Investment Newsletter December 2016
A close run thing You couldn’t get much closer… Our Barclays defined return product reached its second anniversary on 2 December 2016. Had the FTSE 100 closed at above 6,742 on that date, the product would have “kicked out” and the return over the two years from launch would have been 18.3%. Of the 54 trading days from 16 September to 2 December the FTSE had closed above 6,742 on every day but one. Only 11 November saw a close below this level during the period.
Mike Deverell Investment Manager
However, on 2 December the FTSE ended at 6,730, just 12 points below the required level. Our frustration has been compounded as (to date) every day since then has also seen the index finish above this level. Talk about unlucky! Having not kicked out this year the investment now rolls on to its third anniversary. On 2 December 2017 it will go through the same process and if the FTSE is
then above 6,742 the product will end with a return of 27.45% from launch (three times the initial rate of 9.15%). The same happens at each anniversary up to its sixth year with the potential return continuing to increase by 9.15% each anniversary. On 2 December 2020 the product will end, if it has not done so beforehand. If the market is down but less than 40% below the strike level, the final price would be the same as the initial price of £1.00 per share. Investors who bought at outset would therefore get their money back. If the FTSE was 40% or more down on that date the product would fall by the same amount. However, we don’t have to wait for an anniversary date to sell the product. Whilst the price of the investment would have been £1.183 per share had it kicked out, having not done so the price has now fallen back to around £1.12.
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 December 2016
We are of course disappointed that the product has not kicked out, but a return of around 12% in two years is still a pretty good outcome. As the Chart 1 shows, even if we account for the dividends you would have
received by investing directly in the FTSE 100, the product has still outperformed the index.
Chart 1
A- Barclays Wealth- FTSE Autocall November 2014 Edition 12.58% B- FTSE 100 TR in GB 10.59%
Dilemma…
Having not kicked out, we are left with a dilemma. If we continue to hold then the product could return around 15% from current price should the FTSE be above 6,742 on its third anniversary. However, if it takes two years before we get kickout the annualised return would drop to around 10.5%, which is a lower return than we could get by setting up a new defined returns product instead. If the Barclays investment kicks out in four years the annualised return would be 8.7% pa. With a market price of £1.12 and the “capital protection” level being £1.00, there is also now a greater chance of a loss by continuing to hold. We also have to remember why we bought the product in the first place. We initially bought it because we were unconvinced by the prospects for fixed interest and wanted an alternative asset to bring diversification to the portfolio.
02/12/2014 - 07/12/2016 Data from FE 2016
Over the long term we expect fixed interest to return around 6% pa, so over two years the defined returns product has essentially returned what we wanted it to. As you can see, there are pros and cons of holding or switching to a new product. The downside of striking a new product is that the market is now above 6,900 and we would prefer to set one up at a lower level if possible. Unfortunately, the right course of action cannot be known in advance and we have to weigh up all the risks and potential rewards. Given the uncertainty surrounding this decision we have decided to hedge our bets and sell 50% of Barclays for now. Initially, we have sold this to cash with a plan to reinvest this into a new product. However, we will not rush into doing so at these market levels but are happy to wait for a dip.
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 December 2016
A note of caution‌
One reason for our caution in reinvesting the money is because, all of a sudden, many other investors are being very optimistic!
view. For example, the US market is trading on a multiple of 23 times the earnings of the companies, well above the long term average of around 16 times.
We are not being contrary for the sake of it, but there is a danger that markets are getting ahead of themselves. Investors have decided that the election of Trump means there will be big fiscal stimulus, which in turn will lead to higher economic growth and rising company profits.
The UK market trades on around 19 times earnings, above the long term average of 14. Chart 2 shows this price/ earnings ratio on the UK market going back to the late 1960s. The market has only been at or above these levels in four previous periods; for an extended period during the dot com bubble in the late 90s and early 2000s, and for a very short time on three other occasions.
Whilst the global economy is doing well at present, this is more than reflected in stockmarket valuations in our Chart 2 - UK Market Price/Earnings
Given this level of valuation, we would not be surprised to see a pull back at some point in the near future and we are generally holding less equity than normal as a result. Of course, we could well be wrong and markets could carry on rising. However, to sustain this level of valuation for long we think we would need to see significant growth in profits coming through. Profits are generally beginning to improve after a sustained period of falls, but right now we have not seen any evidence to say this growth will be as strong as the markets currently seem to expect. It is also worth remembering that in virtually every 12 month period there is a fall of at least 10% at some point, even where the market ends the year ahead.
To be clear, we are not massively negative on the markets and are not predicting a crash, we just think some caution is warranted. The Federal Reserve has just put up interest rates for only the second time in a decade. The first time was in December last year, and this contributed to a very difficult period in markets at the start of 2016 in our view. The global economy is much stronger than this time last year and so a repeat seems unlikely, but a strong dollar (which often results from rising rates) has historically led to issues in commodities and some emerging markets. Despite our caution, we do believe that a dip in markets would be a buying opportunity.
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 December 2016
General Economic Overview Economic data remains robust across most of the world. Since the US election Trump expectations of infrastructure investment are very high and many are expecting higher inflation as a result. This would likely result in an increase in interest rates in the US at least. Given the weakness of Sterling inflation is likely to increase sharply in the UK but we expect the Bank of England to keep rates at low levels for some time.
Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Equity markets have performed strongly recently and as a result look generally more expensive than they did last month. However, with economic growth prospects improving we maintain our -3 score. We continue to believe that Japanese and Asian equities offer the best value in relative terms.
-3
Fixed Interest Our score has fallen from -2 to -3 since last month given the potential for rising global interest rates which is having a knock on effect on bonds. We continue to hold some index-linked gilts but otherwise prefer corporate bonds.
-3
Commercial Property Our score remains unchanged from last month. Rental income remains attractive but we do not expect capital growth. We remain light on property for now as we would prefer to keep London exposure to a minimum.
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 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.