Investment Newsletter - September 2015

Mike Deverell Investment Manager

US Shows Little InterestThis week, the Federal Reserve will decide whether or not to put up interest rates in the US.

By the time you read this the decision may already have been announced. Whether or not rates have gone up this time around, they go up in December or whether any move is delayed until next year, the one thing we are pretty sure of is that when they go up, they will do so slowly.

It also seems pretty likely that rates will peak at a level far below where they have been historically. In the UK, Bank of England Governor Mark Carney has said he thinks rates will peak at around half of the 5.5% level they were at before the financial crisis. If rates only get as far as 2.25% and they take a long time to get there, this has far reaching investment implications.

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Investment Newsletter September 2015

The UK and US economies, like many others around the world, have been at emergency levels of interest rates since 2009. The global financial crisis has clearly had an effect and will continue to do so for many years, but is there something else going on?

Interest rates at 0.5% or even 2.25% are pretty far removed from what many of our clients have experienced in the past. In the 1970s rates were above 10% for much of the time and as recently as 1992, they hit 12% during the ERM crisis.

However, even before the financial crisis the trend over 30 odd years was for rates to move downwards. Inflation generally came down during this period, even if there were short periods where it increased and rates went up to combat it. This is one of the main factors why bonds have done so well over such a long period, with their yields falling and therefore capital values rising.

This potentially provides support for bonds where yields do not rise so much from their current low levels. When yields go up the capital value goes down, so if rates stay lower for longer this reduces the chance of losses.

However, the UK 10 Year gilt yields less than 2% at present. Lending your money to someone for 10 years and only getting 2% a year interest doesn’t sound like a great investment. On the flip side you can be pretty sure of getting your money back from the UK government so if you hold until maturity, it’s no riskier than cash. If interest rates don’t get above 2.25% over the next decade then there would therefore be no reason for that gilt yield to move much higher than it is now.

I recently attended a presentation by the economist, Stephen King of HSBC, who believes the greater number of retirees will also lead to structural changes to our equity markets. As investors start to invest more for income and less for growth, so companies may respond to demand by paying out higher levels of dividends.

Dividends are a great source of returns and it is often good discipline for companies to return profits to shareholders. However, sometimes it is more appropriate to reinvest profits into the business for future growth. If he is right, we could therefore expect some companies to grow less quickly which would be another drag on economic growth and also potentially leading to lower equity market growth going forward.

An aging population and lower economic growth might therefore lead to lower investment returns in the Western world. Having said that, if inflation is lower too,

A key driver of all this is demographics. The ‘baby boomer’ generation was the power behind the strong economic growth after the Second World War. The expanding population meant, as they grew up, there were more people in work which drove the economy forward. A booming economy can often lead to inflation and requires a high level of interest rates to keep a lid on things.

As the baby boomers are now retiring, the number of people in work relative to the population is declining. As a result, we should probably expect lower economic growth than we have seen historically, not just because of the debt we’ve built up after the financial crisis, but because of changes to the structure of our economy.

Perhaps technology will pick up the slack and perhaps the emerging economies will help drive global growth. However, there’s a good chance that the structural changes to our working population will lead to structurally lower growth and future interest rates.

then the “real” return might be about the same as we have seen historically.

Of course we don’t just invest in developed economies and emerging markets are becoming a more and more important driver of global growth. That’s one reason why markets have reacted particularly badly to the recent slowdown in China and its impact on other emerging markets. It might not seem dramatic if China slows from 7.5% pa growth to say 5% pa, but China is now the world’s second biggest economy. Chinese growth accounted for 40% of the world’s nominal GDP growth last year so even a minor slowdown has a big impact, given lack of growth elsewhere.

China won’t be able to grow at 7%+ forever and so it will need someone else to pick up the baton. One possible candidate is India, home to 1.2 billion or almost a sixth of the world’s population. Going back to demographics, their population mix is the classic ‘pyramid’ shape with more younger than older people.

India is going through their own structural changes but is starting to grow more steadily and is somewhere we’re likely to invest in more over the next few years. Currently the Indian stockmarket looks pretty expensive but no doubt there will be an opportunity to invest at a cheaper price at some point in the future.


Structural changes

Investment implications


The market appears to have stabilised somewhat with slightly smaller daily swings than we saw last month, and with the FTSE staying at around the 6,100 to 6,200 level. It appears we are waiting for the Fed’s decision on interest rates on Thursday before markets move significantly in either direction.

During the market turbulence we again topped up on equities, buying a FTSE tracker which for most clients was purchased at just above 6,000. We plan to sell it again should the market recover to around 6,400.

Whilst we have increased risk to try to take advantage of lower markets, we have also slightly decreased risk within our equity allocation. With the prospects for emerging markets diminishing in the short term, we have cut our allocation to this area and have topped up exposure to US and European equity markets instead.

The markets in US and Europe looked pretty expensive to us until recently. After the pullback this is no longer so much the case, so we have topped up our holdings. However we still hold less than we would normally in favour of holding more in Japan.

We feel the US and European markets have the potential to bounce just as much as the emerging markets in the short term. However, they don’t have the same downside risks as emerging markets at present, if China continues to slow and commodity prices continue to plummet.

As always, we continue to remain vigilant, not just in search of opportunities to improve returns, but to reduce the possibility of losses as much as possible.


Portfolio changes


Market Views September 2015


General Economic OverviewWe are seeing a mixed picture in the global economy. The UK and US continue to grow steadily whilst we have seen a pickup in Europe. However, emerging markets are slowing as China grows less quickly and commodity prices fall. The strong US dollar also hurts emerging economies.

Inflation is likely to remain low for some time and when interest rates do go up they are likely to do so very slowly.

Asset Class

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.

Asset class key+ positive - negative = neutral (normal behaviour)

+5 strongly positive-5 strongly negative

Our score is -3 which means we expect in the region of perhaps 4% pa over the next 18 months. We prefer corporate bonds to government bonds and shorter dated bonds to long dated, especially if interest rates do go up.

With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.

Our equity score has increased to +1 as the market has fallen, meaning we expect slightly more than our usual 10% pa assumption. We have more exposure than usual to Japan and smaller companies in the UK and have reduced emerging market exposure.

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.

Equity Markets

Fixed Interest

Commercial Property

Commercial property returns have slowed after a very strong 2014 and we have reduced weights recently. Our score is -1 which means we expect perhaps 6% to 6.5% pa.

Cash

For a typical balanced portfolio we are underweight fixed interest and neutral property. We are slightly overweight equity and also have with additional holdings in defined returns and alternative equity.

Balanced Asset Allocation

-3

-1

+1

-5

Score

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Investment Newsletter - September 2015