Investment Newsletter November 2019
Seeking certainty in an uncertain world We’ve spent a lot of time this year talking about uncertainty! It’s often said that markets hate uncertainty more than anything else. Given the world we live in today, that is quite unfortunate!
Mike Deverell Investment Manager
Equilibrium Investment Management
Most of this uncertainty is political in nature, of course, relating to Trump and trade, Brexit and now a general election too. All of this has implications for economies, currencies and asset classes. As we often say, investment management is all about weighing up risks against the potential reward. All this uncertainty adds to the risks of almost every asset class we consider. Equity is the asset class which is normally the most volatile and which, therefore, reacts to events in a more pronounced manner. It goes without saying that
this can be in a negative way, but it also reacts strongly to positive events. At present, we are happy to take a normal amount of equity risk despite the uncertainty we face, because we believe the asset class also has a high potential reward over the long term. However, we believe risks have risen for various other asset classes as well. The difference is that the potential rewards of those asset classes are typically relatively low. The most obvious example is in certain fixed interest investments, particularly many government bonds. These bonds have done extremely well this year as markets begin to factor in interest rate cuts. When rates on cash go down, the fixed level of interest paid on such bonds looks more attractive by comparison. That means people are willing to pay more to buy those bonds, and the price goes 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 November 2019
The price of bonds has risen substantially this year, but the flip side of that is that it means the yield has gone down. A year ago, the yield on a 10-year UK gilt was around 1.5% pa. By the end of August 2019, that yield had dropped to around 0.5% pa. In other words, someone who bought the bond then and held it to maturity would get 0.5% a year for a decade. That is likely to be well below the level of inflation, and so would most likely be a substantial loss in real terms. That is a very low potential return, but arguably the risk of loss has increased. If rates go back up again, or perhaps just aren’t cut (as the market has already priced in), then the price of the bond will fall.
If the yield went back up to 1.5%, where it was a year ago, then the potential loss of capital is around 9%. What might cause rates to go up? Well how about some Brexit certainty along with a stabilizing UK economy, perhaps helped by some extra government spending (as all major parties are advocating)? Gilts are not a safe haven asset right now in our view, but a low returning asset with a high risk of loss. This is a view we have had for some time and, until recently, it has been an unfashionable one. However, things look to be changing…
Because of the way the bonds work, we can actually calculate how sensitive they are to rate movements.
Reverse the reversal…
In our most recent edition of Equinox, we highlighted a number of strange things going on in the investment world. We titled the piece “Is everything we thought we knew wrong?”. Perhaps that’s dramatic, but there have certainly been some unusual trends recently which has made managing portfolios quite challenging.
Because of the way analysts value such stocks, low bond yields have helped push up their prices (for a detailed explanation of why, see Graeme Black’s blog, Back to School on our website). A knock-on effect has been that the US stock market has outperformed everybody else, as they have a high proportion of such stocks.
Here are the established truths I highlighted in the article, which have proved not to be quite as reliable as once thought:
We have been careful not to chase this outperformance of the growth style, US stocks or fixed interest investments. Our view was that if low and falling rates could push up the value of such assets, then higher rates could push them down again.
1. Bonds and equities move in different directions 2. Interest rates can never go below zero 3. There’s no political risk here (in the Western world) 4. Value (cheap) stocks will outperform growth (expensive) stocks over the long term 5. Central banks are, and should remain, independent We’ve already discussed the political uncertainty, but this impacts on monetary policy too. The uncertain economic picture, caused largely by political events, has meant central banks have had to cut interest rates. We believe that these ultra-low (often negative) interest rates are having a distorting impact. As rates have been cut, bonds have been driven up. However, that has also driven up the value of growth stocks. These are companies which the market expects will grow their earnings quicker or with more stability than the market as a whole. As a result, they command premium valuations.
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 November 2019
We are starting to see signs that such trends are turning. Below are four charts which illustrate this, looking at returns from 1 January 2019 to 11 November. The charts are: 1. UK gilts total return (FTSE UK Conventional Gilt All Stocks index) 2. Growth stocks relative to value stocks (MSCI the World Growth minus MSCI World Value) 3. US stocks relative to the rest of the world (MSCI USA minus MSCI World ex USA) 4. UK large cap vs small cap (FTSE 100 minus FTSE Small Cap (ex IT) The final three are relative charts – for example, chart two shows the return of growth stocks minus the return on value stocks.
expectations of rate cuts peaked in August, and now have been reduced. This is partly because of slightly less political instability – optimism about a trade war resolution and reduced likelihood of a no-deal Brexit, for example. We are called Equilibrium for a reason – we like to take a balanced view! We are underweight fixed interest and US equities because the risk/reward dynamics aren’t favourable in our view, but we still have some exposure. We prefer UK small caps to large caps, but we’ve not bet the house on it! We have a mixture of growth and value stocks, whilst many other firms have gone for outand-out growth.
The point to note is that all the lines are exhibiting a similar pattern. They go up until around August time and then start to fall again. This is because
Chart one: UK gilts total return
(FTSE UK Conventional Gilt All Stocks Index)
A - FTSE Actuaries UK Conventional Gilts All Stocks (6.91%) Source: Data from FE fundinfo2019. 31/12/208 - 11/11/2019
Chart three: US stocks relative to the rest of the world (MSCI USA minus MSCI World ex USA)
A - MSCI USA (5.14%) B - World ex USA (0.00%)
Chart two: Growth stocks relative to value stocks (MSCI World Growth minus MSCI World Value)
A - MSCI The World Growth (7.86%) B - World Value (0.00%) Source: Data from FE fundinfo2019. 31/12/208 - 11/11/2019
Chart four: UK large cap vs small cap (FTSE 100 minus FTSE Small Cap ex IT)
A - FTSE 100 (5.97%) B - FTSE Small Cap (ex IT) (0.00%) Source: Data from FE fundinfo2019. 31/12/208 - 11/11/2019
Source: Data from FE fundinfo2019. 31/12/208 - 11/11/2019
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 November 2019
Avoiding the bear traps
Another area we are underweight is property. This asset class is having plenty of troubles, mainly in the retail sector. However, even offices are now seeing a slowdown with the weak UK economy and uncertainty around Brexit. We only had 5% exposure to this asset class until recently. That has now fallen to below 3% as we’ve sold all but one of our property funds. The one fund we continue to hold invests in so-called ‘long income’ assets which remain in high demand. For example, a supermarket on a 25-year lease with inflation linked rents. Such assets are seen as very defensive in a downturn and are in demand from pension funds looking at ways to match their future liabilities with bond yields so low. One reason for being so light on the asset class is liquidity concerns. When investors exit property funds they can ‘gate’, and lock investors in. This is because physical buildings cannot be sold overnight when funds experience large redemptions. Fund managers have to take their time to sell them, especially if they want to get a fair price.
There has also been increased regulatory focus on illiquid assets, with the Financial Conduct Authority (FCA) introducing new rules around property funds which may put off some investors. We think this regulatory scrutiny will continue, particularly after the Woodford affair. We work closely with fund managers and make sure we have an open dialogue with them. This is particularly true of less liquid asset classes like property. We made the final decision to sell the property fund recently after the fund manager told us they were in constant outflow mode, and their main job right now is to sell buildings. They were honest with us, and we are honest with them. Having made the decision to sell, we then worked with the fund manager to get our clients money out in an orderly fashion, giving the manager time to sell buildings to meet our redemptions. This is mutually beneficial as it means less chance of the fund having to gate, which would affect all investors. We think this approach is very important. One point to note in the whole Woodford affair is the role of Kent County Council. Their attempt to withdraw around £250m in one go from the fund was the straw that broke the camel’s back and caused the Woodford fund to be gated. As Jupiter’s John Chatfield-Roberts put it: “When you run large amounts of money you have to know, if you like, the rules of the game. You can’t just ring up and say, ‘I’d like my £1 billion back’. You have to do it carefully,” he said. Rest assured that at Equilibrium we will always manage your money extremely carefully indeed.
Risk warning: The content contained in this blog represents the opinions of Equilibrium Investment Management. 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. 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 November 2019
General economic overview Global growth remains relatively sluggish, particularly in manufacturing. This has been hardest hit by the trade war between the US and China, which is now impacting on growth across many regions. In the UK, Brexit-related uncertainty has continued to mean a lack of investment and anaemic growth. Interest rates have been cut three times this year by the Federal Reserve, however they now say any further rate moves are ‘paused’. In the UK, whilst rates remain at 0.75%, two members of the Monetary Policy Committee voted to cut to 0.5% last month. UK rates could therefore fall in the next few months, especially with consumer price index (CPI) inflation now well below the Bank of England’s 2% target.
Equity markets We remain cautiously optimistic about equities, in particular part of the UK and Asian markets which we believe remain relatively cheap. By contrast, we are somewhat wary of having too much exposure to expensively valued growth stocks at present.
Fixed interest Fixed interest has done fantastically so far this year, and that means yields are now very low. The future returns therefore appear to be lower but with increased risk. We like short-dated bonds and prefer corporate bonds to government bonds.
Commercial property Given the rising risks and concerns over liquidity, we have reduced property exposure to less than 3% of most portfolios. Property returns are likely to be in the low, single-digit percentages for the foreseeable future.
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 traditional equity, and are very light on property. This is balanced by holdings in defined returns and alternative equity, giving an overall risk/return profile roughly in line with our long-term average position.
These represent Equilibrium’s collective views and in no way constitutes a solicitation of investment advice. 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 adjusting 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.