Investment Newsletter May 2015
A Complex Relationship Mike Deverell Investment Manager
For some time we’ve been predicting volatility around the election time. We certainly saw it, but not for the reasons we thought! We were expecting a period of uncertainty after the election as we naively believed the opinion polls! As we know, the polls were very wrong and we had a decisive victory for the Conservatives. On Friday after the election the FTSE, which had dropped almost to 6,800 on election-day morning, bounced back 2.2%. However, this probably had little to do with British politics. For example, the Eurostoxx 50 index of continental European companies rose 2.6% on the same day. The dip in markets prior to the election and the bounce afterwards is in fact mainly to do with the bond market. In Europe in particular we have seen some unprecedented moves.
Around six months ago, it became clear that the European Central Bank (ECB) was about to launch quantitative easing (QE). It wasn’t formally announced until January but markets had already reacted by then. Since then, European markets in particular have been acting strangely. One guiding principle of constructing a portfolio is to choose assets that are lowly correlated with each other. In other words, assets that will do well at different times. For example, if the stockmarket is down, your fixed interest portfolio should hopefully hold steady or even make money. Quantitative easing has pushed correlations between asset classes closer together, and that worries us. QE works by the ECB buying up government bonds, which pushes the price up and the yield down. In theory, investors then invest this money elsewhere (such as
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 May 2015
A Complex Relationship cont’d
equities) and this hopefully boosts the economy. QE therefore makes equities and fixed interest both go up together. In Europe this has been much more pronounced than we saw under US or UK quantitative easing.
Euro and the US dollar. The orange line is the price of the German bund (right hand scale. Remember, when prices go down that means yields have gone up). The light blue line is the MSCI Germany stockmarket index:
The chart below illustrates three different asset classes over the past six months. The dark blue line is the exchange rate between the
Euro/US$ Exchange Rate
Source: Thomson Reuters Datastream \ Equilibrium Investment Team
10 Year German Bund Price MSCI Germany Index
What this shows is that the currency, the bond market and the stockmarket have all been moving together. Over the past couple of weeks the Euro dropped to a multi-year low against the dollar before rebounding strongly. The German 10 year bond (known as a “bund”) moved from a yield of essentially zero two weeks ago to as high as 0.8% on Friday, reflected as the sharp move down in the price on the chart. In fact on Friday it went from 0.6% to 0.8% and back to 0.6% just in the morning. That’s unprecedented volatility in a supposedly low risk asset.
The equity market followed the same pattern down and then back up. This had a knock on effect to other markets. I’m not going to speculate on the reasons for these sudden moves too much here as there are different theories. For further thoughts on this and the election you can read my blog “Uncertainty? What Uncertainty?” by clicking here if reading electronically or going to: www.eqllp.co.uk/blogs. However, the point remains that markets are way more
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 May 2015
A Complex Relationship cont’d
correlated than they used to be. UK equities are more correlated with gilts than in the past, for example.
What’s the Alternative?
We had been holding cash before the election in case of a pull back. In the end, the market did not dip far enough for us to invest this cash. So where do we invest it now?
The reason this worries us is that we think most government bonds are far too expensive and prices need to come down. As a result, we hold much less fixed interest than usual. That’s fine as it’s a risk we can manage in isolation. But if we’re right about bonds, then there’s a reasonable chance equities could sell off at the same time.
Apart from equity and fixed interest, property returns are also slowing down after a strong 2014. Given this there’s not many attractive choices to put further investments. At times like these we look more to “alternative” asset classes. We already have more alternative equity than we normally do. Essentially, this part of the portfolio aims to achieve equity like returns over the long term without equity like risk.
To be clear, we still think positive returns from equities are the most likely outcome over the next 18 months, but risks are very much rising. Markets are not functioning normally and this makes them difficult to predict.
Some of these funds call themselves absolute return funds. We tend to dislike the term as this implies that they cannot lose money, however some of our alternative equity funds fit this term better than others. The chart below shows the Invesco Perpetual Global Target Return (green line) and Old Mutual Global Equity Absolute Return (red) funds since September 2013 (when the Invesco fund was launched). The FTSE 100 is also shown in blue:
Invesco Perpetual - Global Targeted Returns Z Acc in GB [15.15%] FTSE 100 TR in GB [14.20%] Old Mutual - Global Equity Absolute Return R Hedged Acc GBP [10.81%]
As you can see, the Invesco fund has outperformed the FTSE whilst the Old Mutual has lagged slightly over this period after weaker performance since February. Both have taken significantly less risk, importantly missing the big dips in October and December 2014. The funds have also often gone up when the stockmarket has gone down.
09/09/2013 - 08/05/2015 Data from FE 2015
Other funds have more potential to produce greater returns but with more volatility. We have been using the Odey Absolute Return fund for more than five years and it has produced some phenomenal returns. For example, over the five years to 8 May it returned 145% compared to the FTSE 100 at 64%. However, the absolute return badge is inappropriate in our view at it has been just as
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 May 2015
What’s the Alternative? cont’d
volatile as the FTSE. In combination, these funds can achieve very good returns but crucially they achieve these returns at different times to the market. For example, sometimes they make money from stocks falling (called “going short”) and sometimes from stocks rising (“going long”). This means that they are a good investment when equity markets look a little expensive.
We still feel that a decent return is possible over the next couple of years, but we may need to work harder to achieve it. As important as making gains when assets go up, is avoiding the dips when they drop. Managing this risk is very much part of our focus right now.
We may look to use more such funds in future. There are two potential additional funds we are actively considering, one which very much fits into the first “slow and steady” camp. The other is more volatile like the Odey fund but differs in that it makes its returns from going “long” and “short” on fixed interest rather than equity.
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.
Market Views May 2015
General Economic Overview There continues to be a mixed picture global economy, with the UK and US continuing to see robust growth. The US may increase rates as early as September with the UK not likely until next year. Meanwhile, Europe and Japan are both trying to bolster their economies with stimulus such as quantitative easing. Inflation is at zero in the UK (CPI) and remains low throughout most of the world. However, the price of oil and some other commodities has rebounded so inflation is likely to move back up as the year progresses.
Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class Equity Markets Our equity score is -1 which means we expect slightly less than our neutral 10% pa over the next 18 months. Valuations are a little high and the correlation to the bond market is a concern. However, there are areas of better value such as Japan, Asia and smaller companies in the UK.
Score
-1
Fixed Interest We have reduced our score from -3 last month to -4 because we think the possibility of a shock to the market has increased. We believe our funds should hold up well as they have low sensitivity to changes in interest rates. A 3% to 4% return is our best guess over 18 months but given the increased risks we are erring towards caution.
-4
Commercial Property Commercial property returns have slowed after a very strong 2014. We are starting to see some income growth coming through but capital values are not increasing at the same rate. As a result, we have reduced our score to neutral.
=
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future. Rates may increase by 0.25% perhaps in the first half of 2016.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and overweight property, and underweight equity in favour of the more defensive alternative equity. 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.
The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. These represent Equilibrium’s collective views. There are no guarantees. 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.