Investment Newsletter August 2016
Emergency measures? Mike Deverell Investment Manager
In March 2009 the Bank of England cut its official interest rate to a then record low of 0.5%.
easy money to banks on the proviso they lend it to consumers and companies.
At the same time as doing so they announced stimulus known as quantitative easing (QE). These were seen as emergency measures in the depths of the financial crisis, designed to stop the UK plunging into a deep depression.
The size of this package shows how worried the MPC is about the UK economy after the recent vote to leave the European Union.
At that time, few would have predicted that seven years later that interest rate would still be at those emergency levels. Fewer still would have predicted that the next move to rates was to drop them even lower. At its August 2016 meeting the Bank’s Monetary Policy Committee (MPC) cut rates to 0.25%. They also announced more QE allowing the Bank to purchase up to £70bn of gilts and corporate bonds, as well as providing
There has been some criticism that the likes of the Bank of England are “talking the economy down” by setting out their concerns so explicitly. After all, “Brexit” hasn’t yet happened! However, in our view it is right that they take pre-emptive action rather than waiting for a possible recession before acting. Recessions take hold not just because of what is happening but also concerns about the future. Businesses become cautious and hold back on investment.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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 August 2016
Unfortunately there is already strong evidence that this is happening. For example, the Bank of England employs numerous “agents” who travel around the country and visit businesses to find out their intentions. The latest agents’ report displays a worrying trend. The table opposite summarises some of the results. More than half of businesses are planning to reduce capital spending and hiring. A majority expect turnover to be lower after the referendum. Given such evidence, the Bank is right to act now.
Source: Agents’ Summary of Business Conditions, August 2016 Update – Bank of England
Effective action?
So will this work? Reducing interest rates is meant to stimulate the economy by making loans and mortgages cheaper, thereby encouraging borrowing. It is also meant to encourage us to go out and spend our savings, or invest them into higher yielding assets. However, arguably those who were going to spend or invest their savings will have already done so, and a 0.25% cut in even a very large mortgage only makes a small difference. However, the effect of the rate cut and especially QE is also to push up asset prices. QE works by the Bank of England “printing” money which they then use to buy gilts and now corporate bonds. With a new, large buyer in the market this tends to increase the price of those bonds. Prior to the referendum the yield on a 10 year gilt was around 1.5%. Before the rate cut and QE was announced it had already fallen to around 0.75%. Since the announcement it has fallen as low as 0.52%.
However, this is a very inefficient way of stimulating the economy and benefits mainly the wealthier. In order to really provide assistance to the real economy, the government seems likely to go out and spend directly. The drop in gilt yields means the government can currently borrow money for 10 years at not much more than 0.5% pa. They can borrow over 20 years at little more than 1% and over 30 years for less than 1.3% pa. Many businesses would look to borrow at these rates as they would feel confident of making a return well in excess of the cost. There is an increasing consensus that governments should do the same. Infrastructure projects which could potentially prove a significant boost to the economy far in excess of the borrowing cost, are likely to be the main beneficiary. We will be watching the Autumn Statement very closely, as chancellor Phillip Hammond has already said he will use this as an opportunity to “reset” the government’s economy policy.
The theory is that by pushing up prices and thereby lowering yields, this has a knock on effect on other assets like property and equity as their yields look more attractive by comparison. Inflating prices makes investors richer, and the Bank then hopes this has a “trickle down” effect by making us more likely to spend elsewhere.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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 August 2016
Investment returns
So what effect has all this stimulus had on investments? Our fixed interest portfolio has benefited greatly with one fund, a corporate bond tracker fund, up almost 10% since before the referendum. The index linked gilt fund we purchased a few days after the result has made more than 8% since purchase. The stimulus has also had a knock on effect to stockmarkets with the FTSE now over 6,900. A typical balanced portfolio is now up over 5% since the day prior to the referendum. This is great news for investors in the short term. However, as prices continue to rise in many asset classes there are several that now appear pretty expensive. Whilst we are happy to take the gains as they come, we are remaining cautious as the danger of a pull back has increased in our view.
We have made one purchase in most portfolios since our last newsletter, which is a new defined returns product with Societe Generale (known as “Soc Gen”). This product was set up on 26 July when the FTSE was 6,724. If the FTSE is above 6,724 on 26 July 2017 the product will end and pay out 9.6%. If not, it rolls on until its second anniversary where if the FTSE is then above 6,724 it will pay out 9.6% x 2 (19.2%), and so on for up to six years. If the FTSE has not been above its starting level on any of the first six anniversaries then the product will simply pay a return of capital, unless the FTSE is down 40% or more on 26 July 2022. We think these products are a good way to play markets when we believe the value is less compelling than usual. We don’t need the market to go up to make the return, we just need it not to go down. The recent Morgan Stanley product is a great example of this, where the FTSE rose from 6,667 to just 6,728, but the product kicked out at a 9.7% return. Even so, we have typically only invested 2% into this product for now and will look to purchase more (or a new product with a different bank) should the market drop back. These products are subject to credit risk and so if Soc Gen were to go out of business we could lose our capital. Whilst a few years ago we may have been more concerned lending money to a French bank, they are now rated much stronger than Barclays or Credit Suisse who we also use for similar products. However, credit risk is the reason we limit investments to only a small part of portfolios. If you would like more information on defined returns please speak to your usual Equilibrium contact.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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 August 2016
General Economic Overview The outlook for the global economy remains fairly robust, if unspectacular, with most regions showing weak but positive economic growth. The exception is the UK where business surveys point to a slowdown following the vote to leave the EU. The pound has fallen sharply since the vote and this may well cause some short term inflation. The Bank of England is not concerned about this and is more concerned about stimulating the economy through a rate cut and quantitative easing.
Asset class key + =
positive negative neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets After some very strong returns our score for equities is now -4, meaning we expect stocks to underperform over the next 18 months. That does not necessarily mean we think they will fall but that growth may be weak. Within equities, Japanese and Asian markets still look the best value, with the UK and US looking particularly expensive.
-4
Fixed Interest Given the prospect for low interest rates or even falling rates for some time, fixed interest could continue to do well. The yield on corporate bonds still looks relatively attractive compared to cash and gilts and as such we could potentially see some reasonable returns, though below our long term expectation of 6% pa.
-1
Commercial Property Commercial property prices have already fallen in response to the referendum vote. Last month our score was -5 but given the price falls we have upgraded to a -4 score. For now we will remain out of the asset class but will reconsider if this stabilises further.
-4
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and equity, and hold no property. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
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, 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. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. 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. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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.