Economic Commentary – July 2015

We are now half way through 2015 and some of the major uncertainties that could have impacted unfavourably on the UK economy have receded. The UK public have returned a Conservative majority, Greece and Germany have done a deal to prevent a possible break-up of the Euro and the Bank of England has signalled their medium term intentions to increase interest rates.

Nevertheless, experience tells us that there is no such thing as calm, steady economics and no doubt something else will come forward in due course to destabilise investments. The only thing that is certain as we look forward is that nothing is indeed certain!

Our investment committee feel that precious few countries have really been prepared to tackle their debt problems in a serious manner and what has happened in Greece and in Cyprus will affect other countries too – the big risk is if a major economy such as Italy or Spain looks to default.

Debts: Our attitude towards debts remains unchanged. In our view, repayment of debts should be prioritised; even in a low interest rate environment.

Verdict: Repay debts!

Cash: The heavily anticipated rise in interest rates has now been signalled and the governor of the BoE has suggested a bank base rate of nearer 2% will happen [we did signal this in our January bulletin – so it comes as no surprise to us]. If this turns out to be an understatement and further rises are needed, the increased costs of continued high levels of government debt being serviced will ultimately give rise to further spending cuts elsewhere or rising taxes.

Verdict: Overweight. Whilst interest rates remain frustratingly low, cash is the only truly safe defensive home for monies at this moment in time, and we therefore continue to support a heavy cash holding.

Low Risk: The ‘low risk’ or fixed income space of the market remains hugely difficult to call. As you may recall, for some time we have been concerned by the record low yields and high prices and have been concerned at the prospect of both capital losses and potential liquidity issues if the bond market is suddenly out of favour; indeed recent price movements suggest that the top has been reached – long overdue in our view. We therefore continue to favour strategic bonds due to their flexible mandates; the ability to ‘go short’ and to dive in and out of the various sub-classes at short notice, and actively remain on the lookout for genuine ‘low risk’ investments which could occupy this space that do not fall under the fixed income category.

Both Gould Financial Planning and many fund houses have been off with their timing where fixed income assets are concerned, but fact remains that these investments are still being marketed as ‘low risk’; we cannot endorse this position – we face a period where the prospect of an upside gain is low, and if there were a rush to the exit door, many positions would become untenable and prices could fall a long way. At Gould Financial Planning we stand by our view that lending to governments does not represent the traditional small risk to capital that it usually does.

Verdict: Remain bottom-weight in low risk (non-guaranteed) investments, continuing to favour strategic bond funds due to their flexible mandates.

Commercial Property: Last time out we were still bullish on the prospects for property and this has again proven to be the case with returns from UK commercial property and property shares in particular being very favourable and exceeding double-digit territory over 12 months in many cases.

Income investors continue to view property as a relatively safe home to generate income from their capital and with interest rates remaining very low, inflows to the sector have remained healthy and savers have been rewarded with higher levels of income for their risk capital.

We still favour a diversified property portfolio, incorporating exposure to the UK and overseas commercial property, as well as exposure to infrastructure and property shares depending upon attitude to risk. Our preferred physically-backed infrastructure trust still carries a premium but with the dividend yields so high, we have returned this investment back onto our shortlist.

Verdict: Overweight. With interest rates predicted to stay relatively low, we retain the belief that commercial property and physical infrastructure investments are likely to remain in favour for the foreseeable future.

Mixed Investments: Investments in this space could range from your traditional ‘Cautious Managed’ fund to long/short ‘Target Absolute Return’ strategies, and include a range of different investment asset types and approaches. We continue to favour investments with a more flexible mandate and our view is that this space is best utilised by diversifying amongst a number of investment managers with differing perceptions of the future. We are looking for this aspect of the portfolio to provide a degree of surety and to generate some kind of return irrespective of the prevailing market conditions, but we are aware that if interest rates were to rise quickly and equity sentiment were to fall at the same time, this asset class could suffer.

Verdict: Neutral. We will continue to spread investments in this sector amongst a number of fund managers with different investment strategies

UK Equity: The UK market has suffered somewhat of a correction in recent weeks falling from a high of ***** to ***** as at ** July 2015. Nonetheless, we feel that the UK could benefit from steady growth in the years ahead especially if this government succeeds in getting the deficit under control.

We note with some caution that there will be a UK-wide debate and referendum as to whether the UK remains in the EU in 2017. At this stage few commentators are calling whether the UK will stay or leave, and even if the UK were to leave, there is considerable uncertainty as to what impact this might have on UK stock markets, interest rates or exchange rates.

As previously mentioned, the UK has emerged from the global economic crisis with more conviction than many other developed economies, and with anticipated continued low levels of inflation and relatively low interest rates, we believe that real returns from UK equities could be attractive looking ahead.

We do feel that the ‘mid-cap’ space looks expensive although for many of our clients banking profits is likely to cause taxation headaches, and we would therefore encourage active management for this element of the portfolio. The small and micro-cap arena continues to look appealing to us because of the tax breaks being offered by the UK government. Some investment trusts continue to trade at attractive discounts and with private investment accounting for a larger proportion of small-cap investment off the back of less funding from banks, the number of investment opportunities in this space for private investors is higher than it has been historically.

Verdict: Neutral – but earlier this year we reduced the asset allocation for this space. In spite of a relatively optimistic view on the UK, we feel that the emphasis of the equity element of portfolios should shift to a more globally-focused mandate and in January 2015 we amended our asset allocation to incorporate a proportionately smaller UK holding in favour of an increased holding in global and overseas investments.

Overseas Equity: As you may know, 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 split this space into four categories; developed equities, emerging equities, commodities and specialist investments.

The developed equity space is invariably where a high proportion of overseas monies is allocated, and our view is that in this well-regulated space, keeping costs low is the key to achieving consistent returns – therefore we have a bias towards tracking funds. Interest rates and inflation in most developed markets are low and therefore the smaller the cost, the higher the level of real return, particularly in markets where active management rarely adds considerable value such as the United States.

That said we continue to believe that active management in Europe and Japan could provide added value looking forward. Shinzo Abe remains in power and appears to have continued support from the Bank of Japan for his monetary policy; this means that continued devaluing of currency in an attempt to stimulate economic growth will likely continue. With this being the case we feel that the Yen is likely to weaken further still against Sterling, and we therefore continue to favour actively managed funds (preferably hedged back to sterling) to provide exposure to the Japanese market.

In Europe we have seen similar measures, with quantitative easing introduced on top of the asset-buying which was already been taking place, as well as lending further money to Greece. In such a fragmented market we feel that active management is important and that it is inevitable that, at some time in the future, some or even all of the loans to Greece will have to be written off – indeed, the markets probably already assume that this will happen. Economic union without political union is unsustainable and therefore at some point the lending from Germany to Greece will become as inconsequential as the loans from England to Scotland. They will just melt away.

We commented last time out that emerging markets looked to be attractively priced as a long term investment, and we still believe this to be the case – indeed the falling markets in China and South East Asia mean that the investments are now much cheaper. We feel that many emerging markets are undervalued and for an investor willing and able to take a long term view, investments here continue to offer great value, albeit at a higher risk!

Of course, not all emerging economies are the same (the recent contrasting fortunes of China and India highlight this!) and our preference remains to hand over the selection of the individual economies and companies to a proven fund manager. At this moment in time there are some investment trusts trading at attractive looking discounts due to the negative sentiment towards this area of the market and we are also finding some interesting strategies domiciled in offshore ‘FCA recognised’ territories which may well come into our thinking for some of our clients in due course.

We commented last time out that we felt, generally speaking, the commodities market looked attractively valued for a long term investor. Regrettably the market has continued to move backwards since then, particularly in the energy sector where the sharp falls in value of crude oil have hit investors hard and investors will have noted that gold has fallen below $1,100 per ounce. A strong US market and, in particular, a strong dollar is invariably negative for commodity investors based outside the US.

In spite of this setback, we are sticking to our guns. We still feel that the commodities market is a good growth play over the long term although we are keen to diversify in so far as is possible in recognition of the fact that the face of commodity markets could be changing somewhat; in a world where renewable energy is playing an ever increasing part in energy markets we are now advocating a core holding to renewables for some of our clients.

Verdicts; Developed World – Neutral. Emerging World – Top Weight. Commodities – Top Weight. As mentioned above for the UK equity asset class, we feel that in a world where the UK is playing an increasingly small role, the equity content of a portfolio should carry more global diversification.