Economic Commentary January 2016

Debts; As the introduction to this section might suggest, we are extremely keen for our clients to repay debt as a priority!

Verdict: Our stance has always been, and continues to be, that debt repayment should be the number one priority.

Cash; Whilst interest rate rises are looking increasingly likely at some stage during 2016, the magnitude of any increase is almost certain to be small and subsequent increases will, in our opinion, be small and infrequent. Nonetheless, with the ever-increasing stockpile of global debt we still feel that cash represents the only truly defensive asset type and should therefore form the core part of a defensive portfolio.

Verdict: Overweight. Cash remains our preferred home for the defensive aspect of client portfolios, although the extent to which we will be recommending an overweight position is likely to be smaller, as new ‘low risk’ opportunities find their way onto our shortlist and inflation remains very low.

Low Risk assets (i.e. bonds and gilts): Our stance here remains largely unchanged; we still firmly believe that the global stockpile of debt is unsustainable and that, sooner or later, this bubble will burst. The bubble has been protected thus far with unprecedented monetary policy, and whilst this may well continue for the short term, there are only so many plasters in a box!

As has been the case for some time now, we do still like the concept of strategic bond funds which have the flexibility of mandate to shift between the various sectors of this asset class at short notice, without any tax consequence to the investor and at relatively low cost. We feel it is important to back strategic bond managers with a reasonable level of conviction in order to extract the necessary value for the risk premium above cash.

Where our stance has changed since we last wrote, is that we have now identified an emerging space within the UK market which we feel could gain the attention of investors in the months and years ahead. The floating rate note market is relatively small in the UK, but there are some players already on the field, the latest of whom is M&G who have a very strong reputation in the fixed income industry. We feel that these assets, whilst carrying a higher degree of credit risk, offer protection against rising interest rates and a reasonable income yield and can form an appropriate complementary holding to a strategic bond fund portfolio.

Verdict: Remain underweight in low risk investments, but to a lesser extent than was previously the case. Opt for strategic bond funds in the first instance, but look to diversify the portfolio with a floating rate note fund once the low risk holdings reach an appropriate level.

Property: Property markets, particularly those in the UK, have been buoyant for some time now. The general consensus from the market experts we have spoken with is that this is likely to slow down in the immediate future, particularly where the UK commercial property market is concerned.

It is generally the UK commercial sector which forms the majority of the property portfolios we recommend, and we will now be advocating (more so than before) targeting those funds which have very low vacancy rates and a focus on high quality tenants, as we believe it will be income which drives the potential for returns in the years ahead where the UK commercial market is concerned.

As our clients will know, we have for some time been recommending an exposure to overseas commercial property markets to complement the UK holdings. The universe of funds to choose from here is relatively small but we do feel that this diversification will provide the potential to add value in a more sedate UK market. Indeed, during November and December we have seen evidence of this with some of the positions taken out in Japan beginning to reap rewards. We will be continuing to advocate an exposure to overseas commercial property markets.

One area where we have been reading some positive news is the potential for rental growth in UK residential property markets. We have identified a fund which we believe could tap into any potential uplift in this area of the market, and will be making recommendations to clients we believe the fund is suitable for.

Verdict: Neutral on balance; however, look to go towards the top weighting for overseas commercial property and, where appropriate, UK residential property.

Mixed Investments; As commented in previous commentaries this space covers an array of sectors, most of which are dissimilar in strategy, content and returns. For 2016 we are looking to categorise funds into one of three strategies; upside strategies – funds which should perform in normal market conditions; downside strategies – funds which should perform in adverse market conditions; absolute return strategies – funds which aim to perform in all market conditions.

In order to provide a solid core to a portfolio we believe that holding a broadly equal exposure to all three strategies is appropriate at this time. Absolute return strategies will not always succeed, whilst downside strategies carry the potential to limit any damage a sudden shock might bring about.

Verdict: Neutral. Look to diversify between different strategies in order to provide a solid core from which the growth funds are able to perform.

UK Equity: As alluded to in the introduction to this commentary, we believe that future growth from equity markets (including the UK) is likely to be more subdued. As interest rates eventually begin to rise and debt needs to be repaid so economic growth expectations are likely to fall. However, continued extreme global monetary policy could see this theme take a little while to play out, and calling time on this is a near impossible task.

We do feel that the ‘mid-cap’ area of the market looks expensive on a value basis; however, equally, with this type of company being more domestically focused as opposed to the international makeup of the FTSE 100 continued low unemployment, earnings growth and low inflation in the UK could see this space continue to grow in the near term in our opinion.

Last year’s re-election of a Conservative government is, in our view, good news for the smaller company market. We currently have a government keen to encourage entrepreneurial spirit and with the clampdown on the range of companies VCT and EIS managers are able to invest in, we believe that opportunities here could become more plentiful to ‘mainstream’ UK smaller company managers.

Verdict: Neutral – Concentrate on large-capitalised companies for the bulk of a portfolio (unless there are tax considerations and/or a particularly speculative risk profile!). Utilise the expertise of active ‘flex-cap’ fund managers in order to pass on the decision making at the critical point to a suitably qualified team.


Overseas Equity: The overseas equity asset class covers a broad range of regions and sectors, all of which will not perform in perfect tandem with each other. We look to split the space between developed equities, emerging equities, commodities and specialist investments. We are also considering the inclusion of a fifth ‘sub-sector’ of overseas smaller companies. I will deal with each in turn.

Developed Equities; Our general stance with this area of the world is to employ the services of global or regional (i.e. European or Asia Pacific) managers who have boots on the ground. We feel that their daily contact with the action is likely to result in a better outcome for investors than an IFA making calls on individual countries.

That said, we do feel that Western Europe presents a potential investment opportunity in the years ahead. We have seen in the UK, US and Japan the positive impact that quantitative easing can have on stock markets and with European QE already underway, it is possible that this added liquidity, coupled with a weakening of the Euro to boost exports, could see European markets fairly buoyant in the years ahead.

Emerging Equities: Emerging markets have certainly suffered in recent times. The well-documented problems in China have contributed to emerging markets as a whole moving backwards and with a continued low oil price many emerging economies, which rely upon energy production as a primary source of income, are understandably struggling. Furthermore, with weakening local currencies, a strong dollar and the prospect of additional interest rises in the US, this potentially spells further problems down the line for some of these emerging countries, many of which have a large proportion of their debt issued in dollars.

In spite of these issues, many emerging market investments look fundamentally cheap when we consider valuations alone and where investors are taking a long term view we do still believe that holding a proportional exposure to this area according to your attitude to risk is a good long term investment decision, even if shorter term volatility may be unavoidable.

With BRIC (Brazil, Russia, India and China) countries accounting for almost half the world’s population we have seen studies which suggest that as the average emerging market consumer comes of age, so consumer led sectors in these markets should benefit from this changing demographic. We therefore take the view that introducing a fund in emerging economies which targets consumer-driven sectors could produce added value over a reasonable investment timeframe. We take the view that an active fund manager should be given first refusal over this strategy, but our second port of call for 2016 is that this emerging market strategy should be held as a complementary holding.

Commodities: The commodities sector is an area which our Investment Committee has been monitoring closely over the past year. We have been very conscious of the losses being incurred in the mining and energy sectors in particular, and whilst we do still think that a recovery from the current price level is inevitable at some stage, we are now questioning at what point will this recovery commence, and to what extent? Statistics suggest that there is already a global stockpile of crude oil, broadly equivalent to over half a years’ US consumption. None of the major oil producers are showing any signs of slowing down production, and in spite of the break-even price for production already being way above the current selling price for all major producers, there are few countries willing to slow down. Our view had previously been that once the US shale market was trimmed as a result of the low oil price, OPEC in particular would begin to curb their over-production and prices would begin to bounce back, but this is not happening.

In fact, we are now seeing evidence from some fund managers who have been closely researching the US shale market, that far from being discouraged by a low oil price, it has driven higher investment into research and development. The consequence of this is that some highly regarded investment professionals now believe that US shale companies could possibly thrive at an oil price of only $50 a barrel. This raises further questions, as even if OPEC were to curb production levels, once the price recovers to somewhere approaching $50 a barrel, US companies are likely to again start fracking, again driving up production. With Russia also a law unto themselves and Iran and Libya re-entering the global fold it is difficult to see a point in the near future where oil production will materially slow down, and without an increased global demand for this increased supply chain, it is becoming difficult to see any sustained recovery in the near future.

There is, of course, another variable added to the mix and that is the global drive towards cleaner, more efficient energy. With EU countries already legally bound to cutting emissions by 2020 and then at regular intervals thereafter, this transition towards a more environmentally friendly, clean energy era has now gone global. In December 2015, 195 countries reached a climate change deal, with developed and developing nations being required to limit their emissions to relatively safe levels, with a target of restricting global warming to 2 degrees centigrade below pre-industrial levels with an aspiration of 1.5 degrees below. This, in our view, is going to see a bigger drive towards renewable energy and environmentally friendly strategies and potentially some serious investment.

Will clean energy provide the best long term solution? This is difficult to predict and we will still be advocating a diverse commodity portfolio incorporating both renewable and traditional energy companies. But, for the time being at least, we have made the decision to give a heavier weight towards renewable energy at the expense of mining and energy companies (which will still be included as already mentioned). Where we are looking to top up commodity holdings therefore, it is likely we will give preference to this type of holding. The matter of what to do with existing holdings which have already suffered through the downturn is more difficult, and is something which we believe should be discussed before action is taken. Energy and mining markets could be in for more difficulty before a catalyst for recovery appears, but we appreciate selling out at the current prices does not seem a sensible course of action where a long term investment timeframe is in place.

Specialist Investments: Our Investment Committee has been researching some new ideas in this space which we anticipate introducing into our portfolios in the first quarter of 2016. Some of these are a play on a continued low oil price; for example, the travel and leisure sector could enjoy a period of increased profitability off the back of a low oil price.

Verdict: Neutral – continue to hold a diverse portfolio to reduce the risk of a single region suffering a correction. Where emerging markets are concerned look towards consumer-driven funds as a second port of call, and concentrate upon renewable and sustainable energy funds for any new investments into the commodity aspect of the portfolio.

PS. With low inflation and a lower expectation for growth, the cost of managing and advising takes on a greater level of importance. It is no longer permissible for the financial services industry to operate in a 2 per cent per annum world as many of the bigger and hungrier advisor firms wish to adopt.

At Gould Financial Planning, we have always striven to reduce the costs of advice and fund management. For the most part our clients benefit from lower advice costs and fund management charges and in the main incur overall costs running at under 1.5 percent, all in. Our drive for 2016 is to move to a 1.25 per cent world. This will inevitably mean a move towards passive index tracking funds for those areas of the market which we believe are highly efficient with reduced scope for outperformance of the index (i.e. developed overseas equities and large-cap UK equities) and we will be looking to utilise active fund managers (and their higher costs) only where we feel that they can add real value. This is a theme which we have operated for a few years now and will continue to adhere to.

Risk Warning: The value of an investment and the income from it could go down as well as up.