The Small Print

The contents of these muses are my own opinions, should not be taken as a personal recommendation to invest in the areas mentioned and does not replace the need for individual independent advice.

Investment Trusts – Part 1

Aside from the US/China trade war flaring up again, this time with actual tariffs being put into place rather than just sabre rattling I don’t have a lot to say about the global economy or stock markets. So I thought I would begin a series of articles about alternative investment products. Some you will be familiar with, others you may know little or nothing about. Today’s topic is investment trusts. In the future I’ll look at National Savings & Investments, structured products, investment bonds and tax efficient investments such as venture capital trusts.

As an independent financial adviser (IFA) I am required under the rules to consider the full range of what the regulator, the FCA, call “retail investment products,” when deciding what might suitable for my clients. These are defined in the rules although not entirely clearly. All the alternative products I will cover in these blogs fall into that category. Marketing of retail investment products and advice on them is fully regulated although perversely not all retail investment products are covered under the Financial Services Compensation Scheme (FSCS) in the event of insolvency.

Due to the technical differences between investment trusts and other types of fund I will cover them in two articles. The first is the technical bit requiring a bit of hard work for the reader. The second will cover the more practical investment applications. Don’t worry if you don’t get everything in this article, the applications are more important and interesting.

What is an Investment Trust?

Investment trusts are collective investment schemes just like unit trusts and opened ended investment companies (OEICS), types of funds that you will be very familiar with. In essence an investment trust is a fund which holds a basket of shares or other securities, typically 50-100, similar to unit trusts and OEICs. This spreads and reduces investment risk. Investors money is similarly pooled and the investments are professionally managed.

Historically investment trusts have remained off the radar for several reasons despite being around for much longer than unit trusts,* having lower management charges and generally better performance. Firstly they never paid commission to advisers, secondly they have additional complexities and risks compared to unit trusts and OEICs and thirdly they cannot be advertised for sale. The reason for the latter is that investment trusts have a very different legal structure than their better known collective investment cousins such as unit trusts. An investment trust is not a trust. It is a company, a PLC. Investment trusts issue shares which are listed and traded on the London Stock Exchange (LSE). At least one, the Scottish Mortgage Investment Trust is a FTSE 100 company, others are FTSE 250 listed.

Being an investor in an investment trust is no different in principle to owning shares in any other company whether that is GlaxoSmithKline, BP or Tesco. The difference is that an investment trust’s business is to buy, hold and trade stocks and shares of other companies rather than manufacture and sell drugs, drill oil or sell corn flakes. You won’t see newspaper or other adverts from Glaxo, BP or Tesco to buy their shares because a marketing campaign would distort the market and drive up the share price. Remember share prices are determined by supply and demand. Similarly you won’t see adverts recommending you buy investment trusts per se although their monthly savings schemes can be promoted.

Closed End Structure

The company structure of investment trusts has several key consequences. Most importantly they are said to be “closed end” because there are a limited number of shares in issue. When investors buy or sell their shares in an investment trust it does not affect the underlying assets or holdings, just the share price of the trust. This means an investment trust’s share price can trade at a premium or discount to what is called its Net Asset Value (NAV) per share, see below.

Consider an investment trust with 10,000,000 shares in issue. If the share price on the LSE is £5 per share at a given point of time then the market capitalisation or value of the investment trust is calculated as for other listed companies, i.e. the number of shares in issue x the share price, i.e. £50,000,000. It is important to understand this is the value of the investment trust as a listed company, not necessarily the value of the underlying assets and investments of the trust. In fact in most occasions the two figures will differ.

If there is large investor demand for the investment trust its share price will rise – say to £6 and conversely if the markets take a dislike to it and investors sell, the share price will fall – say to £4. The number of shares in issue however does not change with the variations in the share price but the market capitalisation of the trust will fluctuate – in this case from £40,000,000 to £60,000,000. Changes in the market capitalisation of an investment trust do not necessary reflect changes in the value of the trust’s assets.

In contrast OEICs and unit trusts are “open ended.” Take unit trusts as an example. Consider a unit trust whose assets i.e. the shares and cash it holds are valued at £50,000,000 and there are 10,000,000 units in issue. You will see parallels with the figures for the investment trust above. So what is the unit price? You’ve guessed it correctly, £5 per unit! However investor demand affects a unit trust in a very different way to an investment trust. If money flows into the fund the manager creates more units and if money leaves the fund the manager redeems units. This is the meaning of the term open ended. For example Mr A wishes to invest £1,000,000 in the unit trust. (Probably not a great idea to invest so much, but it is the maths that matter). The price of units we’ve seen is £5 so the manager simply creates 200,000 more units for Mr A. The unit trust now has 10,200,00 units in issue and the value of the trust is now £51,000,000. The price per unit is still £5. Investor demand has not increased the unit price in contrast to the effect on the share price for an investment trust or any other listed company. The same is true if investors are selling.

So in summary an investment trust is closed ended as there are a limited number of shares in issue. Investor demand moves the share price. A unit trust in contrast is open ended, units are created or redeemed by the manager and investor demand does not affect the unit price, except in special circumstances outside the scope of this article. Get this and you are 75% on the way to understanding investment trusts.

Premiums & Discounts

The share price of an investment trust may trade at a discount (or premium) to its Net Asset Value (NAV) per share. The two move semi-independently. The NAV per share is the value of an investment trust’s assets divided by the number of shares in issue. To calculate the value of the assets of a trust each of the constituent stocks and shares held is valued, cash is added and borrowings are deducted. The value of each stock is the number of shares held by the trust x its share price.

The NAV per share is the inherent value of each share but typically this is different to the share price itself. For example we noted above that the investment trust above has 10,000,000 shares in issue, a share price of £5 per share at a point in time and a market capitalisation of £50,000,000. Let us say the value of the underlying assets also happens to be £50,000,000. If however the value of the underlying stocks and shares and other assets held by the investment trust for example cash grows to £55,000,000 the NAV of the trust is now £5.50 per share. However the share price may only rise to £5.25. An investor buying into the trust will now acquire assets worth £5.50 for just £5.25, the price they paid for the shares. The trust is said to be trading at a discount to its NAV.

In contrast if the assets of the trust are worth £45,000,000 the NAV per share is £4.50 and the investment trust has a share price of £5, it is said to trade at a premium to its NAV. This feature is the same as any other listed company which has a NAV per share and a share price which may differ. For example consider a listed company which is a major food retailer. Its assets includes the value of its properties and stores, stock, cash and debtors. Let us say the share price is £1. The following day a take-over bid is announced and the share price rockets to £1.20. The share price has increased 20% but the value of underlying assets will have barely changed unless they secure a great new deal on their corn flakes. The company is now trading at a premium.


In conclusion a closed end fund such as an investment trust as with shares of other listed companies typically has a share price that differs from the underlying value of the company’s assets. This is because the market has priced the investment trust shares on the overall value it perceives the company is worth, which may be more or less than just the value of the assets. Aside from the issue of potential take-overs the market makes assessments of future cash flows, profits and dividends, and business opportunities and risks.

Unit trusts and OEICs in contrast in general have unit and share prices respectively that equal their NAV and do not carry discounts or premiums. The difference has a profound impact on the benefits and disadvantages of investment trusts.

*The first UK investment trust, the Foreign and Colonial was launched in 1868. The first UK unit trust from M&G came to market in 1931.

The content of this blog is based on my own understanding of investment trusts. Nothing in this article should be construed as personal investment advice, for example to invest in investment trusts. These may not be suitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions. Other cereals are available!

The global economy according to JP Morgan and Donald Rumsfeld

One of the best macro-economic and stock market commentaries I listen to is the JP Morgan’s quarterly “Guide to the Markets,” presented by the excellent Karen Ward, a Chief Market Strategist at the investment firm. In a recent webinar she naturally highlighted the 180 degree turnaround in market sentiment since the end of the year. The key factors have been the volte face in the US Federal Reserve’s monetary and interest rate policy, which has gone from hawkish to dovish, China shifting its foot from the brake to the accelerator with economic stimulus and a more favourable outlook for US/China trade deals. Equities and bonds have both rallied in the last few months.

Ward then considered the impact of the policy changes arising from the world’s two biggest economies. Firstly US monetary policy matters, both domestically and globally. On the former a pause on interest rate rises and quantitative tightening* makes corporate re-financing more affordable and it boosts consumer confidence in the US with lower mortgage rates. On the global stage a weaker dollar is a tail wind for commodities and it is positive for emerging markets with dollar denominated debt. In terms of trade whilst US exports accounts for just 13% of its GDP the US is the world’s third biggest exporter (Source: Trading Economics). Moreover the US runs a trade deficit i.e. imports more than she exports which is one reason that if the US sneezes the world catches a cold.

Interestingly Ward thought China’s stimulus is more significant for the global economic growth. She argued that China is still an emerging market with relatively low rates of urbanisation and real GDP per capita** and its expansion still has a long way to run. China of course has more influence on global trade than the US. The US economy is very consumer oriented whereas China’s is more export and infrastructure led which are both key planks of global trade. Infrastructure although domestic in nature requires raw materials and hence imports and trade. As an example of the importance of China and global trade Ward explained the poor European economy in 2018 was in significant part due to the Chinese slowdown. We also know that intra-Asian trade is strongly influenced by China. Moreover the US economy is expected to slow later this year as the sugar rush from Trump’s fiscal stimulus (corporation tax cuts and spending) reduces.

Whilst sentiment has much improved since the end of the year we are approaching a record for the length of the current global economic expansion. Everyone seems to agree we are late in the cycle. According to Ward equities are no longer screamingly cheap and for ongoing upward momentum in prices to continue we will need to see good corporate earnings growth coming through. The problem with being late in the cycle is that low levels of unemployment creates wage growth pressures which impacts on companies’ margins. Arguably recent US and Chinese policies will extend the cycle but for how long? Interestingly Ward says a late cycle favours investment in larger companies, quality and value.*** I’ll need to give that some thought. As you know I am a supporter of smaller companies.

My conclusion is that although equities have rallied in 2019 and markets are calm there are reasons to be cautious. Whilst there are known knowns such as the current economic stimuli, there are the known unknowns for example when will the cycle end and there are unknowns unknowns. The latter are potentially the most dangerous – unexpected geo-political events or unseen systemic economic threats could through a spanner in the works.

*Quantitative tightening (QT) is the reversal of quantitative easing (QE) in which a central bank offloads from its balance sheet the bonds it has acquired from money printing. QT reduces liquidity and causes bond prices to fall and yields to rise. Ward says that QT will come to an end earlier than predicted in the autumn . With interest rate rises on hold or set to fall (Ward says there is a 60% chance of this before the end of 2019) the bond market reacted very favourably.

**Real GDP per capita is the average contribution to the economy per head of population taking into account inflation. GDP is gross domestic product, a measure of the size of an economy.

***Value is an investment style that favours undervalued companies based on fundamentals. Since the global financial crisis investors have favoured a growth investment style with more visible earnings and superior growth.

The content of this blog are my own thoughts and assessments based on my understanding of the JP Morgan presentation. Nothing in this article should be construed as personal investment advice, for example to invest in larger companies or value investments.. These may not be suitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions.

Unloved UK Equities

There is a general consensus that the UK equity market is unloved. So unloved it didn’t receive a Valentine’s Day card this year. Some have even considered the UK to be uninvestable. Of course Brexit uncertainty is the main concern for investors but the US/China trade dispute and a slowing global economy are additional factors. But is it all doom and gloom? Russ Mould, investment director at AJ Bell thinks not. In a recent article he noted the FTSE 100 index is up about 6% in 2019 – albeit this is a recovery from the sell-off at the end of 2018. Moreover the UK market is relatively cheap, with many stocks trading at very low valuations and the FTSE 100 has an attractive 4.7% p.a. dividend yield. What however piqued Mould’s interest were analysts’ forecasts of record earnings in 2019, estimated to be £223 billion, an increase of 13% on 2018.

Another notable point here is that at the previous peak in 2011 almost 50% of the earnings came from the mining and oil sectors. This time around the earnings base is more widely spread with banks and consumer staples such as Unilever and Diageo expected to make big contributions. Mould however does highlight a number of threats to bank earnings and of course forecasts are just that. They will depend on a number of factors including the strength of the pound. You may have noticed that when Sterling falls the FTSE 100 index tends to rise. This is because 70% of FTSE 100 company earnings are derived from overseas. If Sterling falls against the US dollar or the Euro the value of those overseas earnings translates into more pounds. Of course the converse is true.

Mould concludes the gloom is somewhat overdone and that meeting or beating earnings expectations could convince sceptical investors back into the UK equity market. I agree although I think a resolution of the UK’s future with the EU will be required first. That said contrarian investors, seeing the positive fundamentals may opt to invest early for the very decent yield of 4.7% p.a. and long term capital growth potential. Whilst I favour actively managed funds there is a case for buying exposure through a low cost index tracker fund to complement actively managed UK equity funds held in a portfolio. A word of warning though. The FTSE 100 index has been a rotten investment in the last nineteen years. At the end of 1999 it peaked at 6,930. Today at the time of writing it is trading at 7,388. Ignoring dividends the capital value of the index has risen by a measly 6.6% in 19.25 years, but as you know past performance is not necessarily a guide to future returns. That works both ways.

The contents of this blog are my own thoughts and assessments based on Russ Mould’s article. Nothing in this article should be construed as personal investment advice, for example to invest in UK equities or a FTSE 100 index tracker. These may not be suitable for you. You should seek individual advice based on your own financial circumstances before making investment decisions.

Global Debt – A Concern?

Equity markets have been calm and treading water in the last month after a good start to 2019. A less aggressive Federal Reserve and pause in US money tightening and has clearly been well received by investors. That said Standard & Poors, a leading ratings agency warned about global debt. In a recent report S&P, Next Debt Crisis: Will Liquidity Hold? they stated that global debt has risen by 50% since the global financial crisis in 2008, led by major economy governments and non-financial corporates in China. They warned another credit downturn may be inevitable although they considered contagion risk to be low.

The article in Investment Week that I read about the report stated that in absolute terms the US is the most indebted of all governments with an increase of $10.6 trillion of borrowing in the last 10 years. Debt in China and the Eurozone has also risen significantly. Interestingly household debt has decreased in the US and the Eurozone but it has surged in China.

S&P also noted the quality of the debt issued has deteriorated with large issuance of bonds with BBB credit ratings. As you are probably aware ratings agencies like S&P, Moody’s and Fitch rate the creditworthiness of bonds issued by governments and corporates. Although rating nomenclatures vary depending on the agency the most common is:

Investment grade – AAA, AA, A, BBB. BBB bonds are investment grade but are the lowest ranked of this quality.

Non-investment grade – BB, B, CCC, CC, C & D or variations thereof. In the US non-investment grade are often called junk bonds, just the sort of term to give investors a whole heap of confidence! Here in the UK high yield is the preferred description reflecting the fact that non-investment grade bonds must pay a higher coupon or interest rate to compensate investors for the additional credit risk they are taking. It is funny how the differing terminology colours the perception of whether non-investment grade debt is good or bad. Interestingly high yield debt is sought by income investors and it is less interest rate sensitive than investment grade bonds.

The higher the credit rating the more likely the issuer is to meet its obligations i.e. to pay interest and return investors’ capital at maturity. Bonds issued by the many Western governments and the strongest corporations tend to have AAA or AA ratings. According to S&P 61% of companies have aggressive or highly leveraged financial risk profiles. They also highlighted the greater use of non-traditional fixed income products and covenant-lite bonds with decreased protection for investors. These and BBB bonds are less liquid and more volatile than higher quality credits.

In a low interest rate environment default risk has been muted, but with rising rates and a slowing global economy defaults could pick up. Defaults range from the relatively minor, a delayed interest payment on a bond to the very serious not repaying bondholders their capital at maturity. However interest rate rises are a tool central banks use to curb inflation and inflation erodes the value of debt. Firstly inflation results in higher pay and prices and increases taxes which enables governments to pay down debt. In addition debts falls relative to assets. For example if you have a mortgage of £70,000 on a property of £200,000 and house price inflation results in a 30% increase to £260,000 over five years the ratio of debt to assets falls even if you have not paid off any of the mortgage. For corporates rising inflation may erode earnings. They may be able to increase the prices of their goods and services but labour costs rise as well.

So what do I conclude? Too much debt has a history of causing major economic problems. It happened during the Wall Street crash when people borrowed to invest in the stock market, subsequently wiping out a whole swath of the US banking sector. It happened in 2007-2009 when the US housing market and complex financial instruments built on debt collapsed, again bringing down the banks. It happened with Eurozone with the Greek debt crises and it is bound to happen again. That said undoubtedly the banks are much stronger financially now than they were during the global financial crisis, a decade ago. There are real risks but I don’t see too many red signals at this stage. Investing in equities for the long term should still deliver good returns whilst portfolios should be diversified and have a defensive core.

The content of this blog are my own thoughts and assessments based on the S&P report. Nothing in this article should be construed as personal investment advice, for example to invest in high yield bonds or equities. You should seek individual advice based on your own financial circumstances before making investment decisions.

Mini-Bonds – Too good to be true?

Recently I had an enquiry from an old University friend who is not a client. He got back in touch with me a couple of years ago. He asked me about an ISA he had come across from a company called Capital Bridge. It was offering 9% p.a. interest for three years. My old friend was clearly attracted to this fixed rate bond given the paltry rates of interest on offer from mainstream accounts. However he realised that it was more risky than a traditional cash deposit account as the underlying investments were loans to property companies. That said a salesman who called him after he registered interest seemed confident he would get 9% p.a. over three years. So what did I think?

Looking at the Capital Bridge website the bond offers 9% p.a. interest fixed for three years and is paid quarterly. Investors buy a bond which is held within an ISA wrapper meaning the interest would be tax free. To be fair there are plenty of risk warnings on the website and the downloadable brochure but I could find a link to the Information Memorandum or Prospectus, a detailed legal document required for the issue of bonds. However Capital Bridge make it clear that capital is at risk and there is no Financial Services Compensation Scheme (FSCS) coverage in the event of default unlike a traditional deposit account. As you are no doubt aware you are covered up to £85,000 if a mainstream bank or building society becomes insolvent. The Capital Bridge bond in terms of investor protection is no different in principle to investing directly in the shares or bonds issued by a UK company. If the company goes bust you may lose all your money and will have no recourse to the FSCS.

To reassure potential investors the website and brochure emphasise the due diligence that is undertaken in making loans to property developers and the security that is taken, notably the charges taken on the relevant properties. Phrases like hand-picked UK property developers, significant security and strict criteria suggest care and safety. Personal guarantees are taken from directors, loans are no more than 80% of the value of the property and they are valued by a Royal Institute of Chartered Surveyors surveyor.

To be fair it is made clear the security taken over the properties may be insufficient to repay bondholders and that property is an illiquid asset and the bonds may be difficult to sell. Oddly though it is stated that the investment into a Capital Bridge ISA should be a long term investment but I would not consider three years in any sense to be long term. The point is investors in the bond not only expect 9% p.a. interest for three years but a full return of capital at the end of the term. Where will Capital Bridge derive the cash to fully repay bondholders? All the loans will need to have been repaid in full at the right time. This in turn may require the properties to be sold at good values. Both are big asks.

There are plenty of other concerns about the product. Firstly interest payments are not guaranteed as these depend on interest payments made by the property developers. Secondly Capital Bridge is the trading name of Capital Bridge Bond Co 1 Ltd. It is not authorised and regulated by the FCA. Capital Bridge then pass investors’ money to a related company called Capital Bridge Finance Solutions Ltd (CBFS) who in turn make the property loans and take security on the assets. CBFS are also not an FCA firm. However the underlying investment is held within an ISA provided by Northern Provident Investments who are FCA regulated. That in of itself does not give legitimacy to the underlying investment nor provide investor protection. The ISA manager merely confers a tax free status to a unregulated investment and administer the interest payments. They have no liability for default for the underlying investments. Herein lies one of the problems of regulation, that an unregulated investment can be held within an ISA which is a regulated wrapper. It is similar to the position IFAs find themselves in. If I recommend a client buys an investment trust or exchange traded fund (ETF) for their ISA there is a confusing mix of investor protections. The advice I give is regulated, the ISA plan manager is regulated but investment trusts and ETFs are not and investors have no recourse to the FSCS if the investment goes bust, unless an adviser gave bad advice and the IFA firm itself is in default.

Interestingly the enquiry from my old university mate came at a time when a company called London Capital & Finance (LCF) no long earlier went into administration. They offered a similar 8% p.a. fixed rate bond held within an ISA. There is a page on it on the FCA website:

Also you may have listened to Money Box on BBC Radio 4 last Saturday which covered this story. Around 14,000 customers had invested around £214 million into the bond. Investors may get little or nothing back once the administrators and other debtors get paid. While the asset backed nature of the Capital Bridge loans are different to those made by LCF both are mini-bonds and carry the same risks. The FCA write:

“A mini-bond is an unlisted debt security, typically issued by small businesses to raise funds.

Mini-bonds can be attractive to investors because of the interest rates on offer. However, prospective investors need to understand the associated risks. Mini-bonds are usually illiquid as they are not transferable, unlike listed retail bonds, which they are often compared to. They can also be high risk, as the failure rate of small businesses can be high. Additionally, as with the issue of other non-transferable corporate bonds, there is no Financial Services Compensation Scheme (FSCS) protection if the issuer fails.”

Another concern lies with the fact that the bonds are issued Capital Bridge Bond Co 1 Ltd. They will have very limited assets of their own as they have passed over investors’ cash to a separate legal entity CBFS. I could write more but in conclusion I would not invest in such a bond myself and would actively dissuade my clients from doing so. It looks too good to be true. There are simply too many concerns and risks for me, whilst better investments exist elsewhere. Structured deposits or structured capital at risk products are options for high potential returns along with adventurous equity funds. I plan to write about the former at a later stage.

The content of this blog are my own thoughts and assessments. Nothing in this article should be construed as personal investment advice, for example to invest in structured products or equities. You should seek individual advice based on your own financial circumstances before making investment decisions.

Positive Start to 2019

In my last blog post on 10/1/19 I highlighted a number of things that would be good for equity markets, the first was the Federal Reserve, the US central bank pausing on interest rate rises. On Wednesday the Fed announced borrowing costs would be unchanged. The tone of their statement was much more dovish than previously. They recognised that inflation was muted and remains close to its 2% target. The Fed also expressed it was willing to be flexible on its Quantitative Tightening (QT) programme. QT is the reduction in US government’s balance sheet, which is rolling off $50 billion of bonds each month, thereby reversing QE. In December the Chairman of the Fed, Jerome Powell had said the balance sheet reduction was on autopilot, which spooked investors. The pause was also in recognition of domestic and global economic “cross-currents,” including the US/China trade war, weaker growth in China and Brexit and the harm that an aggressive monetary policy could have on financial markets.

The markets liked what they heard, with a rally in equities around the world. The dollar fell against most of its peers and gold rose to an eight month high. In general commodities prices are inversely correlated with the dollar because they are priced in dollars.* A weaker dollar is also positive for emerging markets.

It is early days yet but January was a better month for investors after the sell-off between September and December.

*Commodities are priced in dollars. What this means is that they become cheaper in local currencies if the dollar weakens, even if the underlying price of the commodity e.g. gold or oil does not change. For example if the £:$ exchange rate is £1 = $1.30 and the dollar weakens to £1 = $1.40, a UK investor buying dollars to buy gold acquires more dollars for a fixed investment and hence acquires more gold.

The content of this blog is intended for general commentary only and is based on my understanding of current stock market conditions. Nothing in this article should be construed as personal investment advice, for example to invest in equities. You should seek individual advice based on your own financial circumstances before making investment decisions.

Guide to the markets

Each quarter JP Morgan produce a comprehensive guide to the markets, pages full of economic charts and tables. For many people, nerds excepted, it would be as interesting as a county bus timetable or a train spotter’s manual. For an investor it is a gold mine of invaluable information. The guide is then followed by an excellent webinar for advisers, presented by Karen Ward, a Chief Market Strategist at JP Morgan. Yesterday’s first quarter presentation was no exception. In it Ward posed the most pressing question facing investors – is this a good to buy equities or is there a risk of further falls, even a big bear market of 50% on par with the tech bubble bursting and the global financial crisis? Her response was that there is more downside potential if company earnings expectations deteriorate. However this would be unlikely if four things happen.

1. The Federal Reserve pauses

If the Fed, the US central banks takes its foot off the accelerator on raising interest rates it will be good for markets. Currently there is a disconnect between economic data and financial markets. The former suggests the economy is good whilst the latter is a signal of a slowdown.

2. Trade wars ease

There are signs that US and China are being impacted negatively. New manufacturing orders have fallen and in the US corporate investment has stalled. However things could get worse. The 2nd of March is crucial date as US tariffs on $200 billion worth of Chinese goods are set to rise from 10% to 25% if a deal is not forthcoming.

3. China steps up the stimulus

China had been clamping down on credit. Now in response to a slowdown it is increasing release of credit in a targeted manner, bringing in a range of tax cuts and increasing infrastructure spending.

4. European and Brexit risks abate

This is mainly geo-political risk. Brussels and Rome have come to an agreement on the Italian budget but problems in the Italian economy remain whilst its bond market is one of the largest in the world. Ward noted however that the sharp fall in the oil price has been like a tax cut for European consumers.

In conclusion Ward was reasonably confident that the Fed would pause, China would up the stimulus and Brexit would be OK but she was less certain about Europe and trade wars easing. Here there is a deeper issue about geo-political and global economic dominance between the US and China.

Another issue is the direction of quantitative tightening (QT), the reversal of massive bond buying programmes (QE). QT will need careful management so that governments reduce their balance sheets without triggering a major sell-off in fixed interest markets. This would cause rising interest rates, harm the money supply and send economies into recession.

Although Karen Ward did not expect the sky to fall in there were plenty of “ifs” and this requires a cautious approach by investors. However at the start of 2019 I am more optimistic than I was at the end of 2018. I think sentiment has been worse than the economic fundamentals and I expect 2019 to be a positive year for equities. Interestingly Wall Street firms have said the same.

The content of this blog is intended for general commentary only and is based on my understanding of the JP Morgan presentation. Nothing in this article should be construed as personal investment advice, for example to invest in equities. You should seek individual advice based on your own financial circumstances before making investment decisions.

Prospects for 2019

We all know the New Year and New Year’s resolutions don’t really count for much. After all we are the same people on the 1st January as we were on December 31st and we will carry the same baggage and issues into 2019 as we had in 2018. So it is with the global economy and stock markets. We all know the causes of the current malaise – US/China trade wars, quantitative tightening (QT*), rising interest rates and dollar strength in the US, a falling oil price, Brexit woes and the Italian budget crisis. I fully expect these issues will carry through into 2019 but are there any prospects for change?

At this time of the year fund managers, chief investment officers and other professional commentators are all putting out their opinions on the state of markets and what investors can expect in 2019. An interesting article from Artemis Fund Managers considered the history of stock market crashes and bear markets going back to the 1929 Wall Street crash and identified the portents of doom that indicated that all was not well. For example the 2008 global financial crises was in the context of high levels of personal debt, lax banking regulation, over-valued bank stocks and rapid growth in money supply.

High valuations appear as a common theme in most crashes whilst other factors included companies with minimal cash earnings as in the technology crash in the early noughties and leverage, investors borrowing to buy stocks in the run up to the Wall Street crash.

Whilst Artemis consider valuations to be reasonable today, debt is a clear concern. They note that total US debt is much higher today than it was in 2008 although this is mostly government debt and reasonably serviceable with low interest rates. In contrast Artemis consider corporate America to have strong balance sheets and few households have high levels of debt. Whilst I concluded Artemis see no definitive signs of a crash coming they are certainly wary, noting that trade disputes have previously led to crashes and fast paced electronic trading platforms have potential for damage.

Franklin Templeton observed a confluence of negative forces coming together in the last quarter of 2018. They think the cause of any global recession will be trade tariffs and Federal Reserve policy error. The Federal Reserve is the US central bank and the policy error would be raising interest rates too fast especially in the light of a slowing economy from US/China trade wars. Franklin Templeton are more optimistic that the Fed will ease back on tightening than they are on trade wars abating, as they reckon US policy is geopolitical i.e. it is as much about curbing China’s global influence as it is about trade deficits.

Another interesting point Franklin Templeton make is that all the negatives are priced in and if there are no further shocks at the very least stock prices should stabilise. They also consider the UK equity market to be cheap with a forward P/E ratio** of 12x at the time of writing on the 7th December and a dividend yield close to 5%. The market is now trading at a discount to its intrinsic value as opposed to a premium. That said I don’t expect unloved UK stocks to rally until the outcome of Brexit is clearer.

Meanwhile in early October the International Monetary Fund (IMF) cut their 2019 forecasts for global economic growth to 3.7% from 3.9% previously. In late November the Organization for Economic Cooperation and Development (OECD) downgraded its forecast for growth in worldwide gross domestic product (GDP) to 3.5%. If these figures prove to be true they don’t seem too bad to me. Clearly there will be wide disparity in different economies. Brexit is bound to have an effect in the UK as will the consumption tax hike from 8% to 10% in Japan scheduled for October 2019. In this respect we need to bear in mind that smaller companies are more geared to the domestic economy and will be more sensitive to local issues. In contrast around 70% of the earnings from FTSE 100 companies are from abroad. Not only are they less affected by poor domestic demand a weak pound boosts the value of those earnings when they are repatriated back to the UK. If Sterling falls yes we will import inflation but it is not an unmitigated disaster as some suggest. Similarly is a falling oil price good or bad? It is good and bad, it is great for net importers of oil like India and Japan and it keeps petrol costs down in the UK. However it is bad for oil exporters notably emerging markets.

So what do I conclude? The long bull market, the flat yield curve (another historic harbinger of doom. This was discussed in August ), unwinding of QE, rising interest rates, a stronger dollar and trade wars suggest a bumpy ride in 2019 with the potential for recession. However in the long term share prices are driven by fundamentals for example cash flows, earnings growth and competitive advantage, and I don’t think the fundamentals look too bad. A culture of shareholder value is developing, notably in Japan and whilst US tech giants have taken a hit recently but they hold enormous amounts of cash which can sustain growth and dividends. Moreover tech companies are dynamic and innovative and I expect them to adapt to challenges for example Apple’s disappointing iPhone sales. Finally Chancellor Philip Hammond would bite your hand off for 3.5% GDP growth in the UK. Global economic growth at that level should support earnings.

In conclusion I can’t help thinking sentiment is worse than the fundamentals would suggest, although there is disparity from economy to economy and sector to sector. No-one would seriously suggest for example that the UK retail sector is in great shape. That said sentiment is a strong driver of markets and trumps fundamentals in sell-offs. I guess I am not too pessimistic. It could get worse with a further crash and recession but if markets have fully priced in the bad news there could be a rebound if things turn out better than expected.

In general my advice to clients is likely to be stay invested, deploy cash on the dips, buy and hold, use monthly investment to reduce risk, maintain portfolio diversity in terms of asset allocation and invest with high quality active fund managers. I expect the withdrawal of QE and QT will result in disparity of stock returns and in this scenario stock picking strategies should outperform passive investment.

*Quantitative tightening (QT) is the unwinding of the bond buying programme (QE) of central banks. It is currently happening in the US. It decreases the size of the government’s balance sheet and the money supply. The Fed is doing this by allowing up to $50 billion of bonds to mature each month without replacing them. Please note QT is not the same as tapering of QE. This is a gradual reduction in asset purchases by central banks. Eventually QT should follow. The European Central Bank has started tapering with an aim of ending it by the end of this year.

**The P/E is the ratio of the price of a stock or market to earnings per share. The P/E is a widely used measure of valuations, the higher the ratio the higher the value. A P/E of 15 means an investor would require 15 years of earnings at the current level to recoup the price of buying the stock or market at the current price. Various earnings are used to calculate P/E ratios. As historic earnings are not necessarily indicative of future returns projected future earnings are sometimes used.

The content of this blog is intended for general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

May I take this opportunity to wish you a very happy Christmas and New Year.

Gravity is not uniform

With a recent lull in work I had time yesterday to take a look at my own pension plan. I was interested to see how individual investments and assets had fared during the recent sell-off in global equity markets. I am a very adventurous risk investor by nature and have limited exposure to bond funds and no holdings in multi-asset investments. They will be for the future when I contemplate retirement. I have absolutely no plans to hang up my boots yet.

I had last valued the portfolio on 6/9/18. Markets rallied towards the end of September, they fell sharply in October and have drifted lower in November.

Looking at the funds I hold, smaller companies have been the clear losers from 6/9/18 to 22/11/18. My holding in the Baring Europe Select fell 12.9%, the BMO US Smaller Companies lost 10.5%, the JP Morgan Smaller Companies investment trust was down 17.8% and the Standard Life Investments Global Smaller Companies fund shed 18.1%. Why have smaller companies been hit so hard in this sell-off? In part this is due to their perceived higher risk, with investors switching to safe haven assets. In addition prices and valuations of smaller companies have risen sharply in the last five years and as such they were especially vulnerable to a correction. Finally smaller companies are much more geared to the local economy in contrast to large companies which are more globally focused and typically have strong overseas earnings. In the UK, Brexit uncertainty and a weak pound favours larger firms.

It is important to say that aside from a selective flight to quality, in a sell-off investors tend to dump stocks indiscriminately. Undoubtedly many smaller companies have been sold without due consideration of their fundamentals* i.e. how good their businesses are. Being confident that fundamentals always come to the fore I am planning to do nothing with my smaller company funds. I will hold them with an expectation of recovery. In the meantime I am happy to sit on paper losses.

The other big falling sector unsurprisingly was technology and my holding in the Polar Technology investment trust was down 15.9%.

It was interesting to see value investments holding up relatively well. They fell modestly. The Fidelity American Special Situations was down 3.7% and the Schroder Recovery shed 3.2%. To remind you a value investment style focuses on undervalued, recovery and out of favour stocks and these have been in the doldrums in the last five to seven years compared to growth stocks, which have been getting expensive. Historically value has outperformed growth** and this may be a reversion back to this trend.

Finally it was a surprise to see a number of my funds rise in value over the last two and a half months. The biggest was my iShares MSCI Brazil ETF, a traded security that tracks the MSCI*** Brazil index. It is a rare example of a passive investment that I hold in my pension. It is up 23.9% since early September. A number of commodity funds investing in gold and silver were modest risers as was the M&G Emerging Market Bond fund.

So what is my conclusion? Gravity is not uniform. In a sell off not everything falls to the same extent whilst some assets may defy gravity and drift upwards. It illustrates the importance of diversification and holding negatively correlated assets in a portfolio. Overall my pension fell by 5.6% from 6/9/18 to 22/11/18 so it hasn’t been an unmitigated disaster.

*Fundamentals refers to the strength of a business and takes into account a variety of economic metrics and qualities such as cash flows, profits growth, dividend cover and sustainability, balance sheet strength, barriers to entry of competitors and strength of the company management.

**A growth investment style focuses on companies with an expectation of a higher than average dividend growth and share appreciation in the future even if they appear to be expensive. The document from Janus Henderson describes value and investment styles.

***Morgan Stanley Capital International. MSCI have created a number of stock market indices which Exchange Traded Funds (ETFs) and index trackers seek to replicate the performance of.

The content of this blog is intended for general commentary only. Nothing in this article should be construed as personal investment advice and the funds mentioned that I invest in are not intended to be recommendations. You should seek individual advice based on your own financial circumstances before making investment decisions.

Stock market falls – time in the market, timing the market

October has been a rotten month for global stock markets. The FTSE 100 closed at 6,939 yesterday having peaked at 7,877 on 22/5/18 – a decline of 11.9%, although this does not take into account dividends. The S&P 500, a more representative stock market index of the US economy than the Dow Jones peaked at 2,929 on 24/9/18 and closed yesterday at 2,705, down 7.6% whilst the German DAX has fallen from its January 2018 high by 17.4%. Emerging markets have fallen further by around 25%.

The cause of the stock market falls has been attributed to rising US interest rates and US Treasury yields, trade wars, the Italian bond market, Brexit and more latterly disappointing earnings from US technology companies. I suspect investors worried about the bull market being long in the tooth are reacting, perhaps over-reacting to any bad economic news or data. However whether the “correction” (defined as a 10% fall) or bear market (a 20% fall) is the harbinger of a more serious crash or global recession is too early to say. What we know is that 2018 has proved to be much more volatile than 2017, which was a very benign period for stock prices. The bear has woken from its hibernation.

So how should investors react? Most of my clients take these events in their stride although I have had a couple of worried clients contact me about declining investment valuations. My advice is to stay invested and ride the waves. Valuations may look bleak but they are paper figures unless investments are crystallised. Selling out of fear turns paper losses into real ones and it is the worst thing investors can do. This is why it is axiomatic to hold sufficient cash to prevent forced selling of equities at terrible prices during market crashes. Cash is the insurance that permits investment for the long term. All the evidence suggest this delivers the best results. I have been an IFA for 26 years now and I have clients with investments they have held for 10, 15 or 20 years. One of the benefits of experience is I can assess the outcomes. In all cases these are highly favourable and reflect the fact that in the long term equities deliver excellent profits for buy and hold investors. Many academic studies support this. I remember a few years ago reviewing a client portfolio. Over a 20-21 year period a holding in a European equity fund had risen from £3,000 to £21,000. The client had held the fund through thick and thin, the technology bubble bursting in the early noughties, the great financial crisis of 2008 and 2009 and more latterly the Greek debt crisis, and she certainly reaped the results. Stock markets typically recover and continue their upward trend in subsequent years. There are very few examples of stock markets remaining in the doldrums for the long term.

Having this perspective is more difficult for clients who have been invested for a short period of time. This is because profit levels are especially sensitive to price fluctuations. Downward movements of markets frequently mean in the early days clients who have just invested go into the red i.e. the value of their portfolios are less than the amounts invested. For long term investors stock market crashes dent profits but rarely wipe them out, so it doesn’t feel as bad.

There is an old adage that says, it is time in the market that counts, not timing the market. The latter is notoriously difficult to do. It is all very well and good if you can buy in at the bottom of the market and a V shaped recovery follows but not so if equities continue to slide after you have invested. However there is a case for tactical investment at times like this to buy in selectively at relatively low prices. Whilst you do not know the direction of markets post investment you can be sure you got better prices than had you invested at an earlier peak. Recently for a few clients I have advised tactical investment of cash hanging around in ISAs and pensions doing nothing and I am aware that some fund managers have used the market falls to add to their best stocks. Fund managers would not be buyers if they thought the market falls represented a systemic threat. Time will tell if they are correct.

The content of this blog is intended for general commentary only and is based on my understanding of stock markets. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.