Investment Newsletter November 2018
Looking back to the future At Equilibrium we know we can’t predict the future. However, we do think historic market behaviour can sometimes be useful when working out what might happen in the future.
Mike Deverell Investment Manager
Equilibrium Investment Management
For example, we have often written about some of the stockmarket indicators we look at to decide if we think equities look good value. One of the most useful is the market’s price/earnings (PE) ratio. This simply takes the total value of the companies on the market and divides it by their total profits (earnings). The higher the number, the more expensive the market, and a cheaper market will mean a lower number. This has historically been a decent indicator of potential future returns. This can be seen in Chart One, which shows the relationship between the PE ratio of the UK stockmarket and its returns. Each red dot represents a
different five-year period on the UK stockmarket. The horizontal axis shows what the PE was at the start of that period and the vertical axis shows what the returns were over the subsequent five years. There is a clear pattern from top left to bottom right. A period which starts with a low PE ratio tends to see much better returns than a period that starts with a high ratio. Of course, it is not a perfect indicator but the starting valuation is pretty important. Those of you who have been reading our newsletters for a while will know we have been banging on about this for years! I therefore thought it might be worth looking back at one of our past newsletters to see what we were saying back then. Five years ago the PE ratio of the UK market was around 14.5 times earnings which is roughly in line
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 2018
with its long term average valuation. Here is what we wrote in our newsletter of November 2013: ‘In our ideal portfolios we have generally been overweight equity, in other words holding more equity than we would in “normal” market conditions, for most of the past few years. However, as markets rose we generally sold some equity in portfolios at a market level of circa 6,750. ‘This means for most clients we are now back at a “neutral” equity position. In fact, for some investors we have even moved slightly “underweight”. We still think UK equities have further room to grow, but stocks are nowhere near as compelling as they seemed 18 months ago.’ Looking back to Chart One, we can see that the typical returns when the UK market is around 14.5 x PE is anywhere between 0% and 20% pa.
In fact, the return over the five years from 1 November 2013 to 1 November 2018 was 5.2% pa, below the median return but within the expected range (based on the Thomson Reuters UK Total Market index). The blue dot in the middle of the chart highlights where this most recent five-year period is on the chart. Funnily enough, the PE ratio on the UK market right now is 14.7 times earnings, almost exactly where we were five years ago. As I write (on 14 November), the FTSE 100 stands at around 7,050, so not that far above where it was back in 2013. The return mentioned above is total return which also includes dividends, but in price terms the index has barely grown. Five years ago we had just moved to a “neutral” position in terms of risk having been overweight equity. More recently, we have just moved back to a more neutral risk weighting having been relatively cautiously positioned.
Chart 1: UK Total Market PE vs returns
Source: Thomson Reuters Datastream / Equilibrium Investment team
Brexit planning
Of course, one reason why the return over the past five years has been towards the bottom end of the range may be Brexit related.
For example, UK domestic equities (those companies that make most of their revenues from the UK) are currently very unloved by international investors.
If we are looking at the next five years, what happens with Brexit will also probably be crucial to the returns of UK equities.
Many of these stocks are therefore relatively cheap compared to similar companies in other countries, and to those UK companies that make their money internationally.
As you would expect, we have already put together a draft plan which goes over what we think might happen to each asset class in different Brexit scenarios.
If there was a Brexit deal which was poorly received, then these domestic stocks could fall sharply.
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 2018
Meanwhile, if the deal was perceived positively then these stocks could rally. One action we are considering is whether we would buy such shares in either scenario! Given they are already cheap then the opportunity to buy them even cheaper after a sell off may be an attractive one. On the other hand, in a perceived good deal their long term prospects would improve and they may be more attractive to international investors. Again, it might make sense to buy after the deal is known
Defined returns
given the long term growth prospects and the current valuations, even if it means missing the first few percent of any gain. Of course, our actual actions will depend on how markets move in the meantime and exactly how our portfolios are positioned at the time. Our planning document is not set in stone and will be regularly updated as the facts change!
Five years ago we also said we liked defined returns relative to direct equities. In November 2013 we wrote:
We have increased the chance of getting a 10%+ pa return but given up the chance of getting more than this compared to buying a FTSE tracker instead.
‘We think defined returns are a good way of achieving equity like returns with less risk than equities. Our aim is not to provide the best returns we can as this will encourage us to take too much risk. Instead, our aim is to provide the target returns at the lowest risk possible.’
In an uncertain world we think that an investment which reduces that uncertainty is highly attractive.
We still feel that way today. Whilst we have less traditional equity than usual, we also have around 15% exposure to defined returns products in portfolios at present. There is some downside protection built into these products but ultimately, they are equity linked and so they do have some market risk. Added together, this gives us an overall portfolio risk roughly in line with our long term strategic allocation. We are neither cautiously nor aggressively positioned but somewhere in between.
Disclaimer: The content contained in this newsletter represents the opinions of Equilibrium Investment Management. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. The commentary in this newsletter 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.
What defined returns bring compared to traditional equity is greater certainty. For example, when the FTSE 100 fell to 7,318 on 6 September we felt this was a good time to set up a new defined returns product with JP Morgan. If the market is at or above that level on 6 September 2019, the product will end and pay us a return of 10.35% from launch. Crucially, the market only needs to go sideways to get this return. Even if the market is down, the product rolls on to the next anniversary giving us another chance to achieve this. There are six chances in total. Of course, the market could be up 15% over that period, in which case we would still only get 10.35%. 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 2018
General Economic Overview The global economy remains in growth mode, though we have seen something of a loss of momentum particularly in emerging markets. The US midterm elections probably mean a continuation of the status quo across the Atlantic, with less likelihood of further tax cuts but also less likelihood of cuts to healthcare. This means we think the US Fed will continue putting rates up steadily but won’t have to increase the pace. The trade war remains an issue not just for Asian markets but also globally, in particular for parts of Europe where there are also concerns over the Italian budget. In the UK Brexit dominates the outlook with things like inflation, interest rates and economic growth all highly dependent on the outcome. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class Equity Markets Some parts of the stockmarket now look good value after recent falls, notably Japan and Asia, with the UK also now better value. The US market remains expensive in our view, with Europe ex UK not far behind.
Score
-1
Fixed Interest Bond returns are likely to be positive but unspectacular in our view. Rates are rising in the US but in the UK the outlook is more uncertain, and they could even be cut in an adverse Brexit scenario. We have a mixture of corporate and government bonds, including index linked, in our portfolio.
-3
Commercial Property Prospects for the asset class remain mixed. We still wish to avoid London offices and much of the retail sector. However, non-London prime offices and the industrial sector are currently doing relatively well. Sentiment could turn depending on what happens regarding Brexit.
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, 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.