Investment Newsletter September 2016
Topsy-turvy times We have often noted that in today’s topsy-turvy investment world, bad news is frequently better for your investments than good news! This is because central banks around the world have become the key driver of markets. Poor economic news can often mean central banks act to stimulate the economy perhaps by cutting rates or delaying hikes, or carrying out quantitative easing (QE).
Mike Deverell Investment Manager
UK investment markets since the referendum are a great example of how economic concerns do not necessarily feed through into asset markets. Gilts traditionally do well when the economy is perceived to be poor, as they are guaranteed by the government. The potential long term returns might be lower but they are seen as a safe haven, and with many people worried about the UK economy their prices rose sharply in the wake of the referendum. Gilts also do well when interest rates are being cut as the Bank of England felt compelled to do in August. Their
new round of quantitative easing has also helped push up prices, exactly as it is designed to do. Essentially, QE works by the Bank printing money and using this to buy bonds, pushing up the price which pushes down the yield. This is supposed to cause investors to take profits and invest the money elsewhere, hopefully stimulating the real economy. Stockmarkets have done well partly because low bond yields and low rates make their earnings and dividend yields look better by comparison. UK stocks have also been especially strong as a result of the fall in Sterling – again a reaction to perceived economic weakness. As the pound falls, so the profits of the UK’s large multinationals rise in sterling terms since most of their money is made overseas. This has helped to push up the UK stockmarkets. This is great news for investors and so we have seen some really pleasing performance over the past few months.
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 September 2016
Trouble ahead?
Unfortunately there are a few issues with all this. Firstly, there is a danger that if things turn out to be better than expected in the real economy, that some of this could reverse! For example, the pound would likely recover if the UK powered ahead, reversing that boost to profits. If the economy was very strong the Bank of England would likely not proceed with the second rate cut they have hinted about and which is already priced into markets. They could also halt QE early. All of this would likely be a negative for investments. There is also a concern that equities and gilts have been moving in the same direction. Traditionally, equities and gilts do well at different times, with investors buying more stocks when they are optimistic and gilts when they are pessimistic. However, right now they are being driven by the same thing. Chart 1 shows how the two asset classes have become more correlated as time has gone on. What this means is that as the two asset classes have gone up together, they could go down together.
In Chart 2, the two lines are remarkably similar – not something that is supposed to happen very often! In the latest Bank of America/Merrill Lynch global fund manager survey, managers cited bond yields as being the likely biggest driver of equity market returns over the next six months. The reason this is a particular concern is that gilts, and other government bonds around the world, are trading at historically low yields. At the same time, most stockmarkets are trading at high multiples of earnings. In other words, both markets look pretty expensive. As the two asset classes have gone up together, so they could also go down together. Over the past couple of weeks we have seen bond yields start to rise, and we believe this has been the cause of renewed volatility in stockmarkets. For example, a 10 year gilt now yields 0.9%, up from 0.58% a month ago. Meanwhile, the FTSE 100 fell by 3.3% from close on 2 September to 13 September, after being remarkably flat throughout most of August.
This can also be seen if we look at the performance of the FTSE 100 and the gilt market since the referendum.
Chart 1
Source: Bloomberg LP
Chart 2
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 September 2016
Diversification
All of this makes it pretty hard to create a diversified portfolio which will do okay regardless of whether markets are going up or down. The traditional managed fund approach of 60% equities and 40% gilts will just not work in the future, in my view. If equities go down there is a good chance that government bonds will go down too.
Normally, we would add further diversification to portfolios by holding commercial property funds. However, in the current environment we are wary about this asset class, particularly the London market. For example, City offices could be particularly hard hit by Brexit, as investment banks may need to have a base within the EU and could move staff to Paris or Frankfurt.
As a result, we have less equities in portfolios and less fixed interest than usual. Whilst we do have some gilt exposure (mainly in index linked bonds in anticipation of rising inflation) our fixed interest portfolio is mainly in corporate bonds which still provide a decent yield.
However, outside of London we think markets have now stabilised somewhat. As a result, we have recently bought back a small amount of property by buying the Kames Property Income fund. This fund has no London exposure and currently has a yield of 5.75%, which is very attractive given current low interest rates. We therefore only need the capital values to stand still to achieve a respectable return from this fund. We are also buying back in at around 3.5% below the level we sold it.
Whilst we also have other asset classes such as alternative equity and defined returns, all of this means we are holding more cash than usual in portfolios. We expect this to be a short term position, but this will help mitigate losses should bond and equity markets slip. It will also allow us to quickly buy back in and hopefully profit from potential volatility as we have done many times in the past.
As always, we will continue to work very hard to protect your money and to profit from opportunities as they arise.
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 September 2016
General Economic Overview Economic data in the UK has bounced back following a sharp dip after the EU referendum. Uncertainty persists and we expect weaker growth for the near future. Growth in the rest of the world remains steady if unspectacular. The pound has fallen sharply since the referendum and this may well cause some short term inflation. The Bank of England remains concerned about the economy and continues with quantitative easing (QE) and has made further hints that they could cut rates again.
Asset class key + =
positive negative neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Markets have been relatively flat over the past month and we maintain our -4 score, with valuations looking relatively high. Within equities, Japanese and Asian markets still look the best value, with the UK and US looking particularly expensive.
-4
Fixed Interest We have slightly downgraded our score from -1 last month to -2. Bond yields have hit new record lows but with interest rates unlikely to rise and with QE continuing, we think positive returns are likely to continue. We much prefer corporate bonds to gilts, with the exception of index linked.
-2
Commercial Property We have upgraded our score from -5 two months ago to -3 and have allocated some money back in the asset class. Prices could come under pressure in some areas such as the City of London but rental income remains attractive.
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 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 (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.