Investment Newsletter August 2015
Interesting Rates Mike Deverell Investment Manager
On the face of it, interest rate decisions are not necessarily that interesting! For example, the Bank of England’s Monetary Policy Committee (MPC) recently voted to keep the base rate on hold at 0.5%. It has been 0.5% since March 2009 more than six years ago - and during that time there have been 78 MPC meetings without changing base rate. This decision was hardly unexpected! However, looking closely at the meeting minutes and the inflation report they released the same day, it is clear the committee believes the economy is pretty robust. Normally, they would consider increasing rates when the economy is doing as well as it is at present. However, the MPC’s mandate is not economic growth but rather it is to deliver 2% pa inflation (based on the consumer prices index or CPI).
CPI inflation remains at zero. Partly this is a result of falling oil and food prices, however there has been a broader slowdown in prices. Core inflation which strips out food and oil is only at 0.5%. Given the Bank’s remit they can’t consider increasing rates with inflation so low, as this could risk tipping us into unhealthy deflation. The Bank has made it clear they don’t expect inflation back to target until the end of 2016 and so it seems clear they won’t put rates up soon. The market is now pricing a 0.25% rate increase in perhaps May next year.
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 2015
Fed not so reserved
On the other side of the Atlantic it seems a different picture. Most economists believe the US Federal Reserve will make the first increase in rates at their September meeting. As I highlighted in a recent blog (http://eqllp.co.uk/blog/ fed-watching-analysing-central-banks ), the language that central banks use when discussing monetary policy is very carefully crafted. Professional “Fed watchers” dissect every word in an attempt to second guess their decisions. For example, compare the two statements from the Fed’s last two meetings:
July: “The Committee anticipates it will be appropriate to raise rates…when it has seen some further improvement in the labour market…” The only difference between the two statements is the addition of the word “some”! However, this has been taken by the market to mean that, unless employment data is particularly bad, rates will go up in September. A number of Fed committee members have since made it pretty clear they intend to vote for a rate increase in September, dependent on the data.
June: “The Committee anticipates it will be appropriate to raise rates…when it has seen further improvement in the labour market…”
Does it matter?
So why should we care about what a central bank in another country does with their interest rates? The US is of course the largest economy in the world and so what they do has an impact globally. In particular, the dollar is the world’s reserve currency. A strong economy and the prospect of rates going up means a strong dollar. A strong dollar has a number of implications, in particular on the price of commodities. Most commodities are priced in dollars and so when the dollar is going up it often means commodity prices fall in response.
However, in many emerging markets the impact of a strong dollar is greater. Many peg their currency to the dollar in some shape or form. A strong dollar makes these countries less competitive as their own currency will have risen too, making their exports more expensive to anyone outside the US. The dollar is only one reason that commodity prices have fallen. The world’s second biggest economy is China and it has seen much slower growth of late. It is also cutting back on infrastructure spending whilst attempting to rebalance its economy to a more consumer led one. This reduces demand for commodities across the globe. Those emerging economies that are primarily commodity exporters have felt a double whammy effect of a strong dollar and falling demand from China and their economies have suffered as a result. All this even has a knock on effect to the FTSE 100. As noted before, whilst notionally it is a UK index much of the earnings actually come from overseas. In particular, some very large oil and gas producers as well as a significant chunk in mining stocks, all of whom have seen their profits hit of late.
For example, Brent Crude Oil is now around $45 a barrel having been give or take $100 a barrel a year ago. In dollar terms it is down 55%.
We live in an increasingly globalised world where everything is interlinked, so an apparently small change in one country can have an impact worldwide.
Over the same period the dollar has strengthened by 7% against the pound, a relatively small move as sterling has been another strong currency over that period. However, against other currencies it has moved much more, up 21% against the euro for example. This means the deflationary impact of falling oil price is lessened in the Eurozone.
Strangely enough, the strong dollar is one of the reasons the Fed might NOT put rates up quite yet. In addition, China has recently devalued its currency which adds further disinflationary pressures to the global economy, as their exports become cheaper. Therefore, merely the prospect of increasing rates in the US has caused events which might put them off increasing rates!
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 2015
Investment implications
The two strongest economies in the world are currently the UK and the US. Unfortunately, the US stockmarket is pretty expensive. In the UK, whilst the FTSE 100 doesn’t look cheap, there seems more value in smaller companies. These also have more exposure to the domestic UK economy and less exposure to commodities. We already have decent exposure to these stocks and are looking to increase this in certain portfolios. In emerging markets, we much prefer the Asian economies which by and large are commodity importers rather than exporters. Strong US growth also helps these economies sell their exports in the States. This includes China as, whilst the economy has slowed we still feel the stockmarket looks good value. The relationship between economies and stockmarkets is complex and it is not as simple as economic growth = profit growth. We have to pay attention to the macro picture, but the key driver of returns with any investment is the price you pay. As a result, we focus much more on the valuation and how expensive an asset is relative to the long term or to other asset classes. In general we see reasonable value within equities but being selective is more important than ever.
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 2015
General Economic Overview The global economy has slowed with emerging market growth anaemic at best. The UK and US remain the best performing regions in economic terms. Japan and Europe have been buoyed by quantitative easing but remain reasonably weak. Inflation is likely to remain low for some time and a change to interest rates in the UK is unlikely until next year. US rates are likely to increase before the end of 2015. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class Equity Markets Our equity score is neutral which means we expect somewhere in the region of 10% pa over the next 18 months. We still favour Japan, Asia and smaller companies in the UK.
Score
=
Fixed Interest Our score is -3, slightly up on last month, which means we expect in the region of perhaps 4% pa over the next 18 months. We prefer corporate bonds to government bonds and shorter dated bonds to long dated.
-3
Commercial Property Commercial property returns have slowed after a very strong 2014 and we have reduced weights recently. We have reduced our score to -2 after previous positive scores, meaning we expect perhaps 5.5% to 6% pa. Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-2 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and neutral property. We have a neutral equity weight together with additional holdings in defined returns and alternative equity. 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.
The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
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.