Following a more positive time in most markets, the main preoccupation for many UK investors seems to have shifted from inflation – with recent readings coming in at only slightly above long-term targets for most major economies and now below target in the UK – towards the impending tax changes that the new Labour Government may introduce in their October budget. We plan to address those in a separate paper as we are currently in the period of maximum speculation where very little is actually known. However, the main area of risk to most investors is a possible rise in the rates charged on Capital Gains in non-tax wrapped portfolios.
On the investment front much of the positivity, with a slight wobble during the summer, has arisen from the now quite widely held view that inflation has been tamed and that interest rates in most of the developed world are trending downwards. Reducing interest rates cuts the cost of borrowing for individuals (mortgages) and also for companies, freeing up cash for investment and expenditure. In theory, therefore, falling interest rates are good news for most asset classes – with equities, bonds and other real assets such as property and ‘alternatives’ (including infrastructure assets) all potential beneficiaries.
There are, however, known worries in the world at the moment, with a significant increase in global tensions and war. We are frequently asked about the worrying conflicts in Ukraine and the Middle East. As these have developed, and notwithstanding the enormous human suffering they are causing, markets have mainly priced these conflicts in. There is always the risk of escalation, and/or other conflicts emerging which would undoubtably cause stock markets to worry but as more time elapses without contagion we are hopeful that these risks will diminish, and we get nearer to peace.
We are also frequently asked about the impact of the US election in November – the ground has moved on this with Biden’s handover to Harris, but the outcome is still very uncertain. There is little agreement about who would be better for markets, with the ‘Trump Put’ resulting in an unexpected stock market rally post 2016, and a real chance that Trump would, again, focus his attentions on ‘wins’ that he can attribute a monetary figure to. That said, the idea of a less volatile leader is likely to result in a less volatile stock market. Much may also depend on the Republican/Democrat balance of power between the President, Congress and the Senate. Historically stalemates, resulting in less government intervention, have been good for markets.
Our other concern is that Central Bank complacency or mistiming of rate cuts might result in either a resurgence of inflation (something that is not uncommon after an initial period of inflation reducing), or in recession(s). The policy dilemma that Central Banks are managing is:
- Reduce interest rates too quickly – as mentioned above, this should increase demand/spending and investment which should ultimately be good for economic growth and markets. However, an unexpected spike in demand without supply chains having a chance to adapt can drive up prices – i.e. inflation. Central Banks may then need to increase interest rates again to cool demand, taking us back to a similar position as found ourselves in 2022.
- Hold interest rates too high for too long – conversely, restrictively high interest rates are likely to stifle demand and levels of investment. People and companies can take this pain for short periods, dipping into savings or short-term credit facilities, however, this ultimately starts to hurt and recessions tend to follow until prices (or wages) adjust to reflect a new (higher) interest rate. This, however, takes time.
Central Banks seem to be claiming victory and may well have found the right balance and timing. That said, these policy decisions have long and variable time lags, so we will not know for sure for some time.
When investing, we are generally positive and think that the outlook is reasonably good. However, in thinking about how to diversify risk we are mindful of the need to include assets that should provide some defence in either of the lower probability, but still possible, outturns. The good news (if it can be viewed as such by those who suffered it) is that the corrections in equity and bond markets in 2022/23 (when interest rates were rising) now mean that there is a wider tool kit of investments and asset classes to use for this purpose which are not currently expensively priced when compared to long term averages.
Asset Allocation
The main action we have been taking in portfolios recently is a gentle reduction in the large US technology names, and the funds that have high weightings in these – taking profits where possible, and an increase in exposure to now more reasonably priced Government and Corporate Bonds. We have also been gradually adding to cheaper developed market equities in the UK, Europe and Japan where there is reason to be optimistic (medium term), but some downside protection (short term) in the form of lower prices, both relative to the US and to history.
Equities – With interest rates trending downwards, there should be a tailwind for most stock markets, but mindful of the risks outlined above, we still prefer those that are less expensive. The main exception is China, where despite well documented problems in the property and shadow banking sectors, which have caused markets to fall to relatively low levels, we remain worried about the political risks, corporate governance and shareholder protections. We prefer to access any return to growth from China via the wider Asian funds where the risks are somewhat lower. We are also starting to add to Emerging Markets exposure, albeit in a small way for most portfolios – a market that tends to reward patient investors.
Fixed Interest – After many years of offering return free risk, bonds now look a more sensible investment – traditionally providing a lower long-term return than equities but with lower volatility and low (or at times negative) correlation to stock markets. These have been a significant part of the well diversified portfolio historically, but more difficult to allocate to sensibly when we were in a very low-interest rate environment. With returns on short-dated UK government bonds around the 4% level and inflation at (now just under) 2%, these offer an attractive real return without having to take too much risk. As returns on these types of holdings are mainly tax free (when owned directly) there is an added attraction at present. High quality government bonds also offer some protection against the risk of recession and we are starting to build positions in these as a helpful risk mitigation strategy.
Corporate bonds require rather more analysis. Dispassionate selling in the bond markets throughout 2022/23 has meant that the difference in returns between lower quality and higher quality bonds is small and, in our view, does not properly reward those taking risk with non-investment grade debt, where default risk is typically higher. This default risk will increase if we see recessions in the future, which is the scenario where we want our non-equity holdings such as bonds to defend. For this reason, we favour very high quality, investment grade, bonds and we will generally allocate to corporate bonds through well managed ‘Strategic Bond’ funds where we can draw on the expertise of a specialist in the sector.
Alternatives – This is a broad category of investment, but for us mainly includes infrastructure, and renewable energy funds, many of which are structured as investment trusts. For several reasons, these have had a tough time, with many trading on significant discounts to the actual value of their underlying assets. However, yields (the income they produce) are still very attractive (5-8%) and a number of the sector’s headwinds seem to be starting to abate. Our approach for most investors, particularly those not relying on very high income, will be to reduce this sector in favour of bonds (where the idiosyncratic risks are lower), however, we would expect the discounts to close giving rise to some capital uplift as interest rates start to come down more meaningfully. This might be a slow process, but investors are being quite well paid to wait for a recovery in most of these funds.
Commercial Property – Falling interest rates are usually good news for the property sector however it continues to face ongoing structural challenges in the conventional areas of the High Street and office space, both subject to change as patterns of shopping and working have shifted. We continue to prefer specialist property funds targeting parts of the property sector that are experiencing rising demand with relatively low supply (for example, high quality warehouse space and storage facilities). Yields are reasonably attractive, and these sub-sectors offer some diversification to equity returns.
Diversification
Given the continued dislocation of global economic results and policy, and the known risks mentioned above, our view remains (somewhat predictably for those who read these updates regularly) that thoughtful diversification is the key to consistent risk adjusted returns. We are always aiming to find the right balance between equities and non-equities (such as fixed interest, infrastructure and real assets), but also in our investment selection within these broad sectors.
For example, it is important to be mindful of your exposure to different geographies, investment styles and understanding how much is invested across the market cap (company size) scale. Too much to one investment type and the underlying risk one is taking can be higher than it looks at the portfolio level.
We, therefore, aim to get this balance right. Being mindful of exposure to expensive investments priced for perfect economics ahead, and actively seeking opportunities and good long-term returns by skewing portfolios towards sectors that we feel are valued well for long term growth.
This note is intended as a general market update and should not be regarded as specific advice or treated as a recommendation to invest in any particular fund or asset class. Stock market investments can fall as well as rise. If you would like to discuss the implications for your own portfolio, please do get in touch.