Investment Newsletter December 2018
Santa goes skiing This past week in the office we’ve been debating ‘what is the opposite of the Santa rally!?’ For those who are unaware, the Santa rally is a (perceived) market phenomenon where shares tend to rise in the run up to Christmas.
Mike Deverell Investment Manager
Unfortunately, this year Santa seems to have lost his sleigh and has decided to go skiing downhill instead! In the past week markets have fallen sharply with the FTSE 100 falling to as low as 6,700 on 6 December. That is roughly 15% down from its peak (in price terms) of around 7,900 achieved earlier this year.
True, this has been compounded by fears over trade especially after the arrest of the Chief Financial Officer of Huawei, one of China’s leading technology firms, at the request of the Americans. Stocks have also been hit by rising interest rates in the US, as well as by the Federal Reserve’s “quantitative tightening” (QT). This is essentially the opposite of quantitative easing (QE) where a central bank prints money and uses it to buy bonds. Under QT, when a bond matures the Fed takes the maturity proceeds and “cancels” the cash (or whatever the opposite of printing money is – rubbing it out?).
Equilibrium Investment Management
So, who or what is the Grinch that stole Christmas this time around? As is often the case, there are several contenders but for us the current front runner is “growth”. Or rather, worries about a possible lack of growth in the next year or two.
These factors only add to worries that economic growth may soon begin to stall.
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 December 2018
Warning signs
We’ve written before about the yield curve, and why it can be a good indicator of future economic growth. Right now, the signals from this indicator are somewhat worrying. This is where it gets slightly technical… The yield curve takes the yield (or interest rate) on a range of government bonds of different maturities and plots them on a chart. Normally, the longer the time to maturity, the more interest you get paid for holding a government bond. You therefore usually see an upward sloping curve. However, there are times when the curve “inverts” and slopes the other way. When that happens it means that the yield on short dated bonds is higher than the yield on longer dated bonds. Historically, when this occurs a recession often follows several months later. The yield curve in the US has just inverted. Or at least, the middle part of the curve has. A five-year US government bond now yields less than a two-year bond. This reflects the market’s expectations that interest rates are near their peak and may need to be cut in the future. And a cut in interest rates usually only happens when an economy begins to slow.
indicator. Most investors use the spread between the 10-year yield and that of the two-year bond. This is still showing a positive figure (just). Chart One shows the two different indicators over history. The blue line shows the difference between the 10 and two-year bonds and how it has changed over time. The black line shows the difference between the five and two-year bonds. Each grey shaded area is a recession. Typically, the 10 to two-year spread inverts before a recession. However, the five to two-year spread tends to invert before the 10 to two-year. In many ways the five to two-year spread is therefore a good predictor of a recession. The US is the world’s largest economy and so if it goes into a downturn, the rest of the world will follow. On top of this there are already concerns about growth in emerging markets (especially China), whilst in Europe we have Brexit amongst various other issues to worry about.
To be clear, the difference (or spread as it is known) between the five-year and the two-year yields is not the one which most people use as their recession
Chart 1: Yield curve behaviour for two, five and ten-year bonds.
Recession
5y - 2y yield
10y - 2y yield
Source: Capital Economics / WSJ Daily Shot 7 December 2018
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 December 2018
Bah humbug
This sounds like a pretty gloomy outlook for a Christmas newsletter, so I’ll try to add a bit of cheer. Firstly, if there is a downturn then we think the odds are that it will be relatively shallow and/or short lived. That is because we have hardly seen an exuberant period of high wage inflation and runaway growth. Rather, what we have seen is a long period of relatively sluggish growth (at least outside of the US where Trump has added further stimulus). In general, the stronger the rise the sharper the fall (and vice versa). Secondly, investment markets are very much forwardlooking. The recent corrections have already factored in this less rosy outlook and have actually made many stock markets look decent value in our view. We are
The other Grinch that stole Christmas (or at least made it more expensive)
Some more Christmas cheer for you. According to Mintec, a data analysis company, the wholesale cost of a Christmas dinner is 20% higher than it was last year. The combination of freezing temperatures during the “Beast from the East” storm, followed by record high temperatures in the summer, has hit vegetable yields. The weak pound has also increased import costs of things like turkey fees and wheat prices. However, don’t despair. The biggest jump in prices is for Brussels sprouts which have increased 70% in 12 months. If we just make a minor sacrifice and avoid sprouts (which I’m more than happy to do) then the impact isn’t quite as bad.
therefore much more optimistic about returns going forward than we were 12 months ago, despite the more difficult economic picture. There is of course the potential for additional shocks to the system, not least from Brexit for us here in the UK. Much as I would like to offer some meaningful comment on Brexit, given how fast the situation is moving by the time I have written anything down it is out of date! Suffice to say we are wary of the risks, however many investments now look somewhat cheaper than they did before, and that tends to mean a higher return.
We wish all our clients and friends a fantastic Christmas and hope for a more positive start to the new year.
Disclaimer: The content contained in this newsletter represents the opinions of Equilibrium Investment Management. The value of your investments will fall as well as rise and you may not get back the value of your initial investment. 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.
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 December 2018
General economic overview Whilst the global economy continues to grow there are signs that the pace of growth is slowing. In the UK, Brexit dominates the landscape with the prospects for the economy, the pound, inflation, and interest rates all highly linked to the eventual outcome. Markets are pricing in a roughly equal chance that the next move in UK rates will be down rather than up. Although the US Federal Reserve has indicated they may put rates up a few more times, they are likely getting close to the peak during this economic cycle. The trade war with China, if it continues, is as harmful for the US economy as it is for China.
Asset Class Equity Markets After the recent sharp falls, most equity markets look fair value and in many cases actually quite cheap. The exception is the US which still requires strong growth to justify prices. We prefer Japan and other parts of Asia. The UK market is now good value in our view but will remain volatile for some time.
Fixed Interest Bond returns are likely to be positive but unspectacular in our view. If economic growth continues to slow this could cause issues for poorly rated corporate bonds in highly indebted companies. We hold a mixture of corporate and government bonds, including some inflation linked debt.
Commercial Property We are concerned that the poor outlook for the retail sector will impact on many property funds. We have deliberately chosen those with lower retail exposure and more exposure to prime offices (outside London) and industrial units which benefit from the move to online shopping. We are cautious about the outlook and remain underweight given Brexit risks.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and property, and slightly underweight traditional equity. This is balanced by additional holdings in defined returns and alternative equity, giving a risk/return profile of slightly above our average position.
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 (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.