15th April, 2016
Investment Review Quarter One 2016
Market Review of Quarter One:
Regular readers of this publication will recall that our outlook for 2016 involved low growth, low interest rates, lots of headwinds, and regular bouts of volatility in investment markets. At the end of the first quarter, we can look back and see that all of our thoughts played out in what was a quarter which might be best described as a game of two halves; the first seeing equity markets sell off by 10%, (falling 20% from the highs seen in April 2015), then recovering all of these losses in the second half.
Initially, Chinese policymakers and equity markets were the main focus, followed by doubts over the European banking sector, worries over a resurgence of a recession in the US, and finally fears surrounding a “Brexit” added to the complexity. Analysts were queuing up to give their predictions on the oil price, which for the most part was positively correlated with equities (when the oil price fell, equities fell). This relationship is rather perplexing, given that a fall in the oil price acts as a tax cut for the western world, making it cheaper for you and I to go and fill our cars up. In turn, we have more disposable income and therefore are more likely to spend, pumping money back into the economy.
Outside of the UK, interest rate moves were again a theme in the first quarter. US officials now seem more likely to raise rates twice this year, instead of the four proposed at the start of January. It is somewhat worrying that markets have absorbed this as a good thing, despite the fact it is due to caution surrounding the state of the world economy. Over in Japan, those in charge reduced interest rates to a negative position (meaning that you have to pay someone to hold your money) and the European Central Bank announced further support for its economies in March.
After many years of stellar returns, UK Commercial Property returns slowed in the first quarter ahead of concerns surrounding the “Brexit”. The already eye wateringly expensive Government bonds were the top performing asset class, and in equity markets, it was emerging markets such as Brazil and South Africa that produced the best returns, with Europe, Japan and the UK lagging.
In summary, the first quarter saw Investment markets remain tightly interconnected. This means that when there is a concern in one, it can spread quickly to another. This can be disconcerting for investors who might expect more rationality behind sizeable market movements. Investors are liable to panic if markets fall on the basis of something which is largely invisible to them, and unfortunately, it is this “sentiment” that is driving things at the moment. Upwards and downwards. We would therefore always point to fundamental. If markets are anywhere near efficient, they should recognise value through the noise, it may just take some time to play out.
There have been only a small handful of periods since the launch of our model portfolios where we have underperformed our respective benchmarks, however, quarter one 2016 was one of those. All six portfolios lagged behind their benchmarks, due mainly to underlying differences in the views on bond markets.
If you had asked us this time last year which asset class had the most downside risk, we wouldn’t have been the first to argue Government Bonds. Quite simply, after 30-years of good returns, developed market government bonds are crazily expensive. Most are priced ready for a global recession, and although there is a chance of this, we see this as the most unlikely of the potential scenarios to play out. Markets have completely ignored this and indeed, the Citi World Government Bond index returned 9.82% over the first three months of this year. To provide a comparative example of our exposure, the current allocation of Government Bonds within our Low Risk Portfolio is less than 5%, in comparison to its benchmark which is holding 29%. We are much more comfortable with our position, and despite our failure over the last quarter, we have performed with lower risk and more return than our peers over all periods above 6 months to the 31st March 2016. Let’s not, therefore, get to concerned with the short term, though it is very important to understand the rational between returns.
Clients that have been with us for some time will be familiar with our value driven approach, and given the risks associated, we still feel uncomfortable with a strong allocation to Government bonds. Of course we review the opportunities and threats to every asset class on an on-going basis, but if put in the same position again, we would make the same choice.
On a three-year view, which is far more preferable, our portfolios are ahead of their respective benchmark’s by 7.28% on average. Whilst this is good to see, we don’t just set-up to beat the industry benchmarks. Instead, our starting point is always the level of return that our clients require to achieve their financial planning objectives at each risk level. We have the longevity to have been through this before and it certainly won’t be the last time, but importantly we are positioned for the right reasons, and this should benefit our investors over the longer term.
We talk a lot in these quarterly reviews about creating value when things fall away and many of you may be sat there thinking “what are these guys on about?” In mathematical terms, if your investment falls 50% in value, you need a 100% return to get back to par. In contrast, if it only falls 10% in value, you only need an 11.1% return to get back to par. Essentially, the better you preserve your capital, the less work you have to do when markets then rally. What happens is that you create “value” by having more of your money invested at lower prices. Inevitably, the benefits of this come, but it can take some time for it is be visible. The last 18 months has been another example of this; the chart below illustrates the value our most popular portfolio (Low to Medium Risk) has created in comparison to its benchmark over the last 18 months (the value is the gap that’s been opened up).
During the next quarter, we will finalise a restructuring of our asset allocations in order to take advantage of the opportunities we are currently seeing, whilst also continuing to protect against downside risks. As you would expect, we won’t be chasing returns by adding government bond exposures, but instead feel we are approaching difficult stages in the cycle for certain asset classes, so please keep reading for more details in our market outlook.
After entering quarter two in pretty much the same position as we did quarter one, we have not changed our view that 2016 looks set to be a challenging year for investors. We are not of the view that we are slipping into another global recession, but we also do not believe that everything is rosy. To generalise, economic data continues to suggest that the economic recoveries remain slow but stable, particularly here in the UK and in the US. As always though, there are numerous aspects to consider, each of which could support or derail markets, and this is what makes it such a difficult environment to invest in.
Through the last 8 years, markets have always had a single fixation when they have been in trouble. In 2011 it was a euro crisis, and in 2014 it was concerns around the US Central Bank stopping their monetary support. Investors pretty much knew where the risks lay and could invest accordingly.
As we move forward though, there are so many factors to consider. Changes in currency markets, central bank policy, company earnings reports, and geo-political issues such as a “Brexit” are just some examples. Each has a slim chance of significantly disrupting investment markets and therefore cannot be ignored.
One of the best economists we meet with, Andrew Milligan of Standard Life Investments, outlined to us last month that he believes there is a 10% chance of a US recession. Whilst that figure might not seem very high, if we said there was a 10% chance of you dying on a flight home from your summer holiday, would you get on the plane? The truth is that most of us wouldn’t take that flight, however, put a million pounds at end of it and suddenly you may make a different choice.
Markets are faced with this dilemma on a number of levels at the moment. There is a slim chance that any of these factors could trigger large market falls, but even if they don’t, we are still left in a world with low inflation, low interest rates and low growth… not exactly the million pounds at the end of the rainbow. The risks are lower in chance, but people are less likely to take them because the benefits are also lower.
This difficult environment is not new to 2016, it was very much apparent in 2015, so our investors should have confidence that our strategy is working. As detailed in our portfolio review, we have created a significant amount of opportunity in relation to our benchmarks, and moreover, have a relatively clear direction as to the changes that are likely to be made over the coming months.
Firstly, we are foreseeing a slowdown in the commercial property market, which will likely result in a small reduction from an already elevated property weighting. Emerging markets are looking attractive for the first time in years, and we are finding a lot of good company stories within the difficult economic backdrop. In the UK equity space, we have also found some exciting funds with great potential. Finally, we are likely to reallocate our bond exposures, not to drastically increase any weighting, but more to ensure the fit within the portfolios remains in line with where we want it.
Of course, more specific details regarding any changes will always be shared in advance, but hopefully this provides you with our thoughts on directional changes. We will remain cautious and active, alive to market volatility and will look to take advantage of the opportunities it produces.
*You should be aware that pension and life fund performance differs from unit trust/OEIC performance, due to the underlying tax treatment. Past performance is not a reliable indicator of future returns. The value of any investment can go up and down, and investors may get back less than they invested.*