Investment Newsletter January 2018
New year, new trends? Time is an odd thing. Over the Christmas break, I found out why Spaniards eat so late in the day - bearing in mind that most of Spain is on the same longitude as the UK, why aren’t they in sync with us?
Neal Foundly Investment Analyst
Popular lore has it that this is due to the weather and higher temperatures in summer. Whilst this may be a quaint story for the tourists, the truth according to a BBC article is that in 1940 General Franco moved Spain’s time zone one hour forward to show solidarity with Germany. As a result the country sits down to meals at least an hour later than us, perpetuating the image of long siestas and dinners deep into the night.
All Time Records Talking of time passing, the asset markets cruised into 2018 without a blip. In fact, the UK FTSE 100 Index
finished with a flurry in December and rounded the year off with an overall return of 11.95% whilst in the US the S&P Index returned 10.62% in sterling terms. Both markets finished at all-time highs. If you have been reading our newsletters, you will be aware that 2017 was uncharacteristically quiet for equity markets with very, very low levels of volatility. This trend has continued into 2018 and, at the time of writing (17 January 2018) the S&P 500 has gone 391 days without a 5% pull-back, the second longest in history - if this continues for another four days, it will be the longest streak on record. Whilst the equity markets have enjoyed such a good time, it should be remembered that their valuations also stand at very high levels. It is true to say that the global economic outlook has improved and corporate earnings growth has picked up.
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 January 2018
Working Overtime
In the US, the tax reforms that were passed into law in December do help underpin 2018 earnings by virtue of lowering tax charges. That said, this has not changed market expectations much. According to Thomson Reuters, last April forecasters’ expectations for earnings growth in 2018 was 12.1%, today they stand at 14.5%. That’s good but this 2.4% uplift in earnings expectations occurred over a period in which the S&P Index rose 18.8% (in US dollar terms), resulting in a much higher valuation.
It is no coincidence that these record high valuations come after $14 trillion of money has been pumped into markets via central bank quantitative easing (QE) programmes over the last 10 years. These taps are due to be turned off this year which will provide headwinds to yet higher valuations.
This background has led us to gradually reduce the asset allocations to equities over the last year. There is good momentum in equity markets but with valuations hitting previous all-time highs we try to make our equity positions work harder.
Secondly, we are circulating funds away from some of the equity markets that have had good returns into those which we see as still offering good value. In particular we are looking to allocate more of our UK equity exposure into smaller UK companies and in the overseas portfolio, into India where we see strong and sustainable growth.
How? Well, firstly by selecting active managers who can generate above-market returns to produce out-sized attribution from the equities we do hold. In 2017 we reduced some of the index tracker holdings to drive higher returns and will continue to do so as we see opportunities.
Happy New Year, Again
At the start of this year a number of people have asked us if we have a new investment strategy for 2018. For us, just because the calendar flipped over to a new year, does not mean our strategy needs to change or be revamped. Obviously, markets that were overvalued on 31 December did not suddenly become less valued on 1 January, or vice versa. In the Chinese calendar this is the Year of the Dog. The year will commence on 16 February and will end on 4
Thirdly, we have increasingly allocated funds to our Defined Returns portfolios which give us a capped return on the markets but, importantly, also significant capital protection in the event of falling markets. At the end of this month, our Morgan Stanley structured product is (at time of writing) likely to kick-out and to maintain our weightings in this portfolio we will be looking to replace it with a similar product.
February 2019 and although we like the Chinese stock market – they were our best performing funds last year – we do not necessarily march to the beat of the lunar calendar either. In case you are interested, chart one shows that in previous Years of the Dog have been pretty good in terms of performances for stock markets (here given as the returns on the US stock market in the respective animal years).
Chart 1: Chinese calendar and stock market performance
Source: Stock Market Almanac**
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 January 2018
Of course, our portfolios do not just hold equities. In fact, with equity funds now comprising around 29% of the balanced portfolio, performance overall is driven much more by broader asset markets rather than the focus on FTSE 100 Index companies that it had several years ago (the top 100 companies now comprise only around 13% of our equities). However, many parts of the bond (fixed interest) market present us with the same issue of high valuations as the equity markets. In September of last year, Deutsche Bank produced a study^ that included a great long term chart (Chart Two) that neatly sums up the rich
valuations for both these asset classes (shown in percentiles from most cheap to most expensive for 15 developed equity and bond markets). In the last year or so we have raised our allocations to alternative equity. These funds give the portfolios a greater diversity of returns so that if bond or equity markets do wobble, there is a greater chance that the alternative equity funds will pick up the performance baton. This portfolio has been purposefully constructed with very low correlation to bond and equity markets.
Chart 2: Aggregated 15 DM country average bond (nominal yields) and equity percentil valuations (100% = most expensive, 0% = cheapest)
Source: Deutsche Bank, Global Financial Data, Bloomberg Finance LP
Tick, Tock
We believe we are getting towards the top of the economic cycle as excess capacity diminishes and many western economies near full employment. It is difficult to come up with a big list of reasons for the markets to suffer a precipitous fall from current levels. However, it is very easy to list the reasons why the
forces that have pushed markets up over the last few years may peter out – high valuations, high investor and business sentiment, QE reversing, record high and rising debt, low interest rates, share buy-backs, etc. Time will tell.
* http://www.bbc.com/travel/story/20170504-the-strange-reason-spaniards-eat-late ** http://stockmarketalmanac.co.uk/tag/new-year/ ^ Deutsche Bank, Long-Term Asset Return Study; The Next Financial Crisis, 18 September 2017, Jim Reid and Team, http://www.tramuntalegria. com/wp-content/uploads/2017/09/Long-Term-Asset-Return-Study-The-Next-Financial-Crisis-db.pdf The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog 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. Past performance is never a guide to future performance. 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 (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 January 2018
General Economic Overview The pace of global economic growth has increased over the last year and is expected to continue into 2018. There are signs that many developed economies are beginning to run at or near full capacity with very low unemployment, high demand for commodities and skill shortages. The UK economy has seen relatively less demand growth and inflationary pressures are likely to be more subdued unless the relative value of sterling falls further. The reversal of the Federal Reserve’s quantitative easing programme in the US and further interest rate hikes are likely provide headwinds for asset markets this year. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets A small increase from the -5 score last month to acknowledge the improvement in economic growth and stimulus from the US tax reforms. Most equity markets are on high valuations and we see better relative value in Far East equities such as China and India.
-4
Fixed Interest Rising economic growth is putting pressure on the prices of commodities like copper and oil and may feed through to higher wage growth. These inflationary trends will likely mean that interest rates will need to be raised this year, certainly in the US and possibly in the UK too. Fixed interest tends to underperform when interest rates go up. We continue to prefer corporate bonds to government bonds but also hold some index linked gilts as a hedge against further inflation.
-4
Commercial Property With the exception of London which has specific issues, most sectors of UK commercial property are seeing reasonable growth in rents. Economic data indicates that new construction in the UK has slowed recently which will help keep supply in check.
-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, 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.