An overview of last year
2016 was, broadly, another year where the growth elements of portfolios added value. In essence, 2016 saw generally solid returns from equity investment, providing a degree of protection against the sharp decline in the value of Sterling seen last year, in a way not achieved by other asset classes, while funds incorporating investment in raw materials delivered better than average results. Other UK assets have not maintained this pace, including incidentally domestic property where, according to the Nationwide house price index, gains last year amounted to just 4.5%.
Last year marked the 8th anniversary of the onset of the financial crisis of 2008/9. That crisis was driven by a super abundance of easy credit for governments, corporations and individuals against a background of apparently everlasting economic growth and seemingly unstoppable wealth creation in housing markets on both sides of the Atlantic. When the bubble burst, banks were left with broken balance sheets and the realisation of need for quick damage limitation in northern Europe and North America, where the sector is now in far better shape. In southern Europe, the problem persists.
A combination of low inflation and low interest rates enabled governments, corporations and individuals to refinance on favourable terms and in the last couple of years this has reflected in stronger growth in the USA, the UK and indeed in parts of Europe. The recent rise in US interest rates is a natural reaction to the inflation that might continue to emerge while of course interest rates were cut in the UK in the immediate aftermath of the EU referendum. This helped to propel Sterling lower but it was also one of the factors supporting the domestic economy as it enters a most uncertain period.
All of this has provided succour for equity investors during 2016, and particularly those in the UK who have also seen the value of overseas investments rising when translated back into Sterling. The UK’s larger companies, with their often very substantial overseas earnings, have seen markets place a higher value on those current and future earnings, while companies with a pure UK focus have often not performed so well.
Emerging markets have produced mixed results. Turkey, for example, has had a poor year but others, particularly those with a strong commodity production base, have delivered better results. We hesitate to describe China an emerging economy as, by some standards, it ‘emerged’ many years ago and economic growth there continues apace. While last year saw the continuation of uncertainties in China’s financial institutions, others areas of the economy have performed well, including those capitalising on the rapid growth in consumer expenditure. However, living standards are on average, way lower than in leading western economies and in this respect, China still has a long way to go.
Global commercial property generally provided good value in 2016 and while the UK’s property sector encountered well publicised difficulties during the summer, stability has returned to that market and some of the big developments that were put on hold in the immediate aftermath of the EU referendum have now been given the green light.
The traditionally defensive fixed interest sector continued to deliver reasonable, by modern standards, rates of interest during 2016 but the beginnings of a trend towards higher inflation and higher interest rates has held back capital values. Index linked holdings enjoyed better protection.
Key drivers for 2017
While we go into the New Year with obvious and significant uncertainties (the impact of Trump, of Brexit, of other EU issues and of further geopolitical developments elsewhere), we do consider that a number of trends are evident which may provide opportunities during the course of 2017. We comment on some of these as follows:
Investment in equities has been the mainstay of portfolios and we envisage that this will continue. Broadly, companies have been able to strengthen their balance sheets, capitalising on inexpensive funding and we believe that many are well placed to take advantage of gradual recovery in a number of economies. While as a general rule rapid economic growth is not expected, we anticipate further strengthening in the US, in parts of Europe, in Japan and elsewhere in Asia, while there is little evidence of material slowdown in India and China’s still rapid rates of growth. Overall, equity valuations, while not cheap, offer reasonable value for longer term investors.
We intend to continue to advise clients to invest in funds where we believe management to be well capable of searching out a range of sound long term opportunities in their specific areas of expertise, whether that be in funds with a geographic focus or those in global sectors eg. healthcare, natural resources, technology and financials which are perhaps best followed globally rather than regionally.
For the UK, the highly complex Brexit negotiation (on which we comment later) will formally commence shortly and we fully expect that this will lead to spells of volatility in UK equity markets. Our long term approach leads us to consider that such conditions often provide interesting investment opportunities.
In the UK market and depending on the outcome of the Brexit negotiation, there could be further disruption to come. If for example consumer purchasing power is squeezed by inflation, we are not sure that landlords will be able to put through significant rental increases in the retail sector. We approach this asset class with a degree of caution, noting that ‘’liquidity storms’’ can blow up very quickly.
As a general rule, we are not at present adding to UK commercial property exposure, preferring instead property funds investing in global real estate investment trusts where any liquidity issues are more easily managed.
We consider that the absolute return sector holds potential to protect against aspects of market volatility while at the same time offering an alternative to holding cash.
Absolute return funds use portfolios of derivatives, managed in a way that aims to provide a positive return in all market conditions over rolling periods of time. The balances and counter balances within such portfolios generally prohibit these funds from performing as well as equities in good market conditions but they do provide potential for protection in other circumstances. Such investments can have a useful role to play, perhaps particularly in pension portfolios where the time for drawdown is approaching or elsewhere if other relatively defensive action is considered appropriate, although they are not risk free.
We anticipate that interest rates will continue to rise in the US, although the pace of this trend is uncertain. In the UK, given current levels of economic growth, in normal times interest rates might also be expected to be edging higher, to head off increasing inflation risks. The issue of Brexit puts this in doubt however and there is a good chance that, in a year’s time, UK interest rates will be unchanged. Investors in the UK fixed interest market may as a consequence feel sanguine but if GDP growth is maintained, and inflation continues to creep higher, or indeed if Sterling suffered a severe collapse, then when it does come, the scale of the first rise in UK rates may be greater than now appears likely. Further, increasing government borrowing, to finance a larger than expected budget deficit, can only add to the pressure.
Given the damage that rising rates can do to the capital value of fixed interest investment, we continue to underweight this sector, except when income is the key consideration.
Index linked investments, where the aim is simply to preserve capital against inflation as measured by the RPI, have performed remarkably well in the last few years at a time of singularly low inflation. This apparent contradiction can be explained in two ways, the first of which is that these investments pay a certain level of index linked interest, and while it is not large, it has nonetheless looked relatively attractive as compared with returns from cash. The second reason is that index linked prices are set at levels that discount the overall market’s view of likely future inflation trends. Particularly since the Brexit vote, which has triggered a well-publicised decline in the value of Sterling, ‘cost push’ inflation expectations have risen, boosting the value of longer dated index linked stocks in particular. The corollary is of course that should inflation turn out to be lower than expected then index linked investments will look somewhat overvalued, at least in the short term: in the current climate we do not consider this to be a very likely outcome.
Index linked investment has for some years often been part of our asset allocation for growth focussed clients with longer term time horizons: given where the UK economy now stands, this will continue to be the case for the foreseeable future.
Holding cash as a defence against market volatility and economic uncertainty has, since the referendum and for some years previously, proved to be a flawed strategy. Not only has the purchasing power of Sterling deteriorated sharply in international terms, cash has lost value relative to equity markets and of course it produces virtually no income. We continue to believe that holding excess cash is, in the medium and longer term, a poor defence for investors. This is not to say that, if one anticipates at some point a short term market fall, it is without merit: however the reality is that timing such market movements is extraordinarily difficult even for the most seasoned investors.
We find it impossible to predict with any confidence just where the Brexit negotiations will end up. The ultimate outcome is however a matter of supreme importance to residents of the UK whose living standards will suffer significant damage if a deal that adequately protects the UK’s commercial interest is not reached. It will be a strange outcome indeed if UK commerce gains easier access to its less important and distant markets if at the same time barriers to a market that accounts for approaching half of its global trade are created. Further, given that in the UK, employment is close to being full by historical standards, we cannot do without immigration.
Our simplistic view is that a UK/EU trade deal in goods and some services will be reasonably easily achievable, it is highly likely to involve lengthy transitional arrangements while some freedom of movement will be involved.
Aspects of banking and financial services (where EU wide activities carried out through London and through other smaller UK centres provide very significant benefit in terms of skilled jobs and tax revenues) maybe harder to protect as remaining EU countries are keen to see these activities moving to mainland Europe. We are not convinced that European centres have adequate infrastructure to deal with this while New York and Hong Kong clearly have. It may be that the UK will end up continuing to pay into the EU, where contributions are very much needed, in order to maintain the City’s European status.
From the point of view of government finances, the Chancellor admitted that all of this will have a negative effect, at least until matters are resolved, as pressure on government spending remains. The net result will be higher than anticipated government borrowing (acceptance of this was perhaps the principal announcement in the Chancellor’s Autumn Statement) which is one factor which may to lead to higher UK interest rates over time.
Of course investing in UK based companies is far from investing in “UK Plc”. As we have said elsewhere in this note, the outlook for UK companies trading overseas (and very many do) remains positive in our view while it is quite likely that, as the Brexit fog gradually clears, a number of UK centric sectors will also be able to demonstrate potential.
Readers interested in gaining a further understanding of Brexit’s implications for individual sectors of the economy will find referring to the CBI’s consultation document entitled ‘Making a Success of Brexit’, published in December, to be of interest. It is freely available on the CBI’s website.
While we do not see world economic growth returning to anything like pre-2008 levels, the massive economies of the USA (Trump inherits a reasonably strong situation), China and India all start 2017 with sound prospects which will deliver benefits well beyond national boundaries. Japan and Europe, in different ways, offer value along with the UK in the medium term. For the foreseeable future our overweight equity strategy therefore remains in place, as has been the case for some while now. While a measure of the potential is already priced into markets, we do not consider that probable medium and longer term earnings growth is fully reflected in current valuations.
With all of this in mind, we continue to create a bespoke portfolio for all of our clients on an individual basis.
Finally, we take this opportunity to wish all readers a healthy and prosperous New Year.