Investment Risk & Reward

Risk and reward are often seen as two sides of the same coin. Reward is easy to measure. It is the investment gains achieved – what your fund or portfolio is worth minus how much you invested. Of course judging the value of that gain is a different issue and until you crystallise gains you merely have paper profits.

But what about risk? Risk when investing in funds such as unit trusts or OEICs, investment trusts or exchange traded funds is normally viewed as volatility of value, peak to trough fluctuations, not the potential for investors to lose all their money. Volatility of fund or portfolio value is caused by multiple factors including market sentiment, currency movements, the asset allocation of a fund or portfolio and the stocks held. In general government and corporate bonds are less volatile than equities, emerging markets assets are more volatile than developed markets and mixed asset funds fluctuate less than pure equity funds.

Conventional wisdom suggests that in order to achieve higher returns investors need to take greater risk. However there is evidence to suggest the opposite may be true. In a recent blog by Terry Smith, manager of the Fundsmith Equity, a brilliant global fund he cites research by Robert Haugen and Nardin Baker from 2012. They analysed stock returns in 21 developed markets from 1990 to 2011 and found that counter-intuitively low risk stocks outperformed high risk ones. They concluded:

“The fact that low-risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is persistent — existing now and as far back in time as we can see. It extends to all equity markets in the world. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward.”

The explicit implication here is that investors can achieve higher returns without taking extra risk. One way this can be achieved is by blending assets that you would instinctively think increases risk. Smith gives an example of adding smaller companies to a global equity portfolio. A change from 100% invested in the MSCI* World Index to 35% in the MSCI World Small Cap and 65% MSCI World Index increases returns but with no additional risk as measured by volatility. For the technicians among you this is an example of an “efficient frontier.”

A similar conclusion is supported by Financial Express (FE) Risk Scores. These are volatility measures of funds over a three year period. The scores and methodology can be found on the FE Trustnet website. Uniquely FE Risk Scores are relative not absolute** measures of risk. This is because the FTSE 100 index is used as a benchmark and this has been assigned a constant volatility measure of 100. For example the Fundsmith Equity has a current FE Risk Score of 108 whilst that for the M&G Corporate Bond is 32. What this means is the Fundsmith Equity is 8% more volatile than the FTSE 100 and the M&G Corporate Bond is 68% less volatile than the FTSE 100 over the last three years. However what I find especially interesting is that if you consider the Investment Association UK Smaller Companies sector 46 funds are listed that have FE Risk Scores. All have scores of less than 100, with many in the 70s and 80s. This seems to blow a hole in the theory that smaller companies are more risky than larger ones. Moreover many of the UK smaller company funds have delivered returns in excess of 50% in the last three years. For example the Marlborough Special Situations rose 59.3% (FE Trustnet 1/9/18). Its FE Risk Score is 83. In contrast the HSBC FTSE 100 Index Tracker (Accumulation share class) which mimics the performance of the FTSE 100 index and re-invests dividends gained just 38.7%. Its FE Risk Score is 100.

A word of caution is needed here. Firstly the FTSE 100 has a high weighting to oil majors, miners and banks which generally have been eschewed by investors in recent years, dampening returns. Moreover commodity stocks are especially volatile being highly geared to the strength of the global economy. This means the FTSE 100 has been hit by a double whammy of low returns and high volatility. If market sentiment changes towards commodities and financials the FTSE 100 could rally and its risk reward profile will improve. On this point banks are looking more attractive with rising interest rates and stronger earnings and balance sheets, allowing a return to payment of dividends. Conversely the fair wind for smaller companies could deteriorate if there is a UK recession. Secondly although there is clear evidence that risk and reward are not correlated it would be wrong to assume this is true in all circumstances. It all depends on what you are looking at. The Haugin and Baker study focused on low and high volatility stocks but that is not the only comparison we can make. As noted equities typically outperform bonds but are more volatile. Similarly an investor moving from a cautious risk portfolio to pure equities should expect better long term returns but more volatile prices.

Finally to assume risk is only about volatility of value is simplistic. There are plenty of other snakes in the jungle ready to take a bite out of your money. Government and corporate bonds carry interest rate or duration risk. Then there is currency risk and fund manager risk. The latter is the potential for fund managers to make big mistakes in their asset allocation and stock selection and for star fund managers to go from hero to zero. Then there is inflation risk which is especially relevant to multi-asset, targeted absolute return and other cautious risk funds. The point is these are all low volatility investments but are subject to a risk that pure equity funds do not carry.

In respect of inflation risk I have recently been assessing the performance of cautious risk funds I have recommended in recent years. I have taken the view that to justify inclusion in a portfolio a fund should have beaten inflation over the last three years. If it hasn’t then the investment has lost value in real terms i.e. it has lost purchasing power. The benchmark I have used is RPI inflation. From July 2015 to July 2018, the latest published data, I calculated RPI was 8.9%. Whilst many defensive funds have significantly outperformed inflation others have failed to do so and have faced the axe.

To finish we need to consider cash. In absolute terms cash has no volatility. If £100,000 is held in a savings account and interest is paid out, the value of the cash will always be £100,000. If interest is accumulated the cash value rises steadily. However its purchasing power or real value decreases if inflation exceeds interest rates. If for example inflation is 1.5% p.a. higher after ten years the real value of the cash drops to £85,973. The point here is there is no such thing as a risk free investment. Risk in one form or another is a necessary evil all investors must take. Hiding your money under the bed is not a solution.

*MSCI – Morgan Stanley Capital International. They produce stock market indices used for benchmarking portfolios and exchange traded funds (ETFs).

**Absolute volatility is measured as the standard deviation of returns around a mean.

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.

Crystal Balls, Yield Curves & Old Folk

Arguably the greatest challenge that faces fund managers, those who give investment advice and investors alike is to correctly assess the strength and direction of the global economy and stock markets. Get those calls right and it should be evident whether to adopt a cautious or adventurous investment strategy. Good asset allocation will then follow. Currently that question is very pertinent to US, the driver of the global economy. Is the US heading for recession? Is the bull market in US equities coming to an end? After all it is the second longest rally in history and rather long in the tooth as some claim. Wouldn’t it be great if we had a crystal ball. Well funnily enough maybe we do – it is called the yield curve. The yield curve is a graph of government bond yields over different time periods. The yields are the interest rates a government must pay for borrowing. In general the longer the loan period the higher is the interest rate that is demanded by investors. This principally reflects the risk of future inflation to capital, the longer the term of a loan the greater the risk. The normal yield curve is upward sloping but there are times when long term borrowing costs are the same or even less than short term rates. In these circumstances the yield curve is flat or inverted.

In an article I read by Darren Ruane, Head of Fixed Interest at Investec, he notes the US yield curve is currently flat with interest rates on 2,10 & 30 year Treasuries* at 2.7%, 3.0% and 3.1% respectively. These are market rates determined by investors buying and selling US government bonds and thereby setting prices and hence their yields. What the yield curve shows is that the market is not placing a premium on buying long term US debt. In other words investors don’t think that inflation risk is high. This suggests the market is predicting economic slowdown. Historically a flat or inverted yield curve has been a reliable indicator of recession in the following 6 to 24 months. Ruane cites several examples including the inflation/interest rate recession of the late 1980s, ahead of the dot com crash in the early 2000s and prior to the global financial crisis in 2006/07. But is the yield curve a reliable indicator this time around?

Ruane says the yield curve should be split into two, the short end of the curve and the long end. The former is dominated by movements in US base rates and they are rising steadily to help cool the economy. Interest rates are expected to reach 3.25% in 2019. Global trade barriers may also lead to an economic slowdown in the US.

The long end of the curve is more responsive to long term inflation expectations and interest rates. However Ruane notes that other factors are in play, notably that the unprecedented programme of money printing (QE) has reduced bond yields. In addition inflation has been muted in part from technological solutions in industry pushing down the price of goods but also from an ageing population in the West. Apparently old folk prefer to save rather than spend! I also wonder whether the influences on the short and the long end of the curve are easily separable. Is it not reasonable to think that rising US base rates is also a major influence on the long end of the curve? Investors could argue the Federal Reserve, the US central bank clearly has a grip on ensuring the economy does not overheat and fuel rampant inflation.

Putting this together, short term interest rates may be high due to base rate rises and long term rates may be low due to QE and disinflationary forces. If so the flat yield curve may not be a reliable indicator that recession is coming. However Ruane says Investec are wary of saying this time is different. All we can conclude is that the crystal ball has got a bit cloudy.

My own view is the yield curve should not be dismissed nor given too much weight. A factor in favour of ongoing expansion of the global economy is that the recovery since the financial crisis has been slow and muted. Emerging markets have been hit recently by a strong dollar whilst Brexit concerns are also weighing on investment decisions and UK equities. Trade wars are also a headwind. With many new jobs in the UK at least being low paid, part-time or zero hours I don’t see runaway inflation. This is supported by the breakdown in the Phillips Curve, something I mentioned in a recent blog. To remind you the normal Phillips Curve states that inflation rises with falling unemployment and vice versa. It hasn’t happened in this recovery. I think this is down to poor quality household earnings and the jobs market is not as rosy as politicians would claim. In summary I conclude there is room for steady ongoing expansion of the global economy and company earnings which drives share prices. However I wouldn’t bet my house on there being no recession in the US in the near future. If there is we all know what happens when the US sneezes. Consequently I am still recommending a generally cautious core investment strategy in my advice to clients but with satellite risk assets to capture any upside to markets. Adventurous investments are of course a good hedge against getting a bearish view wrong. Naturally what to do all depends on individual client circumstances and financial objectives, risk profiles and timescales.

*Treasuries are US government bonds, equivalent to UK government gilts.

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.

Bank of England Raises Interest Rates – Does it Matter?

The widely expected rise in the Bank of England base rate by 0.25% p.a. to 0.75% p.a. was announced yesterday. A surprise however was the unanimous 9-0 vote in favour by the members of the Bank’s Monetary Policy Committee. Was the rise justified and what will the consequences be? To set the context, a rate of 0.75% p.a. is hardly worth shouting about, historically it is well below its long term average – apparently this is 5% since the Bank of England was created in 1694. I recall paying 15% p.a. interest on my mortgage around 1990. For the large numbers of people on fixed rate mortgages the cost of borrowing will not increase, at least until their current deal comes to an end.

Mark Carney, the Bank’s Chairman argued the rate rise was justified as CPI* inflation at 2.4% is above its target of 2%. In addition unemployment is at a record low and there are signs of real wage growth. I am not convinced by the “full” employment argument. I suspect a lot of the new jobs are poor quality – low paid, part-time or zero hours’ contracts. A neighbour of mine is a care assistant on £7.83 per hour working her socks off, five or six nights a week just to pay the bills and save for a trip back to Albania. Night shifts in the health care profession can be as long as 12 hours. She is pretty exhausted.

Personally I am not sure that wage growth and consumer spending are causing inflation. This is evidenced by a slowing UK economy – we have gone from the fastest growing G7** economy to the slowest. Inflation would appear to be imported due to a weaker pound and from rising oil prices and weather related factors. I don’t see consumers with lots of money to burn going out on a spending spree and fuelling inflation. Moreover Brexit uncertainty is a headwind for the UK economy. This makes the decision to raise interest rates somewhat strange for me. It has been suggested that a reason for doing so was that it gives the Bank of England more leeway to lower rates again if the economy deteriorates but surely rate changes should be driven by current conditions not future potential issues.

The final point to note is that CPI inflation has been above 2% p.a. since February 2017. This has not triggered a series of rate rises to curb rising prices, there was just one in November 2017. All in all I am not convinced it is the right action at the right time. It appears to be a solution to a problem that does not exist! Then again what do I know? I am not an economist.

What then are the consequences of the interest rate rise? Tracker mortgages will rise by 0.25% p.a. as I suspect variable rate mortgages will do so too. In theory the rate rise will be good for savers who have been paid thin gruel for many years for keeping money in cash. It is generally accepted that banks benefit from higher interest rates and I presume the reason for this is that they can create bigger margins between what they earn, interest from loans and what they pay out to savers. I would be surprised if banks and building societies pass on the full interest rate rise to savers. There is evidence they have not done so in the past. Despite the Bank of England’s base rate being 0.5% p.a. from November 2017 to July 2018 savers in the worst accounts were getting 0.1% p.a. or less. The lesson here is to check the interest rate you are getting on your cash and shop around for a better deal. Three sites worth checking are Savings Champion, Moneyfacts and

There is a salutary lesson here for savers investing solely in cash (none of my clients), hoping in vain in the last nine years that interest rates would go up. They have lost money in real terms. £10,000 in 2009 is still £10,000 today but its purchasing power has fallen with inflation which has carried a bigger punch than interest earned on cash. The point here is there is no such thing as a risk free investment. Being overly cautious has cost them money. This is not to suggest they should have gone gung-ho into pure equities but they would have been better served investing some of their cash into multi-asset and other cautious risk funds where above inflation returns have been achieved.

Finally in theory rising interest rates should boost Sterling as it attracts foreign investors. However the pound fell yesterday due to Carney’s caution on the economy and unknown Brexit outcomes. He even said if the negotiations with the EU go badly, interest rates could be cut. Foreign investors will have picked up a mixed message on the direction of Sterling. They were clearly unimpressed.

*CPI is the Consumer Prices Index

**The G7 are a group of leading democratic economies. The members are the US, Japan, UK, France, Germany, Canada and Italy.

The content of this blog is my own understanding of interest rates and the UK economy. My comments are intended as 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.

Is the bull market long in the tooth?

The current global economic expansion or cycle has been going for just over nine years since the global financial crisis. Equities keep on rising and seem to shake off bad news. It is the second longest bull market in US history since records began in 1850. Next year it will become the longest. So is it long in the tooth as some believe or is it the case that bull markets don’t die of old age as other investment professionals have opined? Certainly it is a market that keeps on giving. Some of the best performing funds in the first half of 2018 were US equity funds and US heavy global technology funds. In contrast emerging markets performed poorly. I remember about three years ago asset allocators and fund managers were suggesting the US equity market was fully valued and they shifted money out of the US to Europe and the UK where valuations were more attractive. They clearly underestimated the strength of the US economy, the ability of US companies to continue grow their earnings and the potential for equity prices to carrying on rising. Fortunately I never bought into that argument.

So what is going on? According to Iain Stewart lead manager the Newton Real Return fund QE has been the greatest monetary policy experiment the world has ever seen. It was designed to inflate asset prices and it has achieved that. Investors have become conditioned to expect further central bank support every time there is a problem – remember for example Mr Draghi’s promise to do whatever it takes. Moreover this expansion has been characterised by low growth, the real economy has hardly recovered, so investors have had little fear of the economy overheating and interest rate rises. So they feel the outlook remains good and carry on investing. In contrast Stewart says there is now a broad based bubble in asset prices. He argues that the previous two bubbles were quite narrowly focused – the one in the late 1999s was on technology and second on banking and US real estate. This time cheap money from the developed world has spread around the world inflating all asset classes. Stewart refers to this as the financialisation of economies.

Stewart thinks it is tempting to think that if the authorities can extend the cycle this long, why not indefinitely? Such a thesis would suggest the end of boom and bust but don’t however ask for Gordon Brown’s opinion on that! Stewart is concerned about the tremendous amount of debt which has increased by 40% since the financial crisis, not so much by households but governments and corporates. This is hardly surprising with very low interest rates and plenty of cheap money.

He also highlights issues arising out of new regulations on banks and market participants since 2008 with concerns about liquidity in both the bond and ETF market and increased volatility. ETFs, exchange traded funds are traded securities that passively track stock market indices. There has been massive inflows into ETFs in recent years driven by very low charges compared to actively managed funds and the belief that stock pickers can’t beat the market. Richard Buxton of Old Mutual Global Investors, a highly respected UK fund managers is concerned about the “dumb” money flowing into ETFs. It means large amounts of cash is being pumped into mega-companies who have high weightings in indices that ETF track pushing up their share prices for reasons that are unrelated to fundamentals.

Suzanne Hutchins, a co-manager of the Newton Real Return argues that because there is earnings momentum it does not mean that equities market can’t fall. She observes that in the last 13 bear markets there have been three common threads, strong earnings growth, very elevated valuations and no volatility or very little. Spot the similarities with today’s markets! It is evident Stewart and Hutchins do not subscribe to the view that boom and bust has died and they see plenty of risk. Hutchins quotes data from Professor Schiller that suggests the average bull market has been around 131% whilst this one is well over 300%. Moreover investors have been benefiting from 18% to 20% p.a. returns from equities whereas in the very long term the real returns (i.e. after inflation) have been closer to 5% to 6%. There is plenty of scope for a sell-off and bear market.

So what do I conclude? I find these views compelling and remain cautious although not ultra-cautious. I see no need to sell all and buy cash but to position portfolios defensively investing in funds that focus on preserving capital or limiting volatility. The minimum goal however for any investor is to beat cash and inflation.

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.

Upbeat on the UK

When I read articles this morning from two independent investment commentators making positive assessments of the UK stock market I had to take note. For those of you who follow the figures the FTSE 100 has recently posted a new record closing high and is threatening to hit 8,000. So what is going here? Russ Mould, Investment Director at AJ Bell cites four factors that are driving returns:

1. The FTSE 100 index has underperformed its global market peers in 2016 and 2017 and is attracting contrarian investors with a bullish outlook. Brexit uncertainty has undoubtedly been a key factor in creating poor sentiment.

2. The UK is an unloved and undervalued market. It is not expensive compared to its international peers and relative to its historical earnings.

3. The dividend yield is above 4% p.a. attractive to income investors.

4. A weak pound has boosted the overseas earnings of UK companies and makes the UK a more attractive place to invest.

I would also add a rising oil price has boosted the commodities heavy FTSE 100 index specifically the oil majors. For example Royal Dutch Shell B shares have risen 29% in the two months from 19/3/18 to 21/5/18. This is highly significant as Shell and BP are the 1st and 3rd biggest constituents of the FTSE 100 by market capitalisation, so when their share prices motor the index puts on the after burners.

Coming at the UK market from a broader economic perspective Neil Woodford is similarly upbeat. He argues that economic fundamentals are improving and the consensus view has been too pessimistic. Woodford is a contrarian by nature, so cynics might claim, “he would say that wouldn’t he!” Woodford cites multiple factors including higher employment, less inflation, wage growth, better public finances and a recovery in manufacturing and exports. In addition he argues that valuations are very attractive in out of favour domestically focused companies. For example he considers housebuilders and retailers are far too cheap and growth expectations are too low. He predicts a recovery in 2018 and has positioned his portfolios accordingly.

From my perspective I am minded to agree although I remain very bearish on UK retailers. In addition I have had a long term bias to smaller companies in the UK and elsewhere and instinctively prefer additional allocation to them rather than to FTSE 100 companies, certainly for UK domestic exposure.

The content of this blog is my own understanding of the UK economy and stock market. My comments are intended as 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.

Second quarter rally – Is the pesky blonde girl back ?

In the last investment blog I reported that global stock markets retreated in the first quarter of 2018. How things change! Half way through the second quarter there has been a marked improvement in investor sentiment and stock returns. The FTSE 100 index for example closed yesterday at 7,711, a significant recovery from its March 26th low of 6,889 and not far off the all-time high of 7,769 on January 15th. Other market indices have rallied albeit not to the same extent. So what is going on? My reading is there has been a combination of positive factors. One commentator from The Street suggested that in the US first quarter company earnings were impressive but investors have taken time to appreciate this. In the UK inflation fears have abated as economic growth has slowed and according to Charles Stanley & Co Ltd the Bank of England, expected to raise interest rates just a few weeks ago, voted to keep them at 0.5% p.a.

On theme of inflation various commentators including the Chief Economist of Invesco Perpetual, John Greenwood have noted the normal Phillips curve has broken down. The Phillips curve is an inverse relationship between the unemployment rate and inflation. The argument goes as unemployment falls inflation rises and vice versa. It is a very logical assumption borne out in the past by actual data. As unemployment falls not only are there more workers earning and spending but the shortage of skilled labour drives up wages. However in the US Greenwood noted that the tight US labour market has only had a modest impact on wages between 2009 and 2017 and the Phillips curve has been almost flat with a similar result in the UK, Germany and Japan. With inflation fears abating interest rate expectations are muted. This scenario is good for both bonds and equities.

Greenwood also concluded that fears of a US recession are misleading. He said there are three key indicators of recessions and all cases evidence is lacking:

1. The yield curve being inverted. The normal yield curve is based on interest rates on government bonds being correlated with the maturity date of the bond i.e. the longer the term the higher the interest rate paid. This is because investors in longer dated bonds demand higher interest rates to offset the greater risk of uncertain future inflation and interest rate rises. Greenwood noted the yield curve is not inverted and unlikely to become so in the near future.

2. A sharp slowdown in money and credit growth. These have been low and steady for several years.

3. Over-leveraged balance sheets; too much debt in plain English. Consumer balance sheets are in good shape and Greenwood reckons even if interest rates do rise US consumers should be resilient.

In conclusion Greenwood stated that in the US, Japan and the Eurozone low inflation will continue for the next few years and there is a low risk of recession. Greenwood is someone I respect and listen to. I find his analyses of the global economy to be measured, balanced and compelling.

Other factors have contributed to the recent market rally. The easing of tensions between North Korea and the US has been positive, although this has been followed by a deterioration in the Middle East, with the US pulling out of the Iran nuclear deal. The technology sector has recovered from its mauling earlier in the year. Charles Stanley’s Chief Investment Commentator, Garry White noted in a recent blog that Apple shares have climbed to a new high whilst Facebook has clawed back its losses from the Cambridge Analytica data harvesting scandal. Finally mergers and acquisitions are expected to spike in 2018, driving stock prices.

In the first quarter Goldilocks did a runner (see blog of 24/3/18). The bears ate their porridge in peace. However it seems Goldilocks was just being sneaky, hiding in the woods and is now ready to make another foray into the bears’ house in search of goodies. Perhaps the not too hot, not too cold economy is back. We shall see.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as 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.

Markets Retreat in Q1 2018

Global stock markets ended the first quarter of 2018 down. Data from HSBC Global Asset Management and Datastream showed the following index returns,*

UK Equities: -7.3%

Asia Pacific (excluding Japan) -7.2%

Japan Equities: -5.5%

European Equities: -3.3%

Emerging Market Equities: -2.3%

US Equities: -2.2%

*MSCI are an independent producer of stock market indices widely used in the industry. These are total returns including re-invested dividends.

You will recall there was a sharp global stock market sell-off at the end of January and early February, and generally negative sentiment and higher volatility in evidence since then, triggered by fears of a trade war between the US and China. Property and investment grade corporate bonds also fell during the quarter whilst global government bonds rose a tad, 0.3%, in the first three months. On Monday 5th February the Dow Jones Industrial Average plunged more than 1,500 points, its biggest one day fall in history. In percentage terms however, the drop was more modest and certainly not a record.

The principal reason for the February sell-off was a fear of rising interest rates in the US caused by stronger than expected wage growth. Perversely, good economic data is sometimes viewed suspiciously by investors. Whilst rising wages should boost domestic spending and lead to a reduction in personal debt, they threaten a spike in inflation. Moreover wage growth for employees is an added cost for companies and a drag on their profits.

The first quarter of 2018 has been a wake-up call for investors who had become rather complacent given that 2017 was a very benign year with strong equity returns and very low volatility. Commentators are now calling the end of the Goldilocks economy, one that is not too hot or not too cold and doing very nicely, thank you very much. So what is the problem? When inflation bites bond prices fall and yields rise. For example the benchmark 10 year US Treasury yields recently hit 3%, for the first time since January 2014. This means investors can now buy “risk free” government debt and earn 3% p.a. so rising yields tempts investors out of equities and into bonds.

What I found surprising though is that US equities fell much less than in UK equities in Q1 2018 and less than in other markets. This is odd given the trigger for the market falls in February was an issue with the US domestic economy. When America sneezes the world catches a cold, but the US proved more resilient this time around.

To finish I thought it would be instructive to see how a number of targeted absolute return funds and cautious multi-asset funds I have recommended to clients have fared over the same period. These should have protected capital, if not in absolute terms, relative to pure equity funds. Here are the results, they are total returns including dividends or interest re-invested and are net of all fund charges:

M&G Episode Income: -0.67%

Henderson UK Absolute Return: -1.3%

Baring Multi-Asset: -2.5%

Santander Atlas Portfolio: -2.73%

Cornelian Cautious: -3.23%

Premier Multi-Asset Distribution: -3.26%.

Clearly all funds performed better than UK equites, a key comparator for UK investors, although none provided absolute capital protection over the quarter. To be fair most of these funds do not target a positive return over all periods.

The last three funds lost more than I might have expected but I don’t judge investments based on three month performance figures. A final point to make is that charges are not relevant to index returns, unlike with managed funds. In many cases these are more than 1% p.a. when transaction costs are taken into account.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as 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.

Dark Clouds Looming over the Bears’ House

For much of 2017 and the beginning of 2018, various commentators pointed to a Goldilocks economy, one that is not too hot nor not too cold. It has been characterised by synchronised economic growth around the world, with muted inflation and supportive central bank policy. It was also a period of rising stock markets and unprecedented low volatility. It proved to be the calm before the storm. Since January we had a sell-off from bonds and equities on fears of US wage inflation and rising interest rates, followed this week by breaking news of a looming trade war between the US and China. Volatility and the so called fear index has spiked and equity markets tumbled again. All this has taken place in a backdrop of a sea change of policy by central banks to gradually turn off the supply of easy money, the reduction and reversal of QE.

Another concern highlighted again this week has been with UK retailers with major names announcing profits warnings, cut backs and restructuring. The list of firms in trouble in the last few months has been growing. Toys R Us went into administration a few weeks ago whilst Next announced a fall in profits on the back of the most challenging trading conditions for 25 years. Carpetright is in trouble and Prezzo, an Italian restaurant chain is set to close more than 90 outlets. There a clear theme here that the High Street is in trouble. It is not just the corner shops and independents but well known chains too. Lots of people are set to lose their jobs.

It seems as if consumers are not spending. To what extent fears about Brexit are weighing on the British public I don’t know, but those with variable rate mortgages may be more cautious with interest rates rises expected down the line. It is clear the problems with the High Street are multifaceted with some retailers failing to adapt to the rise of online shopping. However I cannot help put blame on what for me is the most unfair, retrogressive tax in the UK – business rates. Many businesses recently have had to cope with double and even triple digit rises in business rates, due to their linkage to local property prices. For example last year traders in upmarket Southwold in Suffolk faced rate rises of up to 177%. What I intensely dislike about business rates is that it is a tax on a shop simply opening its doors to trade, whether it sells anything or not. The business may have a low turnover and make a loss and yet it is still taxed on its rateable value. In contrast most taxes are based on ability to pay – the more you earn the more income tax you pay, the more you can spend in the shops the more VAT you pay, the more expensive the house you can afford to buy the more stamp duty you pay. I for one would like to see a much fairer system of taxing retailers in the High Street one that is based on turnover or profits. Moreover a level playing field is required with online retailers. During the business rates revaluation I understand Amazon saw its bill drop due to its distribution centres being located in less fashionable out of town locations.

So what do I conclude for investors. I have been cautious on equity markets for a long time now and throughout 2017 I have been advising clients to reduce risk, take profits and invest cautiously. That is still my position although I still advise selective equity investment. The tremors in early February and now this week may be early warnings of a bigger shock to follow. Time will tell. Ensuring good foundations, having a solid defensive portfolio offers the best protection in an earthquake. Let’s hope the house of Papa bear, Mama bear and Baby bear stand up. After all we wouldn’t want the porridge to get spilt, would we! As for Goldilocks she seems to have disappeared.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as 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.

Lions, £50 Notes, Bitcoins and the Yield Curve

I came away from a lunchtime investment seminar in Brighton on Thursday with lots of thoughts, a pack of fund brochures and a cuddly toy – a lion. No surprise perhaps since the company hosting the event was Liontrust Asset Management. They are a relatively small independent and respected fund manager with strong investment returns. Presenting was head of multi asset at Liontrust, John Husselbee, an experienced investor who has “run money” for 30 years. This is in house jargon that fund managers often use. I subsequently had visions of a 100 meter race between a fund manager and a £50 note, but enough of the trivia. The key point is he has seen it all from the dot com bubble to the financial crisis. In contrast some young fund managers may never have managed investments through a stock market crash.

Husselbee started his presentation with a compelling argument that by protecting capital during sell-offs investors have less losses to recoup when markets rise. Consequently reducing the downside is crucial in achieving good long returns. From June 2011 to December 2017 a multi-asset portfolio he co-manages matched the total return from the FTSE 100 i.e. including re-invested dividends – but crucially with significantly lower volatility. This is pretty impressive given the fund in question only held 56% in equities at the end of the period. The principle here is winning by not losing. The outcome is good returns and with lower risk.

Husselbee then covered Bitcoins. Clearly some people have made fabulous returns from this cryptocurrency but that in itself is not a reason to invest. First Husselbee highlighted a graph that showed a remarkable correlation between the vertiginous rise in the price of the Bitcoin and google searches. It strongly suggests that prices have been driven by a fad and a mad scramble to buy, not by compelling investment fundamentals. Whilst Bitcoins have features that might identify it as a currency, for example some retailers accept payment in Bitcoins, its price is far too volatile to be considered a credible currency and it has no central bank backing. Moreover on what investable means Husselbee quoted the highly respected economist and investor, Benjamin Graham. He wrote in a landmark book of 1949, “The Intelligent Investor,” that:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

Husselbee concluded as I do that the Bitcoin is not an investable asset but a speculative one. In fact I have not come across a single fund manager who includes it in their portfolios.

Another take-away for me from the presentation was the mixed messages about the global economy from the bond and equity markets. An OECD* study showed global strong and synchronised economic growth in 2017. The organisation monitors 35 OECD and 10 non-OECD economies and in 2017 all were expanding with a majority demonstrating accelerating growth. Not one was contracting, the first time this occurred since 2007. Last year equity markets rallied on the back of this positive backdrop combined with strong company earnings. In contrast the bond market is more pessimistic about the global economy. Here it gets a little bit technical but I’ll try to explain it simply. Economists and fund manager place a lot of store in what is called the “Yield Curve.” It refers to the chart of yields of government bonds with different maturities. Typically the normal yield curve shows that long dated bonds have higher yields or interest rates than shorter dated issues. This is because investors demand to be rewarded for the risk of future inflation. When inflation or interest rates or expectations of such rise bond prices fall and yields increase and the shape of the curve changes and vice versa. Longer dated bonds carry the most risk. However since 2014 the difference in the yield between US Treasury 10 year bonds and two year bonds fell from about 2.6% to about 0.5% in early 2018, before a spike to around 0.75% during the recent market sell-off at the end of January. In other words in the last four years the flattening of the yield curve means the bond market has been pricing in low growth and inflation, arguably even recession. Of course this period has coincided with very accommodative central bank policy and QE life support. I asked Husselbee what he considered the more reliable indicator – the equity or bond market and surprisingly he said the former. Instinctively I would have thought the equity market was given synchronised global economic growth. I conclude the mixed signals must make fund management a tricky business and being cautiously optimistic is probably a good middle ground, not being too gung ho nor too defensive and being selective in what you choose to invest in. Add a dash of flexibility and this probably a good recipe for fund managers.

Finally Husselbee’s presentation emphasised the need to ignore headlines (news events such as the UK snap election, the North Korea crisis or Catalonia) and focus on fundamentals. He also suggested Trump’s economic policies have yet to benefit the US domestic economy as evidenced by the fact that since his presidential election victory in November 2016 US smaller companies have significantly lagged US larger firms. On another point he and his highly experienced co-fund manager, Paul Kim, have tilted their portfolios from growth to value with expectations of rising growth and inflation.

In conclusion I thought Husselbee talked a lot of common sense, he has a clear and compelling investment philosophy which he articulates well and he clearly understand markets and what consumers need. For example he expressed some mild exasperation at regulators who in seeking to improve transparency end up making things more complex and confusing, a view I wholeheartedly share. For example under the new MIFID II** rules which require disclosure of fund transaction costs you can end up with a negative figure! Yes, that is true. It implies a fund manager can undertake multiple trades each year within his or her portfolio and incur no expenses in doing so, for example stock broker fees or stamp duty. Not only that someone plucks £50 notes from a money tree and pays that to the fund.

I may have said this before but I tend to buy fund managers more than funds. It is not easy to articulate but every now and again I listen to a fund manager, something connects and I think I really like the way he sees markets and manages investments. I can see myself entrusting client money to him and his multi asset funds.

*OECD is the Organisation Economic Cooperation and Development

**MIFID II is the EU’s second Markets in Financial Instruments Directive, a complex and bureaucratic piece of legislation affecting fund managers and IFAs alike and which the FCA adopted. It came into force on 3/1/18.

The content of this blog is my own understanding of the global economy and stock markets based on John Husselbee’s presentation. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice, for example to buy Liontrust funds. You should seek individual advice based on your own financial circumstances before making investment decisions.

Stick or Twist – Time to Sell?

Following a review I advised some clients to undertake risk reduction and profit-taking from their investment and pension portfolios by switching selected amounts from pure equity to cautious risk funds. In response although they were happy with my advice they raised a perfectly reasonable question. Should we wait for a recovery in the equity markets before selling from the equity funds I recommended? Here is the gist of my reply.

The issue you raise is a difficult one to call as we do not know how serious this correction is. Waiting for the recovery instinctively makes sense given the sharp falls on global equity markets. Overnight the Dow Jones fell more than 4% whilst in Asia the Nikkei and Hang Seng fell more than 2% and 3% respectively. With ongoing volatility the fallout could continue, equity prices may drop further and markets may enter a longer term slump, suggesting selling pure equity funds later will not prove beneficial. If however there is a V shaped recovery in the near term it suggests waiting to sell is best. We just don’t know whether the slide will continue or reverse in the short term nor the medium term direction of markets, so do we stick or twist?

In favour of selling now is the argument that in some cases market indices have fallen back to their levels of just a few months ago. For example the Dow Jones peaked at 26,616 on 26/1/18. It has fallen to 23,680, its level on 29/11/17. The Hang Seng is now back to levels at the end of December 2017. Your portfolio was very profitable then and had I been advising you a few months ago I would have advised risk reduction and profit-taking. You can see that an emotional reaction to the short term volatility can cloud the fundamentals here. The FTSE 100 however has fallen back to levels last seen in May 2017 and so arguably the reversal is more significant.

In favour of waiting to sell is the strength of the underlying global economy suggesting the fundamentals are supportive of rising equity prices and the recent falls are just a correction to somewhat exuberant markets rather than the initial tremors preceding a global financial earthquake.

In conclusion I am happy to hold fire on all recommended pure equity fund sales. The alternative is we still proceed but reduce the amounts sold by a fixed 10% to account for the market drop. I could also undertake the sales on a phased basis, some today and some next week perhaps over several days. What this achieves is better prices if markets rally next week. The risk is of course that prices continue to fall and the later sales are at lower prices. It is a difficult decision and I am struggling to say what is the best to do. However if I have to get off the fence I would say sell all that I have recommended now reducing the sums by 10%, remembering I have not proposed disposing entirely of profitable equity funds. You will maintain substantial equity investment. What this means is you will still participate in a market recovery whether in the short or medium term. The risk of selling now at lower prices than a couple of weeks ago is arguably not too significant. You will only bank strong profits as opposed to very strong profits.

This blog is intended as general commentary only. Please note this advice is specific to these clients and should not be construed as general advice that other investors sell-down pure equity funds. Nothing in this article is intended as personal investment advice to my readers. You should seek individual advice based on your own financial circumstances before making investment decisions.