The Summer of 2014 has been unusually full of domestic and international activity and in ordinary times equity markets in particular might have been expected to fall back materially as a consequence of a wide range of geopolitical uncertainties. Furthermore, fixed interest markets have remained extraordinarily calm given the potential for interest rate increases, particularly in the USA, that look to be approaching. It is, after all, in these circumstances that one would expect fixed interest prices to fall back after many years when they have been rising as a consequence of rates moving lower.
A part of the answer to these conundrums lies in the fact that, across developed economies, company profitability has generally been increasing, continuing a recovery that has now been in place for some years. As a consequence, dividends have also been moving ahead – albeit not at the fast pace seen during 2012 and 2013. Indeed, many quality equities yield more than a great many fixed interest securities and this yield premium has certainly been beneficial for equity markets. Companies have often been able to restore their balance sheets to better strength which suggest that company profitability may be capable of further medium term improvement.
Another factor supporting markets has clearly been the likelihood that interest rate rises, when they appear, will be limited and gradual. It appears unlikely that we will see a return to pre-crash interest rate norms of around 5% for perhaps a decade. It is also very clear that a trend to higher interest rates will occur in different economies at different times with the Eurozone continuing to cut rates to negative levels in some cases: here interest rate rises may not yet be seen for several years and we may well see the introduction of quantitative easing in an effort to stimulate broader growth.
It is right to dwell for a moment more on the Eurozone, simply to say that measures to restore economic credibility are showing signs of working in, for example, Spain and Ireland. Germany of course remains strong but if anything, matters within France and Italy have continued to deteriorate. These two economies have not yet addressed their very high unit labour costs and as such are likely to act as a drag on Eurozone recovery which matters, as, between them, they account for around 40% of Eurozone GDP. In the UK, what is known as an ‘internal devaluation’ has been taken place where wage costs has been held in check for the last few years, a very necessary, albeit clearly uncomfortable, process.
Getting back to reasons why equity and fixed interest markets have held their values well, it is our view that what is known as financial repression has played an important role. Essentially, as central banks have lowered interest rates, investors have been obliged to move funds away from deposits if they are to have any hope of either protecting capital value or achieving a reasonable income, or both. As interest rates do in due course begin to rise, the effect of this will, albeit slowly, begin to fade. Central Bankers will hope that by that time economic recovery will be increasingly well entrenched, that interest on debt will be manageable and that recovery will become self-sustaining.
Further, overheating still appears unlikely while it is clear that as developing markets grow, in itself an uneven process, they will increasingly rely on internal consumption to replace exports as their engines for growth. This may change the opportunities for western companies exporting to them as some will develop domestic sources of production to good effect.
In summary, to us it is abundantly clear that broad global economic conditions are very far from normal, a situation that, while clearly carrying concerns, also provides significant opportunities. A gradual and uneven easing of financial repression in the developed world over the next few years is in my view likely to be accompanied by growth in company profits: I believe it likely that the two will go hand in hand. Interest rates clearly won’t begin to rise on any great scale while inflation remains relatively low and while unemployment is a key concern for Central Bankers. It is hard to see how well managed companies will not see opportunities for growth in such circumstances even though at the same time fixed interest investors may not fare so well.
ACTIVE VERSUS PASSIVE FUNDS
Readers of this newsletter who follow the financial press may well have read articles concerning the merits of active funds as compared with their passive counterparts, the latter offering a low cost route to follow a given market (eg the FTSE 100 or FTSE 250). Such funds have no regard for the strength or otherwise of companies that make up those indices; rather, they invest in all of them, in due proportion, aiming to track the index as closely as possible.
Active funds, on the other hand, seek to add value through stock selection and often do not have a particular market index as their benchmark. While the cost of investing in active funds is greater (skilled managers, supported by well-founded research teams are required for active management), it is our belief that in general, well managed active funds have the edge and they are not driven by ‘flavour of the month’ market sectors.
The 2014/15 ISA season has opened with a flourish as investors seek to take advantage of the newly increased allowance. We have noticed however that a number of banking institutions have cut rates on their cash ISA offerings, rendering them even less competitive than hitherto. If your bank or building society has announced ISA rate cuts, do please bear in mind the merits of ISAs investing in stocks and shares in terms of income production or, alternatively, capital growth potential, the choice depending upon individual investor requirements.
REVISIONS TO NATIONAL ACCOUNTS
The UK, along with many other wealthier countries, has now adopted a global system of national accounts, the overall effect being to move towards harmonisation of international accounting standards.
The impact for the UK is to have increased the size of the economy in 2013 from £1.6 trillion to £1.7 trillion, an increase of just over 6%. Further, the fall in GDP from 2008 to 2009 has been reduced and the subsequent recovery was sharper than previously recorded, to a degree that is roughly the equivalent of one year’s typical GDP growth.
As a consequence of changes to the way in which pension savings are calculated, the recorded rate of household savings has materially increased.
On a negative side of the equation however the current account deficit has been revised higher as has the level of national debt.
We think it unlikely that these and other changes that have been announced will effect overall economic policy or interest rate levels, certainly in the short term, but as the new arrangements are adopted by more and more developed countries, international comparisons will become increasingly meaningful.