The Great Bond Massacre, inflation, and what family offices should know

Rising inflation threatens the future of every family office and it has become the one risk which most concerns Dan Higgins, investment chief at Marylebone Partners.

It hits purchasing power and burdens beneficiaries. It produces a rise in discount rates and undermines portfolios, as with the bond catastrophe of 1994. It has the capacity to shock the next generation and lead to social unrest. 

Higgins recalls this happened in 1994, during the so-called Great Bond Massacre, when the Federal Reserve hiked interest rates to tame inflation… 

Marylebone’s clients comprise family offices, charities and wealthy individuals so Higgins is sensitive to their anxieties. He argues active managers like Marylebone are positioned to find stellar stocks whose earnings can cope with rising discount rates more easily than ETF baskets of equities. To build returns, Marylebone invests in third-party funds – as well as direct investments – as do family offices.

Higgins says: “We are selecting assets with top-line earnings power we think will compound earnings meaningfully above discount rates. We do not believe an over-diversified portfolio – including a passive exposure – is going to work. The opportunity for the best active managers to add value is as good as it has been in a decade.”   

Last year, stock-picking helped his Marylebone Lane fund return 19.3% against 13.5% in 2019 and an annualised 6.6% since inception in 2013. Equities managed by Higgins plus team and third-party funds delivered 32% in 2020, double the MSCI World index. Overall, the firm targets volatility two-thirds of the equity market. Fees are a base 1% plus 10% of performance over a 5% threshold.

Since 2013, Marylebone has lost momentum in two years through indifferent trading strategies and premature profit-taking. It has now abandoned trading and allows its equity gains to run for longer. Higgins has taken sole charge of direct investment, going into the 2020 pandemic with risk controls which preserved capital and led to strong returns. 

Marylebone has evolved over the last eight years under the watchful eye of Stuart Roden, who chairs the investment committee. Roden is former chairman of hedge fund Lansdowne Partners, once worked at renowned London-based fund manager Mercury Asset Management with Higgins and Marylebone’s new senior partner, and risk officer, Richard Milliken. 

Co-founder Micky Breuer-Weil, who used to work for Lord Jacob Rothschild’s RIT Capital Partners as investment director, has stepped away. 

Nobody at Marylebone is impressed by the thin yields on offer from government, corporate and junk bonds. Higgins says “Investors are not being compensated for the risk of credit default.”

He is wary of sectors in receipt of excessive liquidity, notably private equity where dry powder currently totals $1.7 trillion: “It feels improbable that it will earn the same returns over the next ten years as it did last year.”

He says liquidity has distorted the price of a range of assets including cryptocurrencies, electric vehicles, smaller shorted stocks like GameStop and work-from-home businesses which will take years to grow into their ratings. 

Marylebone retains external managers in sectors where it needs expertise. It recently invested in mid-market distressed debt managers in a bid to benefit from stress in the loan market which can result from credit shortages. 

The firm uses funds to invest in areas like China, real estate, biotech and Japan. It backs hedge funds but avoids trading and quant strategies. It has co-invested in the odd investment deal but not private equity: “I don’t see what we could add,” says Higgins.

Higgins believes the equity market is facing big distortions when discount rates go up. But he has avoided tactical positions in pro-cyclical stocks, precious metals, index-linked bonds and equity options. He prefers to buy inflation protection, rather than shifting his portfolio too far, given official inflation data remains low. The gathering inflationary storm may not arrive until 2022, after all, and Higgins can only deal in probabilities. 

But economic recovery, stimulus, low rates and the spending of household savings are a potent mix. In the fourth quarter of last year, inflation-driven stocks started to outperform. US Treasuries recently hit a one year high. 

Central banks could bend the yield curve to keep interest rates down. But this kind of situation may not hold. Higgins says: “We’ll have to be mindful of what happens if inflation becomes such a problem that the long-end of the bond market sells off, interest rates go up in a hurry and liquidity gets pulled.”

He recalls this happened in 1994, during the so-called Great Bond Massacre, when the Federal Reserve hiked interest rates to tame inflation: “This is not our central case, but now is the time to think about it.”

He points out central banks have thrown massive stimulus at the markets arguing that moral hazard offered less risk than a Covid-driven crash. Excess liquidity is trapped in the stock market and may remain there. But it is more likely it will enter the underlying economy in a post-Covid spending spree. 

Elsewhere, Higgins finds the value/growth debate banal. He argues that growth stocks can be a “fantastic” value opportunity as long as investors access long-term earnings with rising expectations capable of beating inflation trends.

Marylebone’s directly managed equities have a cash flow yield of 4% projected to grow 15% a year. Higgins manages a fairly concentrated portfolio of 20 stocks.

He seeks a margin of safety between the intrinsic value of stocks and their market price. He accepts ESG is important, but only gets impressed by clean energy stocks with the potential to undercut fossil fuels if they make returns above the cost of capital.  

He denies that the big technology stocks are in a bubble. For him, Microsoft is a quality compounder:  “It’s a company with a free cash flow yield three times a 10 year Treasury, with exposures to an attractive market.”

Spotify is primed to boost its cash flow: “We believe the market could be materially mispricing this stock, which has an incredibly attractive customer base. Unusually, it’s a form of social media you can use while consuming another.”

Global Payments as a quality stock in a fast-evolving market, whose position in its ecosystem will greatly benefit from consumer recovery, particularly in the travel sector.

Pernod Ricard offers access to a top brand with growth prospects and pricing strengths.

Higgins also bets on unloved stocks with potential. Terminix, a pest control specialist, is a more recent purchase following its restructuring, deleveraging and a satisfactory revaluation of its businesses. Whatever the underlying economic conditions, people are unlikely to lose their dislike of pests.