Introduction
The investment outlook continues to be dominated by a number of factors that have been in the forefront for several years now. These include in particular the outlook for global growth and the trade war between the US and China. While Brexit is of intense interest to the UK, and on which we comment separately below, its global significance is modest given that estimates suggest that the UK will account for just 1% of global economic growth this year with China accounting for 33% and the rest of Asia 30%.
Turning to look at global growth in a little more detail, we note that while growth held steady during 2017 and 2018, it is forecast to fall to approximately 3.5% this year and to increase slightly during 2020. If the actual results come in close to forecast then, from a global perspective, equity investors should be generally comfortable with the outcome which will be supportive of company profits and dividends.
Against this background it is on the face of it surprising that the Federal Reserve, the central bank of the USA which remains the globe’s largest economy, is now indicating that it may make two to three small cuts in US interest rates over the year or so, and that it is pausing on quantitative tightening. You will remember that quantitative easing was put in place after the financial crash of 2008/09 to ensure that economic confidence was maintained, a mission very largely achieved. Raising interest rates and quantitative tightening, measures designed to reduce the QE lifeline as economies improved, was always supposed to be the second part of the programme. That it is now coming to a halt in the USA, as may well be the case in the Eurozone, reflects greater economic unease than the headline global growth figures suggest.
In our view much of this can be explained by the ongoing trade dispute between the USA and China and the threat that this implies to world trade and arguably in particular to the US economy. The trade war is perhaps a symptom of a wider clash of cultures and economic systems given the huge degree of state control in China over its economic development as compared with the very much more market driven western culture. We do not see a speedy resolution to the broader political points – however we do believe that sensible compromise will in the end be found on the economic issues at least.
Over the last 12 months, equity markets have been volatile, in large measure reflecting factors touched on above and after a difficult second half of 2018, equities have recovered their poise and the possibility of interest rates remaining at rock bottom levels for longer than was ever originally envisaged is a source of encouragement to companies, enabling them to raise funds for investment at lower cost and to make dividend yields look attractive by comparison with the ever squeezed returns available from the fixed interest sector. It is for this reason that, except for clients with short term time considerations in mind or with higher levels of risk aversion, potentially more volatile equity investment continues to form the basis of portfolios that we recommend to clients.
Brexit and the UK economy
The UK Government’s finances are clearly in better shape than they were 10 years ago in that the deficit is much reduced, in large measure as a result of austerity but also somewhat assisted by the slow economic growth that has been achieved. There has however been a cost: net of inflation, the budgets for defence, the country’s infrastructure and the full range of public services have been considerably squeezed, debt has continued to grow, productivity has lagged behind that of our competitors and while employment is relatively full, only very recently has wage growth started to outpace inflation. Mr Hammond’s much mentioned Brexit ‘war chest’ is based not on actual cash but on OBR forecasts of cash to come.
Whatever form of Brexit might occur adds a further deep layer of uncertainty into this uneasy mixture. A so called soft Brexit, with a transition period to an unknown ultimate destination does at least have the benefit of delaying the final result and providing some further time for negotiations while a hard Brexit, destroying long established trading arrangements with our principal economic partner and putting very little of substance in their place, makes it impossible for businesses to prepare because they have no way of knowing what it is that they have to prepare for.
Some suggest that a hard Brexit would enable the UK to make up trade lost with EU through the creation of a speedy deal with the USA, an economy of broadly similar size to that of the EU. This fails to note that we do some 3 times more trade with the EU than with the US (geography and regulatory alignment play significant roles in this) and it has been calculated that a decline in the UK’s trade with the EU of 10% would require an increase in trade with the USA of approaching 40%, an outcome that would surely take many years to achieve, leaving a considerable hole in the UK’s economy in the interim. This might be filled by further government borrowing, by increasing taxes, through devaluation or a combination of all three.
As seasoned observers on economic matters, we fail to see how Brexit can avoid handing economic advantage to others.
Trends in UK Company dividends
For some years now, many UK companies have been paying steadily increasing dividends, boosting the total to record levels. Factors behind this trend include increased company profitability as the global economy has been growing while a continuation of low interest rates, enabling companies to finance long term debt cheaply, has clearly been a help. Further, a number of companies have been buying back their own shares, reducing the equity base so that a given amount of dividend paying power is spread among the smaller number of shares that remain.
There is another factor, namely that companies dislike cutting their dividends as it is perceived as a sign of corporate weakness. However, if dividends are not covered by earnings or if there is insufficient cash coming in to finance expansion once dividends have been paid, it becomes difficult for companies to invest adequately in their business. In the last few weeks several, including Keir, Vodaphone, Marks & Spencer and Royal Mail, have bowed to the inevitable and cut their dividends sharply.
Reduced dividends from a number of companies is not in itself sufficient to reverse the general UK trend towards higher payments, but we do expect that trend to slow and other weaker companies may well follow the example of the four just mentioned.
On a more positive note, as the UK’s leading mining and commodities companies (e.g. BHP, Rio Tinto and Glencore) have recovered from slumping commodity prices a few years ago, they have been able to increase dividends significantly.
In broad terms, some 18% of FTSE 100 company dividends are derived from the oil and gas sector with a further 10% from each of basic resources and personal and household goods. While the remainder is derived from a much more diversified list, the fact that volatile areas such as oil, gas and basic resources between them account for approaching 30% of UK dividends is not a recipe for diversity. In addition, the threat of confiscatory nationalisation, should a Labour government be elected, hangs over many of the UK’s relatively high yielding utility companies.
Comparisons between the UK and the rest of the world show that global markets have achieved greater dividend growth, albeit from a lower starting point, over the last decade. We therefore conclude that income seeking investors should include global income funds as well as their UK counterparts, accepting that while the shorter term return may be lower and that exchange rates fluctuations will play a part in the final amount received in the UK, diversification into global equity income funds has significant potential benefit.
Ethical and Sustainable Investment
For many years a number of clients have expressed interest in investing in ethical funds and, more recently, the question of sustainability has also been raised by a number.
Ethical investment has a long history and was often based upon an investment policy that screened out certain activities deemed to be unethical. Classic examples of these include the alcohol, gambling, armaments and tobacco industries. There are also funds that adopt a positive screening approach, i.e. specifically to include certain areas which might, for example, include healthcare.
Difficulties arise with interpretation of ethical policy: for example, should retailers that sell products such as tobacco or alcohol be screened out? If the answer to that is yes, then clearly most of the retail sector in the UK and globally become un-investable.
From the point of view of investment performance, history suggests that investment driven by ethical policies can lead to a measure of underperformance compared with more widely based funds. While we monitor a number of ethically orientated funds, we do not as a general rule recommend them to clients unless they have expressed a specific wish for them.
In recent years there has been an increased trend among a number of investors to focus on companies that can demonstrate strong environmental, social and governance metrics (ESG). As a consequence, a number of fund managers offer funds that aim to deliver meaningful outcomes by addressing the world’s major social and environmental challenges while at the same time seeking to produce a financial return. There are a relatively small number of funds targeting what is a potentially very broad sector and of course some of the technologies in which investment will be made are relatively new and not yet fully proven. Our view is that many good quality equity funds will already be investing in a number of companies that can demonstrate good ESG attributes and that demand for purest funds, carrying the more focussed risk which sometimes walks hand in hand with a specialist approach, will not appeal to all. We do however monitor a number of funds deemed to be ‘ESG focussed’, they are often very varied in style and it will be interesting to see how they evolve.
Conclusion
In this newsletter we have sort to comment on a number of areas that are of topical interest to investors: as a general rule we are presently not advocating significant changes of direction within portfolios noting what we perceive to be the long term potential for, in particular, equities, despite current uncertainties. Clients looking to raise funds in the shorter term might however take a more cautious approach: we continue to review portfolios very much on a case by case basis.
Finally, we hope that you have a lovely summer.
Budget 2024