Autumn Newsletter

Investment Background

Unusually among developed economies, the USA has a limit on the level of US public debt that can be issued which requires Congress’s approval if it is to be raised.  This system has been in place since 1917 and, generally, when increases are required the necessary vote in Congress has been passed.

In the last few years, reflecting the balance of power between the US political parties, it has become increasingly difficult to obtain agreement on debt ceiling increases – hence the recent stalemate which led to partial shutting down of some areas of the US Government until, at the last minute, agreement was reached to continue for at least a further period.

This stalemate sent shudders through financial markets as it became clear that the US might find itself forced to default on interest payments and indeed capital repayments had the situation endured for much longer.  In the end however good sense prevailed, agreement was reached, and financial markets (which never really doubted the outcome) regained their poise.

At risk of straying into politics for a moment, the bad tempered debate in the US, where so much was at risk, provided an excellent demonstration of how not to run the World’s leading economy.

It is worth spending a moment considering the impact of the ‘easy’ monetary policy that has been practiced in North America, Europe and elsewhere over the last few years.  Our view is that the essential impact has been to take huge pressure off the banking system, it has materially assisted households to manage a tricky balance between falling interest payments on the one hand and what is generally been a decline on real wages on the other, equity investors have benefitted as companies have been able to effectively refinance and grow profits while governments have clearly gained in terms of being able to issue debt at lower cost. All of this has promoted the recovery in economic activity that it now underway, albeit unevenly and in some areas, tentatively.

Loose monetary policy is generally seen as a precursor to high inflation.  The Bank of England’s 2% inflation target has consistently been exceeded and savers (with cash on deposit, as opposed to investors in assets) have seen the real value of their capital reduce on a compound basis.  Our view however is that had the capital released by Quantitative Easing in the UK, for example, found its way out of the banking system (where much has been retained to boost capital ratios) inflation may have been significantly higher.  It seems to me highly unlikely that the Gilts that have been purchased by the Bank of England will ever be resold in the open market, the implication of this being that medium term inflation, created by a permanent increase in money supply, will, as velocity increases, make it increasingly difficult for the Bank of England to meet its inflation target.

This now leads me to consider the outlook for interest rates which I expect to remain relatively low in the US, in Europe, and Japan for possibly several years while in China, and perhaps India, higher rates seem likely over time to check inflation.  The challenge for the Bank of England over the next couple of years is to maintain internationally competitive low rates while at the same time ensuring that the level of Sterling remains competitive and that inflation is contained.  In the absence of the latter, it is possible that interest rates in the UK will begin to rise before the same pattern emerges in other Western economies, a trend that may be exacerbated if the pace of GDP growth accelerates at too great a rate.

Investors are therefore faced with an interesting mixture of factors to consider where varying degrees of economic recovery are underway supported by low interest rates.  Indeed, the Bank of England’s base rate (0.5%) and equivalent base rates set in North America and Europe remain at crisis levels (what I mean by this is that they are firmly into negative territory after inflation is taken into account), the commercial banks are in effect hoarding cash and seeking to shrink balance sheets so that large scale monetary tightening looks to be a long way off if recovery is not to be curtailed.  In most developed economies, inflation looks set to remain relatively benign (the outliers are Japan, where the authorities are actively seeking to move away from deflation and to achieve a 2% inflation rate and the UK, where inflation remains persistently above target, is at the other end of the spectrum).  What is clear however is that as recovery continues, monetary conditions will surely begin to tighten, a fact that has clear implications for investment policy over the next few years.

Asset Allocation

Against this backdrop, we continue to underweight investment in the fixed interest sector because although yields are reasonable, and indeed are very attractive when compared with rates available from cash deposits, there is scope for capital to be lost when interest rates eventually rise.  In the UK, indications are that financial markets expect interest rates to rise relatively soon, a view not held by the Governor of the Bank of England who believes that this process will not commence until 2016.  Betting against the Bank of England, or indeed against any other central bank, is not always a wise course for investors and given the reliance on cheap money within the UK economy my view is that, having had something of a setback this year, values in fixed interest markets now look reasonably settled for shorter term income seekers but overall we maintain a significantly underweight position in fixed interest markets, watering this down slightly where interest can be accumulated on a tax free basis, offering a rather more compelling compound interest effect.

Over the last few years, investors in Index Linked Gilt funds have enjoyed decent returns but these too have been negatively impacted in the last few months by interest rate considerations.  While the effect of Quantitative Easing on inflation has to date been relatively benign, our view is that this is largely a symptom of the fact that cash released by the QE programme has stuck in the banking system and has not yet reached the broader economy on any significant scale.  As recovery progresses, I believe that this will change so that QE inspired inflation will have a “slow burn” inflationary impact in the UK economy over the next few years which can only be enhanced by the possibility that wage growth will edge higher as the shortage of skilled labour in many industries intensifies, leading to increasing pressure on employers outside of the public sector to bid higher for good people.  I therefore believe that, while inflation linked holdings will be affected by a gradual return to more normal interest rates, inflationary pressures in the UK economy will endure so that longer term investors seeking inflation protection should make use of this sector.

I have commented on a number of occasions to the effect that company profits and dividends have been increasing and that companies have been able to rebuild balance sheets that in many cases were damaged during the recession.  This continues to be the case and in many instances recent company announcements, reflecting their results for the first nine months of 2013, have been encouraging.  It is also my view however that, assuming a reasonable recovery is maintained, more companies will, as we move to 2014, start to invest cash rather than to continue to accumulate it.  They may also take on additional bank finance and I anticipate that we will see a return to greater capital expenditure, the benefits of which, in terms of additional profit, can take a little while to materialise.  The outcome is however a further strengthening of corporate situations but possibly accompanied by slightly lower dividend growth in 2014 than we have seen in the last couple of years.  If such a return of confidence among companies does emerge, I will regard this as highly supportive for equities in the developed world and remain overweight in this asset class.

In developing markets, the long term trend (in good measure driven by the potential for huge increases in the numbers of consumers enjoying higher living standards) remains in place, but in the shorter term I am less convinced about the abilities of some rapidly developing countries to control inflation.  In the case of the vast Chinese economy, where growth in accelerating again, it is difficult to be fully confident in all of the economic statistics that are produced.  When money supply does become tighter, there may be some difficult times, for example in the not well understood Chinese shadow banking sector, which lead me to be relatively cautious in the short term where developing economies are concerned.

Commercial property is often regarded as an alternative to fixed interest and equity investments and, after a number of difficult years, there is evidence that the boom in London Commercial property is spreading to the regions, at least in so far as quality buildings are concerned, while opportunities in Global markets also remain. On this basis, I believe that Commercial property should continue to play a role in most longer term portfolios where immediate income is not a large consideration.

Historically in these Newsletters I have not commented on Hedge Funds as these have not featured, beyond a marginal degree, in portfolios.  Many Hedge Funds seek to balance out risks in other markets through use of complex derivative portfolios, the workings of which are extremely difficult to understand.  Although investment fashion suggests that one might de-risk portfolios by using such funds, I am generally content to remain unfashionable in this respect on the basis that the complexities of Hedge Funds are great and the risks difficult to understand.

For the very risk averse client, holding cash appears to be a panacea in that, if it is distributed across an appropriate number of banking institutions, risk of loss is effectively nil.  However, set against that must be the fact that inflation is steadily destroying value, even at current relatively benign rates while interest rates are tiny even where the depositor does not bare tax.  While investors should always retain suitable reserves of cash for contingencies, for a general reserve and for any projects that may be planned for the foreseeable future, holding significant investment funds in cash remains inappropriate in my view.

Summing up, while monetary policy across the globe may begin to gradually tighten over the next two or three years, interest rates are a long way from returning to levels that are generally regarded anywhere near normal.  These are conditions that are generally benign from the perspective of medium and longer term equity markets in particular, notwithstanding periods of volatility that sometimes occur.

Fund Manager changes 

Readers of the financial press may well have noticed that there have been a number of mergers and takeovers within the world of the fund management groups while at fund level, several key manager changes have been announced.  Specific examples include the takeover of the Cazenove fund management range by Schroders, and it has been announced that Aberdeen are in talks to acquire Scottish Widows from Lloyds.  Individual fund manager changes have been announced within Old Mutual, Fidelity and, perhaps the one to hit the headlines most noticeably, Neil Woodford, an equity income fund specialist, is standing down from Invesco Perpetual next year.

All of these changes have the potential to impact on the range of funds available and on their performance.  When fund management groups merge, there often follows a period when funds with similar objectives are merged and some of the individual managers therefore become redundant.  From an investor’s perspective, our task on such occasions is to seek to ensure that the merged fund presents a sensible and appropriately risked investment for individual clients.

When individual fund managers move on, such as Mr Woodford, the judgement that we make is in some ways broadly similar but on occasions where the departing fund manager has a particularly strong track record, clearly we have to be mindful that his or her successor may or may not hold the same potential.  Of course this may not become apparent for a year or more after the changeover has taken place so that in the interim there is a period of additional uncertainty.

While a manager change may cause disruption, and some investors may switch out of a particular fund, in order to follow the manager to his new home, it is far from universally the case that such changes lead to deterioration in performance.  Our general view, bearing in mind that one of our investment aims is to ensure that portfolios are well diversified so that no one individual fund manager accounts for more than a small percentage of client’s portfolios, is in most circumstances to take no action, on a basis that our stance is to adopt a long term, rather than a speculative short term viewpoint.  Clearly at some way down the line a particular funds comparative performance deteriorates then a rethink may be necessary but our experience suggests that over reaction can sometimes be more damaging that the reverse.

Retail Distribution Review – One year on

Most investors will inevitably have only a relatively hazy idea as to the impact of the Retail Distribution Review (RDR) which first came into effect just under a year ago.  One positive development has been the requirement for higher levels of adviser qualification, including the need for what is known as Continuous Professional Development, aimed at making sure that advisers remain up to speed with current developments which of course all good advisers have been doing for many, many years past.