 per cent plunge a year ago, but Mr Douglass said he wasn’t losing sleep over it, pointing to the downside protection in the portfolio.

We had a major stress test (last year) and our downside protection was in the top 1 per cent of the market.

“We cap our risk; we’re always running less risk in our strategy than the market is running. We’re never going to give up our downside protection,” he said.

The fund holds 50 per cent of its portfolio in utilities, cash, and consumer staples, he added.

“They have dramatically underperformed the market, across the board. It’s because there’s been a rotation out of defensive assets into economic recovery. Our view is that’s a timing issue.

“There is a lot of value in those assets and if you were to measure it over the next three years, I’m very confident that those assets can deliver the type of returns we want,” he said.