Investment Newsletter August 2018
What now? Earlier this month, the Bank of England put up interest rates to their highest level in almost a decade.
Mike Deverell
A 0.25% increase to 0.75% may not seem very significant, but this is the first time rates have been above 0.5% since they were cut to that level back in 2009. At that time this was meant to be a short term emergency measure as policymakers battled the financial crisis. However, this proved to be anything but short term. In fact, the first move in rates after the financial crisis was actually to cut them further, back in 2016 in the wake of the EU referendum.
Investment Manager
Equilibrium Investment Management
The main reason the Bank feels it needs to increase rates now is that inflation remains higher than its target of 2% pa. This is partly driven by higher commodity prices but, more significantly, the fall in the pound after the referendum is continuing to have an impact.
As the pound fell this increased the cost of imports. Whilst the initial impact is now working its way out of the inflation figures (which are a year-on-year calculation), the pound has weakened again recently. In April the pound was around $1.43 against the US dollar but since then has weakened again to as low as $1.29 in the past few days. This increases the chance of inflation remaining above target for longer. However, the Bank also has to be mindful of the strength of the economy when setting the official base rate. The economy remains relatively anaemic with weak retail sales and business investment continuing to drag down growth. Arguably, the economy can’t stomach much in the way of rate increases. Clearly, a single small rate hike will only have a limited impact on the economy. This will increase the cost of
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter August 2018
borrowing for some households, however fixed rate mortgages have experienced a surge in popularity. Over the same time, mortgage rates have been generally coming down in the past few years.
your money to the UK government by buying a gilt, there is (almost) zero risk they won’t repay your loan. Short term gilts rates are therefore driven mainly by interest rates.
For example, when I moved house two and a half years ago we opted for a variable rate mortgage at 1.25% above base rate. After that two year deal came to an end we moved to a new two year deal with the same provider at 0.79% above base. Even after the recent increase in rates our monthly mortgage payments are less than they were six months ago.
Let’s look at things from a yield perspective. A two year gilt yields 0.75% pa, the same as base rate. A three year gilt yields just 0.78% and the rates don’t go above 1% until we get to five year maturities. We can infer from this that the market is not expecting a further rate hike for at least two years.
Whilst one hike will have limited impact, any further rate hikes would have more of an effect. However the market is not expecting any for some time.
Mark Carney, the Governor of the Bank of England recently said that the market’s “rule of thumb” - which he said was one 0.25% rate hike each year - was “broadly correct”.
One way of assessing the market’s view of future interest rates is to look at the gilt market. If you lend
No deal?
Like the market, we don’t believe we should expect any further hikes soon. In fact, many believe there is just as much chance of rates going down again over the next 12 months as going up.
Whether this is a sensible approach is a matter of debate. One of the best descriptions I have heard about this is that it’s like “dousing your house in water today, in case it catches fire tomorrow!”
In March 2019 we will of course leave the EU. If all goes to Theresa May’s plan, we will then have a transition period before we begin a new arrangement which will see us out of the Customs Union but will avoid a hard border in Northern Ireland.
So would the Bank cut rates in the event of a so-called “disorderly” Brexit, or might they actually go up? Some people think that if the pound fell sharply, as seems very likely in that scenario, they would need to put up rates to prop up the currency.
However, speculation that things won’t go to plan is growing. The other weekend, international trade secretary Liam Fox said that the chance of a “no-deal” Brexit is growing. In fact, he now thinks it is more likely than not, putting the chances at 60-40. Mark Carney also said that the risk of no-deal was “uncomfortably high”. The pound did not react well to such pronouncements and this is the main reason it fell sharply over the last week.
However, this is not what the Bank did after the referendum when the pound fell sharply. Then they cut rates by 0.25% and instituted a new round of quantitative easing. In our view this is the most likely response to a similar shock.
If Carney is as worried as he says he is, then it makes you wonder why he feels now is the time to put rates up. One reason mooted for doing so is that it gives the Bank room to cut rates in the future if they need to do so.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter August 2018
Hedging the risk
We are often asked how we are positioned for the risks of a disorderly Brexit. The short answer is that it would not be desirable or indeed really possible to position explicitly for such an event. It is a very binary outcome and there is no way we could accurately predict what will happen! We can however say what we think might happen given a realistic scenario and plan for each eventuality.
Disclaimer: The content contained in this newsletter represents the opinions of Equilibrium Investment Management. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. The commentary in this newsletter in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.
The best defence against any macro-economic or political shock is diversification. If the pound fell sharply, then our overseas holdings rise in value in sterling terms. We also hold a position in index linked gilts which we think could do well in such a scenario as inflation expectations would likely rise. On the other hand, if we had a smooth Brexit then some of our UK assets could do well. Domestic UK stocks are pretty unloved by international investor and as such there are some possible bargains in this area.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter August 2018
General Economic Overview Whilst the global economy continues to grow, there are some signs that it may be losing momentum. The US has continued to outperform, helped by Donald Trump’s tax cuts. The so-called trade war actually helped the US economy as the Chinese bought American produce ahead of tariffs being introduced. This will likely have a negative impact as the year progresses. In the UK, recent falls in the pound may help keep inflation relatively high. However, we see it very unlikely rates will go up again any time soon given the ongoing uncertainty over Brexit. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Markets remain nervous, in particular in emerging markets where investors are concerned about Turkey. We still see decent value in Asia including Japan, China and India, but are more wary of overvalued US and European equities.
-3
Fixed Interest We have upgraded our outlook for fixed interest where markets have been nervous of rising rates. Given rates have now gone up this could provide a bit more certainty. We continue to prefer corporate to government bonds and hold a small amount of index linked.
-3
Commercial Property Prospects for the asset class remain mixed. We still wish to avoid London offices and much of the retail sector. However, we are more optimistic about other cities and in the industrial sector. Our selective approach limits the amount we are able to invest in property at present.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-3 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest, property and equity. 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 EIM’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 (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.