Investment Newsletter October 2016
Tricks and illusions The tradition of jack-o’-lantern and the hollowing out of pumpkins at Halloween all goes back to a simple phenomenon called ignis fatuus – or illusions created by photons released by peat bogs that give rise to ‘spooky’ sightings. The mixture of biological and chemical emissions create flickering lights and acrid smoke which hang over the bogs that over the years have been attributed to evil forces at work.
Neal Foundly
Regardless of the simple scientific explanation, a whole Halloween industry has grown up built on superstition and fear.
President Obama - warning that Brexit would portent a very bad future for the UK economy. However, once the count was taken and the decision made to exit the EU, darkness did not descend. Indeed, with the help of the Bank of England’s announcement of a 0.25% cut in interest rates and a fresh round of quantitative easing, asset markets from the FTSE 100 Index to the gilt market forged ahead, silencing many of the critics.
Investment Analyst
Fear of the unknown and unclear signals are now gripping the value of sterling. Arguably this started with what has been dubbed ‘Project Fear’ prior to the EU referendum with supporters of the Remain campaign – including everyone from Mark Carney to
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 October 2016
Pounded
However, sitting in the middle of this is our currency, sterling. At first, after the outcome of the referendum was known, sterling suffered falls of around 10% against the other major currencies. However, over the last month the pace of the decline has accelerated and the value of the pound has reached a 31-year low against the US dollar and a 5-year low against the euro.
This has many implications for the UK. A key issue is that the UK economy relies on inward investment to balance its books and if overseas investors believe that sterling will continue to devalue, they may delay new or additional investment in the belief that it will be cheaper in the future.
Value of Sterling relative to the US Dollar and Euro
Inflation shock
For bond investors a key consideration is the prospect that inflation rises sharply. It is difficult to tell precisely what the impact will be but as the cost of goods imported rise, this will need to be passed onto consumers on the high street. Last September the Bank of England released a research piece entitled, ‘Much ado about something important: How do exchange rate movements affect inflation?’ in which they tried to look at the relationship between currency movements and inflation. They explained that, “Using very rough rules of thumb, the Bank of England has traditionally estimated that the pass-through from exchange rate movements ... to the consumer price index is … around 20% to 30%.”*
basis) by 18% over the last 12 months would imply an inflation rate of around 4.5%, significantly higher than the current 1.8% retail price inflation rate or 3.4% inflation expected by the markets. On top of this currency effect, the rise in price of oil over the last few months will add to the inflationary pressures. Since the start of this year, the US dollar price of a barrel of oil has risen by 50%, but in sterling terms it is now up by 66%. * ‘Much ado about something important: How do exchange rate movements affect inflation?’ Speech given by Kristin Forbes, External MPC member, Bank of England 47th Money, Macro and Finance Research Group Annual Conference, Cardiff 11 September 2015
Acknowledging the approximate nature of this calculation, the decline of sterling (on a trade-weighted 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 October 2016
Illusions
For holders of fixed income bonds, especially for those of very low yielding government bonds, this prospect of inflation could wipe out real (after inflation) returns very quickly. Remember, returns after inflation are the important numbers, much more than the absolute return numbers – economists call this tendency to focus on the latter as ‘monetary illusion’. Stock markets could also be said to be performing a similar trick of the eye. The FTSE 100 Index now stands above 7,000 and has risen by 12% since the day the EU referendum result was announced. Such performance would normally signal good health for the UK economy but the truth is that this is driven almost entirely by the translation effect on the overseas earnings of the companies in the Index. The lower pound has served to increase the value of those foreign businesses in sterling terms. How much is down to currency? Well, if you were a US investor in the FTSE 100 Index over this period your returns would have been -4.4%. As you can see, by far the largest part of the sterling returns of 12% have been generated by the currency weakness.
Treats
Equilibrium portfolios have relatively little holdings in government fixed income bonds. Instead, we expect inflation to pervade for some time and most of the gilt exposure in the portfolios is in index-linked bonds that pay coupons at a rate above the rate of inflation – the higher the inflation rate, the greater the income. That said, the majority of the holdings in the fixed interest portfolio are corporate bonds which offer higher yields than government bonds. We have not added to equities at current levels of 7,000 or more. The valuation is relatively high and thus the returns that can be expected from buying at these levels have correspondingly fallen. One area where we believe there is great opportunity is infrastructure. The state of many roads, bridges and other important structures that we all use on a daily basis have had less investment in recent years, especially since many governments adopted austerity measures following the credit crisis. This is not just a UK issue but shared across many developed and developing countries globally.
The need to improve the state of key assets is now pressing given the increasing costs of maintaining the aging infrastructure but also to update to include smarter technology to improve efficiency. We have identified a well-managed fund that invests in a broad spread of infrastructure companies, from electricity grids to toll roads, and we will be looking to include it as part of the alternative equity portfolio in the coming weeks. This is one of a number of ideas to garner positive returns for our clients in these tricky times. It is important in these markets to cut through the noise and fog to get to the truth of market valuations and investment opportunities and not to fall for the illusions that can end in horror stories.
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 October 2016
General Economic Overview Although survey data of hiring and investment intentions remain negative, most of the monthly economic data in the UK has remained reasonably positive. Across most developed economies, growth is steady but relatively low by historic standards. The value of sterling against the US dollar and most major currencies has fallen to record lows over recent weeks. This may result in higher inflation expectations and the rising price of oil over recent months is likely to exacerbate cost pressures.
Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class Equity Markets Equity market valuations have not moved significantly in the last month. We believe that Japanese and Asian equities offer the best value whilst US and Europe are overvalued at current levels.
Score
-4
Fixed Interest Our score for bonds remains the same as last month at -2. Low bond yields combined with the prospect of rising inflation are likely to reduce returns from this asset class. We continue to hold some indexlinked gilts but otherwise prefer corporate bonds.
Commercial Property Last month we took the step to cautiously buy back into property. Rental income remains attractive but we are avoiding exposure to London given the high valuations and risks associated with Brexit.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-2 -3 -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, 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.