Investment Newsletter January 2015
Premium Bonds? Mike Deverell Investment Manager
“I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” James Carville, Clinton administration adviser, 1993 We’re often told we shouldn’t underestimate the power of the bond market. It can force governments and central banks to change policies. For example, in 2011 the bond yields of certain European governments went through the roof, forcing a writedown of debt in Greece, changes to fiscal policy by European governments and monetary stimulus by the European Central Bank. The bond market has also historically been a great indicator of economic performance. Bond yields have in the past been used to reliably forecast recessions, and
they have historically been a good signal for the future prospects for inflation and interest rates. So what is the bond market telling us now? The current yield on the 10 year UK government bond (or gilt) is 1.64% per annum. This is the rate of interest you could get if you lent money to the government for the next 10 years. A gilt is seen to be as close to a “riskfree” investment as you can get since it is guaranteed by the state. The UK government has never yet defaulted on a loan so short term gilts are seen as essentially the same risk as cash. Longer term gilts are more volatile but are still seen as low credit risk. Very crudely, you could say that because 10 year gilts are yielding 1.64% pa the bond market essentially thinks interest rates are not going to average more than 1.64% for the next decade.
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 January 2015
Premium Bonds cont’d
You could also say that it is telling us to expect very low inflation. The Bank of England is meant to target consumer price index (CPI) inflation of 2% pa. If it was successful then this gilt would be returning a real return of MINUS 0.36% pa. Yields this low therefore would normally imply the Bank are not going to achieve their inflation target.
than expected. It is therefore rational that gilt yields have come down over the past year. This means a gilt investor will have done extremely well, as when yields are coming down it means prices have been going up. Prices have also been pushed up by a reduction in risk appetite, with stockmarkets becoming more volatile and some investors looking for safe havens.
If this scenario is correct then it would also normally suggest a stagnant economy (at best) with little or no economic growth over a decade.
However, yields have come down way too far in our view. Yields are now back to levels we last saw in the Eurozone crisis, where money flooded into gilts and other safe havens like German bunds or US treasuries. Despite some renewed concerned about Greece, we see nowhere near the same level of stress in the global economy and no reason that yields should be so low.
So are these signals from the bond market right and should we be worried? Consider the Bank of England’s last inflation report, issued in November 2014. In this they forecast economic growth of somewhere between 2% pa and 3% pa from now until around 2017. This is in line with long term trends. Inflation has fallen to 0.5% in December, mainly due to the falling oil price. However, the Bank forecasts it will recover to 2% by 2017. With respect to interest rates, at the last meeting seven members of the Bank’s Monetary Policy Committee voted to keep rates at 0.5%, but two are already voting to increase rates by 0.25%. Those that voted to keep rates the same noted a pickup in wage growth and it was implied that if this continued they would vote to increase rates. The information coming from the Bank of England certainly does not support the initial conclusion you might come to from a quick reading of the bond market. Other forecasters are generally giving similar forecasts and the consensus is that rates will increase at some point in 2015. When they do go up they will only do so very slowly, but it seems likely that the base rate could be above the 1.64% that a 10 year gilt yields, perhaps within the next two or three years. It is certainly true that the first rate increase keeps getting pushed back, and that inflation has dropped more
Santa’s Bumpy Ride
We didn’t see a Santa Rally in the end, with the FTSE 100 ending December lower than where it started. However, this volatility gave us the opportunity to buy at a market low, investing typically 3% of client portfolios into a FTSE 100 tracker at around 6,205 on 16 December. We then sold this at around 6,600 on 24 December, little more than a week later. We have now done this twice since October and also have another volatility trade “in play”, having bought at around 6,500. As I write (the morning of 14 January) the FTSE 100 is around 6,450.
We have been avoiding gilts for some time and in the past year this was the wrong call. However, over the next year or two, we think some gilt investors are going to be hit hard. Across the pond, the US Federal Reserve seems likely to put up their interest rates in the first half of this year, if their latest meeting minutes are anything to go by. Once the US starts to put rates up, there’s a good chance the Bank of England will follow, otherwise Sterling could weaken dramatically relative to the US Dollar. Once the first rate increase happens, this may give some gilt investors a nasty shock. We will continue to avoid gilts and have a generally low allocation to fixed interest, preferring property. The fixed interest we do have will remain short dated, which has less sensitivity to rate increases.
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Readers may recall we ran a “guess the FTSE” competition. The FTSE 100 at the end of December was 6,566.10. The winning guess was Dr Dawes who guessed 6,565, just 1.1 points away! May we take this opportunity to wish a happy New Year to all our friends and clients.
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 January 2015
General Economic Overview Global growth has slowed a little with the UK and the US seeing a reduction from the very strong growth levels seen last summer. The falling oil price continues to weigh on certain economies but will provide a boost for others. Cheaper oil led to a reduction of CPI inflation to 0.5% in December, however core inflation which strips out the effect of oil actually rose. The Bank of England will be watching this carefully when deciding whether to increase interest rates. A rate increase is now not likely until towards the end of 2015. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets We still have a positive outlook towards equities with many regions still looking good value. We remain especially positive towards Asia - especially Japan and China - and towards smaller companies in the UK.
+1
Fixed Interest We believe that fixed interest will return significantly less than our neutral 6% pa assumption over the next 18 months. We feel that longer dated bonds yields are too low and should increase, meaning a fall in prices. As a result we prefer shorter dated bonds.
-4
Commercial Property Property is still seeing a lot of momentum and money flowing into the sector, pushing up property prices. We are just starting to see falling vacancy rates and rental increases which will aid the asset class and we retain a very positive outlook.
+3
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future. Rates may increase by 0.25% perhaps in late 2015.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and overweight property, and slightly overweight 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.