Investment Newsletter November 2012
Gilt-y Conscience? Quantitative Easing in the UK has now reached £375bn. This means that the Bank of England has bought £375bn of UK Government bonds.
This amounts to around 31% of all the gilts in issue. To put it another way, the state (Treasury) owes a third of its debt to another state owned institution (the Bank of England). If this didn’t already seem like a smoke and mirrors way of injecting money into the economy, then consider the interest payments. To date, the Bank of England has received around £35bn in interest payments on the gilts that they own. This has basically been sitting in an account at the Bank, going unused. This money is now to be given back to the Treasury. To put it in context, £35bn is enough to pay for the entire UK defence budget for a year. £11bn of this money will be used to reduce this year’s deficit, with the remainder used over the next two years to keep the deficit down. The UK Government is already paying record low yields on its borrowing, just 1.75% over 10 years and only 0.72% over five years. Now, it turns out that a third of that debt is actually “interest free”! Not only that, but many people think the gilts will never be sold again but will just be allowed to “mature”. Some commentators have called for an end to this smoke and mirrors, and for the Government to come clean by just cancelling this debt. However, for now the status quo has been accepted by markets. Whilst things continue as they are, our vast debt remains more than sustainable. Some even believe we should borrow more and invest in infrastructure and other GDP boosting projects. Certainly, debt appears to be an issue for the future, whilst economic growth is a big issue for now. Central bankers and politicians are increasingly looking for more “unconventional” approaches to economics, and this trend is likely to continue for some time. 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 | November 2012
Defined Returns In our last newsletter we explained that we were reinvesting the proceeds from the previous Defined Returns plans into three similar products. The average potential return over the three different plans we have selected is 9.26% pa (not compounded). The first product, with Barclays, began on Monday 12 November. At the close of business on Monday, the FTSE 100 was 5,767. Provided the FTSE is the same or above this level on 12 November 2013, the product will “kick out” and pay a 10% return. If the FTSE is below this level next year, it will roll on to November 2014 and pay a 20% return, if the FTSE is then above the start level. If not, it will roll on another year and so on. If, by 12 November 2018 the FTSE has not been above the start level, the product ends and clients receive just their money back. However, if the FTSE is down by 50% or more at that point, clients lose money in proportion to the fall in the FTSE.
Other Products Our second product, with Royal Bank of Canada (RBC), began on 19 November. The RBC product works in exactly the same as the Barclays one, based on the FTSE 100 only. RBC are not well known in the UK, but have been named in the top 20 World’s Safest Banks by Global Finance Magazine, ahead of HSBC who were 23rd. They are rated AA- by S&P. Because they are deemed safer, and also due to market conditions, the rate offered by RBC was much lower, at 7.5%. The “strike level” of the FTSE 100 was 5,737. The rates offered by banks increase as volatility increases. As we have been in a fairly benign period, we have had to accept lower rates. We still believe this is worth the risk, as outlined below.
Risk and Return Our third and final product is with Credit Suisse, beginning on 22 November. The potential rate of return is 10.3%. This brings the average of the three products to 9.26%. The Credit Suisse product is slightly different in that it is based on the FTSE 100 and the S&P 500 in the US. For this product to pay out, both indices need to be above their starting level. The strike levels of the FTSE was 5,791 with the S&P strike price to be confirmed as yesterday was Thanksgiving. Our analysis showed that a dual index FTSE/S&P product is slightly less likely to kick out in year one with around a 75% chance historically as opposed to 80% with just the FTSE. However, they are more likely to kick out in year two. In total, a FTSE/S&P index product would have kicked out in the first two years 88.7% of the time historically. A FTSE only product would have kicked out
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 | November 2012
in the first two years 88.9% of the time, virtually the same. The chance of loss from the market being down has historically been the same with each product. Both have historically seen no return 4.7% of the time, with neither product having seen a capital loss due to the market element. This analysis is of course based on historic data, and the risks may be different in future. In return for the small additional risks of the dual index product, Credit Suisse would pay us around 1.5% pa more than for a FTSE only product. In our view, this is an excellent risk/reward trade off. Credit Suisse are rated A+ by Standard & Poors, the same rating as Barclays. By another measure of risk, Credit Default Swaps, Credit Suisse are rated higher risk than HSBC and less than Barclays.
Default Risk To our mind the main risks of these investments is not market risk, it is default risk. We have chosen banks we think are relatively secure, with Barclays being deemed the riskiest. It is important that clients understand that these returns are not guaranteed. If the banks go bust, we will lose our money. These products should be thought of as similar to a corporate bond. They have similar default risks as bonds from those same banks, but with generally higher potential returns due to the stockmarket element. It is for this reason that we are only investing a relatively small proportion of your portfolios in these products, and for spreading the risk across three banks.
Christmas Opening Times Although it is still some time away, we thought we should let you know our Christmas plans. The office will be manned by a skeleton staff only from Christmas Eve until 2 January 2013, when we re-open as normal. Please be assured we will be able to react to any market events and answer any urgent queries from clients.
Mike Deverell Investment Manager
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 | November 2012
General Economic Overview We have seen more turbulence with uncertainty over the “fiscal cliff” situation in the US, and renewed concern about Greece. This uncertainty could cloud markets for some time, although we expect both issues to abate somewhat. However, global growth remains muted at best with many Western economies barely growing. We expect more central bank stimulus to keep the economy on track. This could lead to inflation down the line.
Asset class key + positive - negative = neutral (normal behaviour)
+5 -5
strongly positive strongly negative
Equity Markets We remain very positive taking an 18 month view, based on valuations such as the Price/Earnings ratio. We particularly favour the UK and emerging markets.
Outlook
+4
Fixed Interest After a strong run in corporate bonds we have downgraded our view from +1 to -1. Returns are likely to remain positive but should slow down. We are avoiding Gilts whose values have been inflated due to recent risk aversion.
-1
Commercial Property Whilst the rental yield on commercial property remains attractive, this is diluted by high levels of cash in property funds. We are seeing capital losses although we believe that overall returns will probably be positive, but low. However, we don’t believe the returns are worth the risk of investing in property at present.
-5
Residential Property
-5
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, neutral fixed interest and hold no property. 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. 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.
-5