Investment Newsletter November 2017
It’s quiet. Too quiet...? We have recently highlighted just how calm stock markets have been this year. The FTSE 100 index ended 2016 at 7,142. By May it had hit a new record high of 7,547 but over the next six months it pretty much went sideways, peaking at 7,562 on 6 November.
Mike Deverell Investment Manager
Since then volatility has picked up somewhat with the market dropping to 7,380 as of close on 17 November. In comparison with recent movements, this drop of around 2.4% over a couple of weeks feels relatively dramatic but in actual fact it’s more like what we would expect to see regularly in a more “normal” year! Chart one shows the calendar year returns of the FTSE All-Share going back to 1986. The red dot for each year shows the largest intra-year decline during that 12 month period.
As we’ve highlighted before, more often than not markets see a drop of at least 10% at some point during the year, regardless of whether the market ends that year up or down. The last time we didn’t see a double digit sell off was in 2005. The biggest peak to trough movement this year has been 4%. If this was still the case at the end of 2017 it would be the smallest intra-year decline since 1995. This of course highlights what we always tell clients; that past performance is not a guide to future performance! You cannot rely on historic statistics and assume the future will be the same as the past. Having said that, we do think historic data can provide some insight into market behaviour. Chart 1 tells us that it is very unusual to see such low volatility, but it is not without precedent. Likewise, stock market
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 2017
valuations tell us we probably should expect lower returns over the next couple of years than we have seen over the past few. But then again, we might not. Returns could be the same or even higher. Successful investing is about using such historic data sensibly whilst acknowledging this uncertainty. If history tells us the odds of a significant correction have increased, then we should hold less equities than normal, but we shouldn’t hold no equities. We can also look at more defensive ways of gaining exposure to stock markets, such as defined returns investments.
Understanding historic statistics helps us choose which areas to invest in. At current market levels we think the chance of getting a 9% return from the stock market over the next year or two is lower than usual. If we had to choose between an index tracker or a defined return product, we’d currently be more likely to choose the latter. We would accept the possibility of making less money in return for a greater chance of making a decent return. By contrast, we’d be more likely to choose a FTSE tracker when markets are lower.
This type of structured product is designed to provide a pre-defined positive return should the market be the same or higher on a given date than it was at the beginning of the period. A typical rate for a FTSE based product might be around 9% pa. Whether the market goes up 0.01% or 25% over that period, we still get 9%. Investing in defined returns increases the odds of us getting a 9% return compared to buying a FTSE tracker, but that return is capped whereas the FTSE tracker return is theoretically unlimited.
Chart 1: FTSE All-Share Index intra-year declines vs calend ar-year returns Despite average intra-year drops of 15.8% (median 12.6%), annual returns are positive 22 of 31 years
Source: FactSet, FTSE, J.P Morgan Asset Management. Returns are based on local price only and do not include dividends. Intra-year decline refers to the largest market fall from peak to trough within a short time period during the calendar year. Returns shown are calendar years from 1986 to 2017. Guide to the Markets. UK data as of September 2017.
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 2017
Fund manager positioning
We are not the only ones who think markets look expensive. Bank of America Merrill Lynch carries out a global survey of fund managers every month in which they ask all sorts of questions about how those managers are positioned and their views on various asset classes. In the most recent survey, a record number of fund managers said they felt equities were over-valued. The last time the response was anything like that high was in the tech bubble in 1999. Given this, you would expect that most fund managers would be acting cautiously, holding more cash than usual and less in the market. Strangely, the opposite is true! Cash levels have been falling and (as chart two We think that’s rather a strange way of managing money and perhaps it is driven by the way most fund managers think. Most managers are rewarded for relative performance against their peers or against their benchmark. If markets are rising, they want to make absolutely sure they don’t get left behind or they won’t get their bonus!
performance. However, we know that volatility can itself be pretty volatile! Markets can go from ultracalm to extremely stormy essentially overnight. Whilst we’re not trying to forecast anything, this type of behaviour is often seen towards the top of the market. It’s called a “bear capitulation”. Those fund managers who have been bearish towards stocks get fed up of being left behind and not getting paid their bonus, and decide to join the party. This often gives the market one last leg up before finally correcting. Our philosophy is very different to most of the managers in the survey. We pay very little attention to relative performance but concentrate on trying to achieve the returns our clients need whilst avoiding unnecessary risk. If we think an asset class looks expensive we’ll have less of it in portfolios in an attempt to minimise losses. We won’t hold more of an asset class just because everyone else does.
Additionally, the low levels of volatility we’ve highlighted may be another reason fund managers feel inclined to put more money into stocks. Many managers are targeted on this measure as well as
Net % taking higher than normal risk levels 3m chg Source: BofA Merrill Lynch Global Fund Manager Survey
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 2017
General Economic Overview The global economy is still seeing robust growth according to most indicators. Having said that, UK growth has been somewhat disappointing this year as inflation hits consumers in their pockets. Inflation is probably near its peak and is likely to fall back unless there is a further drop in the value of the pound. The Bank of England recently increased rates from 0.25% to 0.5%. We think it unlikely that they will make any further increases in the next year. However, the US look likely to increase rates in December and potentially do so again in the early part of next year. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Most western equity markets look expensive on most measures, such as the ratio between price and earnings. There is better value in Asia and Japan in our view, where markets look somewhat cheaper and earnings growth has been robust.
-5
Fixed Interest With recent interest rate increases bond prices have generally come off slightly. However, with little likelihood of further increases to UK rates we don’t expect this to continue. We continue to prefer corporate bonds to government bonds but also hold some index linked gilts as a hedge against a further inflation led economic slowdown.
-4
Commercial Property The latest survey from the Royal Institute of Chartered Surveyors saw a slight increase in commercial property demand and reduction in supply. Rental growth has also shown signs of increase. As a result we have increased our outlook from a -4 to a -3 this month.
-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 and equity, and hold only a small amount of 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, 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. 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.