Investment Newsletter May 2016
Fixing Portfolios Mike Deverell Investment Manager
After a very volatile start to 2016, stockmarkets have settled down somewhat and stabilised. Most stockmarkets are now pretty much flat over 2016 so far but have recovered significantly over the past quarter. For example, the FTSE 100 is 8.55% higher than it was three months ago and the equity content of a balanced portfolio up 9.74% (total return 12 February to 13 May 2016). Whilst things look a lot brighter, the FTSE 100 is still well below where it was this time last year, closing at 6,138 on 12 May, or 8.66% down over 12 months. Of course, investors in Equilibrium portfolios have fared somewhat better, with the equity within a balanced portfolio down 1.54% over the same period.
significantly improved economic data. In particular, we think UK stocks are unlikely to go anywhere much until after the EU referendum in June. Importantly, we don’t just invest in equities and other asset classes have of course been positive over the same period. One of the best performing assets over the past few years has been UK commercial property, with our property portfolio gaining 24.7% over three years, or just under 8% pa on average. However, things have slowed down recently and the portfolio is only up 2.63% over the past 12 months.
Stockmarkets remain a little jumpy and it is difficult to see a sharp move upwards in the short term without 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 May 2016
Brexit Slowdown?
One of the reasons for the slowing returns is a reduction in the amount of money flowing into commercial property. The property unit trust sector has seen three consecutive months of net outflows (up to the end of March, the latest data available), and we think this is indicative of the wider commercial property market. In particular, we are hearing anecdotal evidence of big investments being put off until after the referendum. For example, one of our contacts tells us they are aware of several commercial property developments being signed and sealed, but contingent on a “remain” vote on 23 June. In other words, should we vote to leave the EU those deals will not go ahead. In addition, according to the latest commercial property survey from the Royal Institute of Chartered Surveyors (RICS), 80% of surveyors in London report a slowdown in investment as a result of the referendum. As well as returns slowing, outflows from property funds can also have an effect on their pricing. Over the past twelve months, several property funds have “re-priced”, including in the past week the Henderson UK Property fund, M&G Property Portfolio and Standard Life Ignis UK Property fund. Transacting in commercial property is an expensive business, with stamp duty and legal costs potentially adding up to a “round trip” cost for buying then selling a building of up to 7% of its value. These costs are not too much of an issue when funds are experiencing inflows and are growing. However, if funds start experiencing outflows then their cash levels start reducing and they have to consider the sale of buildings. Funds are able to reflect this risk in their pricing by shifting from what’s called an “offer” basis to a “bid” pricing basis. Essentially, they can drop the value of their funds to reflect the possible transaction costs. This move is designed to discourage sellers but also encourage buyers who can buy in at the new lower price.
Should there be a “remain” vote in June then we may start to see more money going back into the sector, which would help returns. The funds can of course re-price back up and in fact, Henderson has even called their move a “protective” one ahead of the referendum. It is also worth pointing out that we have been proactively reducing property exposure for some time. In April 2015 a balanced portfolio had over 28% in property. Now that is down to 15% of the portfolio, with the latest move happening a month before the recent re-prices. We invest in six different property funds and so each fund is only 2.5% of a balanced portfolio. This means the 5% drop in the Henderson and Ignis prices and the 6.25% fall in M&G’s price has had an effect on the value of a balanced portfolio of around 0.4%. Direct property funds can be illiquid - if redemptions accelerate they could need to sell buildings to meet outflows. In extreme cases, they could need to temporarily “gate” the fund whilst they sell properties. Right now, we think this is unlikely as cash levels remain high but we will of course be watching closely. There is always a trade-off between the illiquidity of property funds and their possible returns and diversification benefit. It is possible to invest in more liquid funds that invest in property shares or REITS (real estate investment trusts). However, whilst REITs are more liquid they are also more volatile. The FTSE 350 REIT Index is down 3.86% over the past year whilst our property portfolio remains up by 3.68%, even after accounting for the re-prices. This still makes property one of the better performing asset classes over the past 12 months, outperforming both equity and fixed interest.
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 May 2016
Fixed Interest
Much of the money we took out of the property sector has been reinvested into fixed interest. This is an area we have held very little of for some time, with a balanced portfolio only holding 8% fixed interest as recently as January. This has now been increased to 15%. Our first top up to this asset class was on 4 March and since that date our fixed interest portfolio is up just over 3%. We then topped up again on 11 April and this part of portfolios has grown a further 1% or so since then. Fixed interest encompasses both government bonds and corporate bonds. Through buying a bond you are lending money to either a government or a company for a fixed level of interest, for a fixed period of time. However, the bond does not have to be held until maturity and can be traded at any time. The market value of the bond will depend on various factors such as the potential return until maturity and the possible return you could obtain elsewhere. For example, if you bought a 10 year UK government bond (or gilt) right now, lending money to the government for the next 10 years, you would receive a rate of return of 1.37% pa. If you hold until maturity, your capital is safe as it is guaranteed by the government. Currently, Bank of England base rates are 0.5% so 10 year gilts are yielding 0.87% pa more than rates. If the Bank of England put up base rate, say to 1.5% pa, then the bond would be yielding less than cash. The price of bonds would probably fall to adjust to the new rate environment and to maintain a similar premium over base rates. However, if rates went down then the price would probably go up.
Corporate bonds work in the same way as gilts but with an additional layer of complexity. Buying a corporate bond means lending to a company. Companies can go bust and so corporate bonds tend to have higher yields than gilts to compensate for the risk of default. In normal conditions, corporate bonds and gilts tend to move in similar directions but in times of fear they can move in opposite ways. As fears of recession rise, then fears of corporate bond defaults increase. We believe these fears are overdone and whilst economic growth is undoubtedly “soft”, there seems little likelihood of a global recession. This led to a mismatch of value in our view where corporate bond yields had a historically wide premium over gilts. As a result, we felt it was time to top up fixed interest as the potential return was attractive. This premium has somewhat reduced as corporate bond prices have risen since we topped up fixed interest, however we still feel there is more value to come in this asset class. If you would like more information about fixed interest and some of the in-depth analysis we do on this sector, please see my latest blog “Fixed Interest: Risks vs. Returns” which can be found on our website here.
Another factor that drives investors to buy government bonds is fear. When investors are worried and don’t want to buy equities they can focus more on protecting their capital than on returns. Whilst 1.37% pa is a pretty poor return and would probably be less than inflation over ten years, the government guarantee can be attractive. As a result, the price of gilts has been driven up to very expensive levels by current investor nerves.
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 May 2016
General Economic Overview Global growth remains positive but weak. Commodity prices have rebounded somewhat from their weak start to the year and this has helped emerging markets to recover. However, this recovery remains fragile. In the UK, uncertainty in the run up to the referendum is having an effect with some investment being placed on hold until the result is known. Inflation remains low and the Bank of England is unlikely to tighten interest rates this year. In the US, the Federal Reserve is now only expected to increase rates by 0.25% in 2016. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets This score is unchanged since last month. Most stockmarkets are fair value but corporate earnings growth remains patchy and this is likely to limit the level of returns we can expect from equities. We continue to prefer Japan and smaller companies in the UK.
-2
Fixed Interest Our score has dropped from -1 to -2 over the past month, after some good returns from corporate bonds means the yield has come down. However, the spread over gilts remains elevated and the overall yield on our fixed interest portfolio is attractive in our view.
-2
Commercial Property Returns from commercial property are slowing and re-prices have also brought down the returns. We believe returns from property over the next 18 months will be driven primarily by the level and growth of rental income, with little capital growth.
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, equity and 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, 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.