Investment Newsletter April 2017
Running on empty Last month, 562,337 new cars were registered in the UK. That’s roughly one shiny new car rolling off the forecourt every 4.7 seconds, 24 hours a day, 7 days a week. This was an all-time record for new car sales in the UK and follows on the tail of strong sales growth in the last year.
Neal Foundly Investment Analyst
Indeed, the car market is not the only consumer sector in rude health. In February, month-on-month retail spending grew by 1.4% and on an annual basis, it rose by 3.7%, significantly ahead of forecasts of 2.6%. Online sales rose by a fifth on the previous year.
What’s going on? Well, it is true to say the UK economy is in generally better shape than many predicted this time last year. The labour market is relatively tight and many are likely to feel secure in employment and inclined to
spend more as a result. It is precisely this wave of strong data and positive sentiment that no doubt led to Theresa May’s call for a snap general election in June. Improving economic conditions never hurt in persuading voters to stick with you. Around 60% of UK economic growth is driven by consumer spending and this served to propel growth in gross domestic product (GDP) to a year-on-year rate of 1.9% in the last quarter of 2016. However, the underlying trends are more troubling. Quite simply, UK consumers are increasingly spending more than they are earning. As you can see from the chart on the following page, the savings ratio, i.e. the proportion of income that UK earners save rather than spend, has fallen to a level not seen since the 1960’s (as shown in chart 1).
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 April 2017
What’s going on? Continued
In and of itself, this would not necessarily be a major cause for concern because the rising expenditure tends to drive greater economic growth which raises incomes over time. For example, at the end of February 2017, UK households owed £1.524 trillion up from £1.476 trillion at the end of February 2016 which is an extra £964 per UK adult which would be manageable if the average worker saw their income rise by more than £964 over the year.1 The problem is that the ratio of debt to income is rising. The debt-to-income ratio for UK households peaked in 2008 in the depths of the credit crisis as incomes fell markedly. Subsequently, banks were much more reluctant to lend money and consumers were less interested in taking on credit, with some focusing on paying off existing loans. As a result, the household debt-to-income ratio fell to just over 140%, where it remained until early 2016. More recently, with the acceleration in household debt levels the debt-to-income ratio has risen from 140.8% in Q1 2016, to 143.9% in Q3 2016. 2 Clearly, many consumers are enticed by lower interest rates to borrow more and save less. After all, the Bank of England has signalled that any rate rises will be gradual, and besides, the cash is hardly earning anything in a bank account.
Worryingly, borrowing is rising not only in terms of mortgages but also unsecured lending. The annual pace of growth in unsecured lending, i.e. credit card and personal loans (for shiny new cars), is currently around 10.5%.3 In February alone, credit card debt rose to £67.3bn and is growing at its fastest pace for 11 years. Bank interest rates may be low but the average interest rate on credit card lending bearing interest is 18.48%, 18.23% above the base rate of 0.25%.4 Borrowing more on a credit card is fine if your income is growing faster than 18.5% but in reality average earnings growth in the UK is currently 2.3%. Another factor to consider is inflation. Inflation can be both a positive and a negative. Because debt is fixed in amount, its real (after inflation) value can fall over time as the rate of price rises increases. Conversely, however, it also has the effect of eroding the purchasing power of incomes as the prices of goods and services rises, often above the rate at which wages grow. At the moment in the UK inflation (consumer price index) is running at 2.3% which means real wage growth is pretty much zero. This is borne out in the recent figures showing that consumers are starting to spend less on the non-essentials in order to afford the rising prices of the basics such and food and energy (much of which is imported). Meanwhile, a 2.3% rate of inflation will hardly cause a dent in credit card debt growing at 10% and charging 18.5%.
Percentage
Chart 1: UK household savings ratio
Year
Source: www.tradingeconomics.com
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 April 2017
How does this inform us in terms of investments?
For several months we have been cautious on UK equities given the valuations for the market. Valuations can be deceptive because if growth comes through stronger than expected then the true valuation can be lower and we may miss out on good returns as share prices rise. This is why we put a lot of effort into scratching below the surface to see the underlying factors driving the market. As you can see from the figures above, our conclusion would be that a key driver to UK GDP growth (and UK company earnings) in the form of the current high level of consumer spending is not sustainable. Yes, consumers can continue to borrow and we are pretty sure the banks or Visa or Mercedes Leasing will lend it to them. But it is not sustainable at this pace.
These investments, along with many other ‘real’ assets in the model portfolios, serve to protect clients’ assets against the many possible different scenarios for inflation – whether it be stagflation, hyperinflation or even Trumpflation. Although inflation has not notably accelerated so far this year, the returns from both these investments have been ahead of our expectations as investors have sought these assets. This gives a flavour of some of the themes that inform our recent investment decisions. Don’t get us wrong, we are not pessimistic and as the inflation examples show, we can find good opportunities to drive returns in this economic environment. Instead, we believe in being honest with the facts and when something looks unbelievable or unsustainable, it probably is.
What if we are wrong? What if consumers get the ‘feel good’ factor and UK economic growth forges forward? In this scenario, the Bank of England is likely to raise interest rates. This may be an unfamiliar situation for many mortgage holders because, after all, it has been over a decade since the last one but it is worth remembering that a 1% interest rate rise for an interest-only mortgage on an average house (£217,502) would raise monthly payments by over 23%. Set against moderate pay growth, this would, again, serve to apply the brakes to the spending spree. Hopefully this gives you some insight into our thinking for UK equities and some of the background for our caution. Inflationary pressures have been in evidence, particularly since last year’s Brexit vote served to lower the value of sterling and thereby raise the price of imported goods and services. As we highlighted above, inflation can reduce the value of debt over time which can be a good thing, but if you hold debt, as we do in the bond portfolios, then this can reduce returns. In anticipation of this, after the Brexit vote last year the decision was made to invest in a fund of indexlinked bonds that pay a coupon that increase with a rise in inflation (and vice versa). Similarly, last November we bought into an infrastructure fund that focuses on assets that have their revenues linked to the rates of inflation.
References 1 http://themoneycharity.org.uk/money-statistics/ 2 http://researchbriefings.files.parliament.uk/documents/CBP7584/CBP-7584.pdf 3 http://www.telegraph.co.uk/business/2017/03/29/three-chartsshow-britains-borrowing-binge-isnt-growth-credit/ 4 http://www.credit-connect.co.uk/consumer-news/march-2017money-statistics-2/
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 April 2017
General Economic Overview The momentum of global economic growth has been maintained in recent months although there is little evidence to indicate any acceleration in output growth. Markets had pinned a lot of hope that President Trump’s campaign promises, such as infrastructure spend and lower tax rates, would drive higher growth. However, early attempts to implement some of
his proposed policy changes have been successfully challenged and forecasters are starting to moderate expectations. In the UK, inflation has been stoked by the weak value of sterling since the Brexit vote, although it has rallied following the Prime Minister’s call for a snap general election. In this light, we would not expect the Bank of England to raise interest rates in the near term.
Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Unchanged over the month, our score of -5 reflects our view that many equity markets are fully or over-valued. In relative terms, our valuation indicators point to better value in markets like Asia including Japan.
-5
Fixed Interest The score is unchanged from last month. Higher energy and commodity costs are driving up inflationary expectations and providing headwinds for bond returns. We continue to hold some indexlinked gilts but otherwise prefer corporate bonds.
-3
Commercial Property We expect most the returns from property to largely comprise of the rental yields with little in the way of capital growth. Brexit raises particular issues for the London office market and we are therefore avoiding this part of the market.
-3
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 only a small amount of 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, 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. 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.