Investment Newsletter February 2012
Riots, Fear & Greed The European debt crisis continues to rumble on, with the Greek parliament finally agreeing more spending cuts, despite riots on the streets. Implementing these cuts will be difficult given the weight of public opinion. In addition, with elections likely later in the year, this is not over yet. However, as we keep reiterating, Greece isn’t really the problem. The main cause for concern has been the effect the sovereign debt crisis has had on the banking system. In the second half of last year, we saw credit crunch-like conditions in European banks. They virtually stopped lending to each other, becoming wary of what other banks were holding on their balance sheets. This was reflected in the “Euribor” rate – the interest rate that banks charge each other for lending. A higher rate indicates a reluctance to lend. The chart below shows how this changed last year:
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Month
As you can see, the rate at which banks can borrow from each other rose during the first part of 2011, before coming down sharply in the past few months. The European Central Bank has restored confidence to the system by effectively committing to lending banks virtually as much money as they like for up to three years. This has “unfrozen” the banking system and vastly reduced the likelihood of a major bank going bust in the next couple of years. This restoration of confidence in the banking system is what has allowed equity markets to move higher, despite the ongoing uncertainty in Europe.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Services Authority. Equilibrium Asset Management is entered on the FSA register under reference 452261. The FSA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission
Investment Newsletter | February 2012
Equity Outlook In our last newsletter we highlighted that, ignoring all the news coming out of Europe, equities look extremely good value based purely on earnings. The UK market has a Price/Earnings ratio of around 11, below the long term average of 14.1. We have carried out some research into the returns we have seen in the past given different levels of P/E ratios and we hope this gives you some insight into our decision making. Each blue dot on the chart below shows a different five year period of returns of the FTSE Allshare Index, since 1985. Along the horizontal axis is the P/E ratio at the start of the five year period. The further to the left, the lower the P/E. On the vertical axis is the annualised return of the Index over that five year period – the higher the dot the higher the return:
This shows there is a strong correlation between a low P/E ratio and a high return. There are only a few occasions in this research period where the P/E has been as low as it is currently. As you can see on the chart, when P/E ratios have been this low in the past we have seen some very high returns over the next five years. For example, the four periods circled in the top left hand corner began with P/E ratios similar to the current level. Each period saw returns in excess of 15% pa over five years. P/E ratios normally only get this low in times of great uncertainty. We’re forever quoting Warren Buffett, but right now one of our favourite quotes of his springs to mind:
“Be fearful when others are greedy, and greedy when others are fearful.” We believe that it is time to be “greedy” with regard to equities.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Services Authority. Equilibrium Asset Management is entered on the FSA register under reference 452261. The FSA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission
Investment Newsletter | February 2012
Fearful... Turning to UK gilts, we believe now might be the time to be “fearful.” The recent turmoil has seen investors search for safe havens, and have therefore bid up the values of UK government bonds. Using simple mathematics, we can say with complete certainty, that most investors in gilts are likely to experience capital loss at some point in the near future. We just don’t know exactly when. We can illustrate this using the gilt which matures in March 2022; just over ten years’ time. This has a “yield to maturity” of just 2.03% per annum. The yield to maturity is calculated by adding together the interest you will receive during the life of the bond (currently 3.39% pa), with the capital gain or loss when it matures. Currently, this bond is priced at £117.95. When it matures, investors will be paid £100. This means they will lose £17.95 – a 15.2% loss - at maturity. Not only do we know there will be a capital loss at maturity, we can also say that it will likely happen much earlier. Your total return if you buy this bond at these levels is circa 22% (2% pa for 10 years). However, the annual interest is 3.39% pa. Divide your 22% total return by 3.39% pa and we can calculate that you will have received ALL the return from this bond in 6.5 years; after that it’s pure loss. More likely, we believe that a capital loss will happen (at the latest) when interest rates are increased, or when the market believes they are going to increase. This bond will be VERY sensitive to interest rate moves.
Fundamental Approach We are forever saying that we cannot predict the future. We don’t know exactly what is going to happen and we don’t know when. However, we can look at fundamentals and make some educated assumptions. To summarise: • In previous instances where the P/E ratio on the UK equity market has been this low, we have seen high returns in the next five years • If you invest in UK gilts you will at some point make a significant capital loss Given these two facts, we hope you will understand why we are continuing to avoid gilts and are overweight equities, especially the UK. This may lead to more volatility in portfolios than normal, but we believe it will also lead to some great returns. Equilibrium Asset Management LLP Brooke Court Lower Meadow Road Handforth Dean Wilmslow Cheshire SK9 3ND United Kingdom Visit us at www.eqasset.co.uk t : +44 (0)161 486 2250 f : +44 (0)161 488 4598 e : askus@eqasset.co.uk Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Services Authority. Equilibrium Asset Management is entered on the FSA register under reference 452261. The FSA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission
Market Views | February 2012
General Economic Overview Global economic growth is likely to remain muted. However, the improving picture in the US and emerging markets should mean growth will remain positive. We believe the UK will just about avoid a recession, but recession is very likely in the Eurozone. Interest rates are likely to remain low for the next 18 months at least. European issues will continue to concern markets for some time causing occasional bouts of volatility. Inflation may fall back in the short term but we remain worried about it in the long term. Asset class key + positive - negative = neutral (normal behaviour)
+5 -5
strongly positive strongly negative
Equity Markets Equity markets have moved strongly upwards as the risk of a banking crisis recedes. Despite the rally, equities remain very undervalued relative to history on both a price/earnings and price/book ratio basis. We particularly favour the UK market.
Outlook
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Fixed Interest Inflation and interest rate risk has receded for the short term. Corporate Bonds still provide reasonable yields and could do reasonably well in this environment. We are avoiding Gilts whose values have been inflated due to recent risk aversion.
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Commercial Property Whilst the rental yield on commercial property remains attractive at over 6%, this is diluted by high levels of cash in property funds. We can foresee some capital losses although we believe these will be small and that overall returns will still be positive.
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Residential Property
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We believe prices are likely to remain flat over 18 months. Cash With interest rates remaining at record lows, returns on cash could remain below average for some time. However, there is a short term safe haven appeal. Balanced Asset Allocation For a typical balanced portfolio we are overweight equity and cash and underweight the other asset classes. Based on our above scores and current tactical positions we’d expect a Balanced Asset Allocation (excluding client cash) to return approximately 8.1% pa rather than the normal 8%pa.* A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall. * Includes Defined Returns holdings. See previous briefings for details. These represent Equilibrium’s collective views. There are no guarantees. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.
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