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 http://montgo.co.uk/crystal-balls-yield-curves-old-folk/ ), 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.

https://az768132.vo.msecnd.net/documents/108897_2017_12_15_02_58_25_613.gzip.pdf

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.

Global Stock Market Falls

They say timing is everything and on reflection the timing of yesterday’s investment blog post about price and value was inappropriate. Global stock markets have tumbled in the last week. An article yesterday on the BBC News website provides a succinct explanation:

https://www.bbc.co.uk/news/business-45820640

In summary aggressive interest rate policy in the US and US/China trade wars are the main culprits. The former has led to falling bond prices and rising yields. At certain levels these tempt equity investors to sell and switch to bonds. The trade wars now appear to be having a negative impact on the global economy. According to Luca Paolini, Chief Strategist at Pictet Asset Management global indices of manufacturing activity have fallen to a two year low whilst there has been a spike in companies cutting profits forecasts. Earnings upgrades are now lagging downgrades.

Pictet are however not too bearish pointing to more favourable indicators and valuations compared to January 2018. From my perspective seeing portfolios hit by stock market falls is never comfortable but it needs to be remembered that economic fundamentals change much more slowly than stock market prices. The latter are highly volatile, a shock to some after a very benign 2017, but sharp falls do not necessarily mean there is something rotten at the heart of the global economy or that valuations are too high.

In conclusion I don’t think the content of my blog yesterday arguing that price and value are different and markets are not especially over-valued was fundamentally flawed. Recent events demonstrate that whilst prices have fallen sharply the underlying fundamentals of the global economy have not changed that much. After all we knew about rising US interest rates and trade wars a week ago, two weeks ago and two months ago. That said I should apologise for the timing of my message or not including a comment about market events, perhaps leaving you with impression that prices are well supported and are likely to be stable.

The content of this blog is intended for general commentary only and is based on my understanding of stock market valuations. 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.

Price and value are not the same

There is a difference between price and value. An asset may have a high price but be at fair value. In other words it is not necessarily expensive. Similarly another asset may have a low price. Its price may have even fallen in recent times but that does not necessarily mean it is cheap. Terry Smith, the highly respected manager of the Fundsmith Equity fund warns against the potential perils of so called “value investing” – buying stocks whose intrinsic values do not seem to be recognised by the market. Value investors buy expecting an upward revaluation. However if and when this occurs depends on market sentiment and unpredictable events. The risk is that low growth companies remain just that or their values deteriorate over time. In other words they were cheap for a reason and should have been avoided. Similarly Smith points out investors can confuse highly rated with expensive. The conclusion is that understanding price and value is essential when buying and selling as investors may make wrong calls if decisions are based on price alone.

The fact that S&P 500 recently reached a new high and technology stocks have made stellar gains have led some to conclude that the US equity markets are overvalued and prices could correct. This may be a misunderstanding as suggested below but even so I have some sympathy with the conclusion, albeit from a different perspective. It is about banking profits while you can. Take an investment of £10,000 that grows by 50% and is valued at £15,000 a year later. That £5,000 is a paper profit only. If markets fall by 20% the investment drops to £12,000. The profits fall from £5,000 to £2,000 a decline of 60% from their peak. It is not unreasonable to want to take risk off the table and crystallise paper gains by partial sales. What I advise my clients do depends on a variety of factors including their risk profile, their financial objectives, whether they need a cash injection now and their investment timescales. Sometimes it is better to do nothing and retain the profits to compound capital growth over the long term, ignoring the short term market noise and price fluctuations. There is a lot to be said for a buy and hold strategy, providing the fund manager hasn’t lost the plot.

In this blog I want to explore current equity valuations. A number of fund managers I have listened to and read recently have shed some light on the matter for me. One source was JP Morgan who produce an excellent quarterly guide to the markets, the latest was a 99 page document packed with charts and tables about the global economy and stock markets. One chart shows global forward price to earnings ratios. P/E ratios are a commonly used measure of valuations. The higher the ratio the higher the stock or index is valued. There are several measures of earnings that can be used. Arguably the use of projected forward earnings for a company or a market is more useful than historic data.

What the chart surprisingly showed was that at 30/9/18 forward P/E ratios were higher in the US, Europe (excluding the UK), Japan, the UK and emerging markets than they were a year ago and for all bar the US, valuations are below their long term average since 1990. Moreover US valuations were not excessively high. The long term average is 15.8x whilst at 30/9/18 the S&P 500 had a P/E ratio of 16.9x. (Source: JP Morgan citing FactSet, IBES, Robert Shiller and Standard & Poors). This means prices are 16.9 x earnings per share. I conclude the US is not cheap nor especially expensive whilst the fact that forward P/E ratios have declined in the last 12 months across the board means that earnings growth has accelerated faster than prices, therefore supporting the gains in prices. However JP Morgan did observe that global economic growth is less synchronised than a year ago.

The cheapest market based on a comparison of the long term average is Japan which is trading at a P/E ratio of less than 50% of its long term average. A word of caution though. The long term average in Japan is much higher than other markets I suspect due to a bubble in property and equities. Very high P/E ratios have skewed the long term average.

Finally turning to technology. You know you are advancing in years when fund managers look no older than your children. At a recent seminar I listened to Richard Clode, one of the fund managers of the Janus Henderson Global Technology fund who presented a compelling case for the tech sector. He was an impressive young man who clearly knew his stuff and communicated it very well. There is a lot going for technology. It is dynamic and innovative; technology companies lead the way in research and development, an attribute Terry Smith thinks is very important in stock selection. The terrific performance of tech stocks in recent years* has been driven by superior earnings growth whilst valuations are in line with the long term average. Large cap technology stocks have huge amounts of net cash estimated to be in excess of $285 billion at the end of July whilst non-technology large cap companies (I think in the US) had net debt of more than $60 billion (Source: Bloomberg, cited by Janus Henderson). That said Clode thought some technology companies are overpriced meaning stock selection is important. I conclude as long as tech stocks are cash generative and are growing their earnings then this sector has further to run.

Those who follow the markets know the FTSE 100 index has lagged the S&P 500 across the pond. In the last five years data from BBC News online show the FTSE 100 rose 12.8% (from 11/10/13 to 5/10/18). In contrast the S&P 500 rose 73.9% over the same period. This lesser known index is more representative of the US economy than the more famous Dow Jones Industrial Average. These return figures exclude dividends.

I had always thought the poor performance of the FTSE 100 was due to its heavy weighting in banks, oil majors and miners. These stocks have had massive headwinds since the great financial crisis and have delivered awful returns in the last 10 years. Whilst this is true what I hadn’t taken into account was that at 30/6/18 just 0.6% of the FTSE 100 index was represented by technology stocks (Source: Bloomberg, cited by Janus Henderson). According to CNBC in an online article on 6/8/18 26% of the S&P 500 was in technology. No wonder the S&P 500 has done so well whilst the FTSE 100 has been as exciting as a wet blanket on a cold January day. It is a lesson for UK investors who are too UK centric in their portfolios. Their home preference or bias, in part due to thinking Sterling was the place to be, to mitigate currency risk, fell victim to the unintended consequences of being underweight in technology.

*The average IA Technology & Telecoms fund has delivered a total return of 121.2% in the last five years whilst the average IA Global fund gained 67.3% (FE Trustnet, 10/10/18). Bear in mind funds IA Global sector include some technology stocks meaning if the non-tech returns could be stripped out the disparity would have been greater.

The content of this blog is intended for general commentary only and is based on my understanding of stock market valuations. 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.

Do equity returns justify the risk?

The answer to this question is one all investors need to consider but it should be determined by a comparison of returns from other investment types that carry low risk or “no risk.” By risk I refer to volatility of returns. Although investment risk is multi-faceted and means more than just volatility of returns, as highlighted in the next paragraph, for the purposes of this article volatility will be my focus.

I don’t consider any investment is risk free. The real value of cash is eroded by inflation whilst highly secure UK, German or US government bonds are subject to interest rate risk, if not credit risk. This means although the issuing government almost certainly will not default on its loans, bonds are driven by other market influences for example interest rate rises and consequently bond prices can fall. In some developed markets investors are paid a negative yield on holding government debt, meaning they are paying for the privilege of investing.

For an investor the question is can I get the same return elsewhere but with lower risk? If you can why invest in riskier assets? Consequently professional investors talk about risk premiums. It is commonly used in bond markets. Let’s say you can get a 2% p.a. interest rate on government debt. This is often referred to as the risk free rate. The question how much extra interest will investors demand for holding corporate debt, whether investment grade or sub-investment grade? In the US the latter are called junk bonds, a kind of reverse euphemism. Corporate debt carries credit risk (as well as interest rate risk) and the lower the credit rating of the issuing company of the bond the higher the interest rate they must pay to compensate investors for the extra risk. For investment grade bonds interest rates might need to be 3% p.a. and for sub-investment grade 4% p.a. You get the idea. The figures are for illustration only and don’t necessarily reflect current market rates.

Risk premiums are also applicable in the equity market too and here I want to share the thoughts of Glenn Meyer, head of managed funds at RC Brown Investment Management, a firm of discretionary fund managers that I have used for a few clients. In a recent newsletter he wrote:

“Mehra and Prescott found that between 1889 and 1978, the risk premium on US equities was 6%, but the largest premium they could derive from their model (by using standard measures of risk – which are focused on volatility) was 0.35%.”

Meyer also quoted a further study from Fama & French that found:

“…the long-term equity risk premium on the US equities was 6% between 1963 and 2016, but their data also encouragingly showed that as the time horizon increases bad outcomes generally become eless likely and extremely good outcomes become more likely…the high volatility of monthly stock returns and premiums means that for the three year and five-year periods used by many professional investors to evaluate asset allocations, the probabilities that premiums are negative on a purely chance basis are substantial, and they are non-trivial even for ten-year and 20-year periods.”

The clear conclusion is that long term equity investors are very well compensated or even over compensated for the extra volatility they experience compared to holding “risk free” government debt. This is certainly my experience in reviewing the profitability of long held equity investments and portfolios through thick and thin.

Glenn Meyer suggests that the risk premium for equities may fall as investors cotton on to the fact that the measured risk is much smaller than the equity risk premium but in the meantime he is happy to bank these incremental returns for his clients. I concur, and like Meyer as this point in the cycle I strongly favour equities for long term investment. However this is not to suggest that valuations are unimportant. Gary Potter co-head of the multi-manager team at BMO Global Asset Management suggests most assets are not cheap and expects returns over the next 10 years to be lower than the last 10. Investors should perhaps lower their expectations, be more discerning about what they buy and pay attention to true valuations. With the withdrawal of central bank monetary support, so called Quantitative Tightening (QT) active fund management is favoured in my view.

The content of this blog is intended for general commentary only and is based on my understanding of Glenn Meyer’s and Gary Potter’s views which they may not necessarily endorse. 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.

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 Moneysupermarket.com.

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.