Seismic or Temporary Shifts?

One of the most interesting aspects of my job is to produce updated portfolio valuation statements for my clients’ investments. Sometimes it makes good reading, other times not. In my report I compare the figures with previous valuations, typically undertaken six months’ earlier. Aside from the change to the total figure it is very instructive to see investment trends i.e. what asset classes, sectors or funds have done well or poorly over the period in question. In the last six months there has been some significant, unexpected and interesting changes to asset performance.

To explain I want to go back almost a year to August 2015 to the global equity sell-off, triggered mainly by fears about China. You will recall her economic growth was slowing, global trade was falling and Chinese debt was a worry. During the sell-off the shares of large companies represented by the FTSE 100 index fell sharply whereas UK smaller companies and many mid-caps did not. Why was this? The falls in the share prices of larger companies was a rational reaction by investors to concerns about the health of the global economy. FTSE 100 companies are global players with around 70% of their earnings derived from outside the UK. The index also has a high weighting to oil and other commodity companies whose fortunes and share prices are extremely sensitive to the global economy and specifically Chinese demand. In contrast UK smaller companies and mid-caps, typically represented by the FTSE 250 index are much more domestically focused with most of their earnings arising in the UK. As the UK economy was recovering well and smaller companies are less impacted by global events they were largely insulated from the slowdown in China and their share prices held up well.

Roll on to the EU referendum and in the two weeks since the UK voted, FTSE 100 companies have generally rallied sharply (the banks being a notable exception, due to their domestic focus). Why? The pound has fallen sharply against other currencies notably the dollar which means overseas earnings are worth more when repatriated back to Sterling. A weak pound is bad for imports but it sure gives a turbo charge to global earnings and UK exporters. In contrast a vote to leave Brexit has resulted in uncertainty and fears about the UK economy specifically. You will be aware of all the potential problems – trade tariffs, reduced investment into the UK, jobs relocating to the EU, higher inflation, recession, higher taxes and interest rates. It would be fair to say some of the fears are illogical or over-stated. For example if the UK goes into recession it is likely to be mild and interest rates are unlikely to rise.* Other fears are of course entirely justified and uncertainty itself is a powerful disincentive for investors. It is for this reason that smaller and medium sized companies with their focus on the UK domestic and consumer economy have fallen sharply in the last few weeks. House builders and recruitment companies have been hit especially hard.

So in summary, global events last August hit FTSE 100 companies hard but the vote to leave the EU has now triggered a rally in their share prices whilst the opposite has happened to smaller companies and mid-caps. I should also add that in the last five years smaller companies significantly outperformed larger companies and mega-caps and I suspect investors used the Brexit vote to take profits.

Moving on I want to highlight another asset allocation shift in the last six months. Anyone who has invested into a commodities fund in recent years will have seen huge losses on their investment.^ As an example take the JP Morgan Natural Resources fund. Data from FE Trustnet (6/7/16 and for all other performance statistics) shows the fund is down 53.9% in the last five years. However the last six months there has been a rally of 50.5%. Yes you are reading correctly! The rally has been due to the significant recovery in the oil price since the January and February 2016 lows, a small decline in the value of the dollar~ since the beginning of the year, more efficient deployment of capital by commodity companies, some abatement of fears over China and investors recognising the exceptional value in an over-sold sector.

Precious metals have been beneficiaries too with the spot price of gold and the shares of gold producers rising sharply. Gold has recovered its safe haven status whilst a fund I recommended to many of my clients and bought myself, the Blackrock Gold & General is up a staggering 117.5% in the last six months. I will be the first to admit I wrongly called the bottom of the commodities’ crash and advised clients to invest too early but I am pleased I got one thing right. I recommended clients hold their loss making funds on anticipation of a recovery. I always suspected that when a rally comes it would be rapid and substantial. It’s nice to be right occasionally!

The other major assets that have finally rallied in the last six months are global emerging market equities reversing a long trend of underperformance compared to developed market equities. The average global emerging markets fund is up 22.1% in the last six months. There are multiple factors here, one of which is the rally in commodity prices; the two sectors are correlated. More perhaps at a later stage on emerging markets.

Whether these asset allocation changes are the start of seismic shifts in favoured asset classes or just temporary rallies is too early to say. I think the global economy needs to recover more before we can conclude the rally in commodities and emerging markets is sustainable.

*Mark Carney, the Governor of the Bank of England warned of a technical recession. This is hardly a scary prospect as it could mean as little as a 0.1% decline in GDP for two successive quarters. If there is a recession interest rates are more likely to fall than to rise unless inflation is a serious issue in which case we could see so called “stagnation.”

^A loss is only a paper loss unless an investor crystallises the fall in value by selling or switching to another investment.

~There is a historic negative correlation between commodity prices and the US dollar. Commodities are priced in dollars and when the dollar falls in value against other currencies it is cheaper for non-dollar investors to buy commodities and vice versa.

This blog post is intended to be general investment commentary only. Nothing in this article should be construed as investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.