Question the Committee – Summer 2024 Edition

Firstly, a big thanks to everyone who submitted questions. It has been a couple of years since the last Question the Committee though it is fair to say this is the most engagement we have had of any so far. In part this is probably down to the forthcoming General Election spiking interest, and also because our readership has doubled over that period, so thank you to all who take the trouble to read and hopefully enjoy our content!

This format always gives us an interesting barometer of what is on people’s minds, and interestingly (but perhaps not surprisingly) this year a resounding 43% of all questions were directed at or linked to the upcoming UK election. We can’t cover all the questions asked in this blog, so we have picked a selection that we think answer the majority of questions, be it election-related or not…

Do you think there will be a change in government, and if so, how do you expect this to affect the performance of my investments?

“Anything can happen in politics” as they say, though at this point it seems highly likely. The polls have Labour 21% ahead of the Conservatives at the time of writing, so even if voting intentions are never a perfect indicator of the number of seats won, it would be a historic turnaround from here.

From an investment standpoint, the party in power matters much less than the policies they bring in. Both Jeremy Corbyn and Lizz Truss were financial risks because of their intention to spend more than markets perceived we could afford. On key economic issues there is very little difference between the Conservative and Labour manifesto’s, with both looking to be responsible when it comes to fiscal spending and tax policy.

We think a change in government will have a minimal impact on investment performance. If anything, compared to the other main elections happening on the global stage, the UK’s looks much less polarised and uncertain than many areas globally. 

What credence do you place on Rachel Reeves saying she will not increase taxes? If she doesn’t, does this increase government borrowing?

This is an interesting point, and worth exploring a bit. The future direction of government borrowing depends on economic growth, tax receipts, spending policies and how effective  those spending policies are. Economic growth is the most crucial of these factors, as for example, in a booming economy, tax receipts can be high as people and businesses earn more irrespective of whether tax rates have been tweaked up or down. Similarly, high tax rates in a low growth or recessionary environment would still lead to low tax receipts as people and businesses earn less.

With respect to economic growth, it does seem the UK is improving after a challenging couple of years recovering from the inflationary pressures, largely driven by Covid and the Russia-Ukraine war.  Inflation is now reducing and will hit the Bank of England’s target in the coming months. Wage growth continues to run much higher (6%) than inflation, and we expect Interest rates will reduce by year end, which will also help to reduce the pressure on households and businesses with borrowing. We therefore expect economic growth to be positive this year, so even if the Labour party doesn’t increase taxes, they are likely to receive more tax revenue.

The Labour party’s manifesto supports this idea, suggesting they can raise £8 billion in revenue without increasing tax. It has already allocated spending of £5.5 billion, suggesting a £2.5 billion surplus. Personal tax is forecast to rise slightly higher under Labour than under the Conservatives, though as mentioned before they are both committed to a similar strategy which is based around hiding tax increases in plain sight (by continuing to freeze the income tax bands) and pushing more of people’s earnings into higher tax bands.

Overall, at the current time it does not look like there will be a huge difference in tax policy between either party, so the key issue that will determine whether government borrowing goes up or down from here is economic growth. 

Labour have previously said they would reintroduce the lifetime allowance and reverse some of the recent pension legislation. Would a change in government alter my pension planning?

The last decade has seen a lot of positive legislative change to pensions. This is sensible in so much as it encourages people to make provision for their retirement, reducing the reliance on the state to provide support for their income, care costs etc. The dismantling of the lifetime allowance (taxing the size of your pension above a certain level) and improvements to the annual allowance (how much you can contribute), are both positive steps for encouraging savings and sensible planning. The Labour party have reflected on what was clearly a knee jerk reaction to the removal of the lifetime allowance, by stating in their manifesto that they have no plans to reinstate it. Even if they reversed this decision, it is estimated it would take around 3 years to reinstate this type of legislation.

Even so, it is important we remain vigilant to potential changes to pension scheme legislation, and how it links into inheritance tax planning. Currently pension schemes are exempt from inheritance tax, so changes in this regard would alter our planning strategies considerably. Again however, there would be advanced warning of this, and presently there are no lobbies in parliament to this effect. We are kept up to date on white papers and pre policy planning discussions via the industry and the regulator, so hopefully we can continue to provide our clients with a good steer on legislative changes and how to best manage the most effective solution given any future changes.

As an average we seem to be assured of 5% income (including dividends) per annum moving forwards. As a rough guide what capital return are you targeting, and how long do you see the income being maintained?

Great question. The main factor driving the level of income is interest rates, or more precisely, the path interest rates are expected to take. At the current time interest rates are 5.25% in the UK, however they are expected to reduce to around 4% over the coming two years. Assuming so, we would expect the income returns currently on offer (4% to 6% per annum) to be maintained over that timeline.

That said, there are many factors that might influence income levels from here, such as a recession which would require interest rates to be cut further. If income did reduce for some reason, we would then pick up capital growth, so the returns from our portfolios should still be strong here.

The opposite scenario is for income to increase further, and an example that could lead to that would be a second inflation spike, which is more concerning. As a guide, the interest on bonds and property, as well as the dividends from shares, generally need to be above the level of interest rates in order to attract investment. If interest rates were increased further therefore, those assets would have to fall in value in order for their income returns to remain competitive. This would cause short term pain but in return for even higher income looking forward.

At the current time we don’t see either of these alternative scenarios as significantly likely. Our central case remains for a moderate reduction in interest rates on the back of slow growth and generally low inflation, settling between 2% and 3% after falling to the lower end of that range in the near term. On this basis we see our income yield looking fairly sticky for now.

As you also elude to, the total return on your portfolio will also include an element of capital growth (or loss). This is a lot less predictable than income, and the potential for capital growth also varies significantly by risk level. Low risk portfolios are much more income driven as an example, with high risk more reliant on capital growth. What we can say is that as per our last blog (https://www.dbwood.co.uk/blog/may-performance-update-2/), stock markets tend to go up over the long term, so our role is to ensure the portfolios are exposed to the best subset of opportunities at any one time, without being overly skewed to any one sector or trend.

Overall, we do not set a capital growth target, but over the long term, if we do a good job and markets go up over time, we expect it to make a meaningful difference to returns. Add in the consistent income we now get and that gives us a high degree of confidence that we can deliver the return targets set for each portfolio e.g. 5% to 7% per annum for Low to Medium on a five-year view with inflation averaging 2-3%.

Why do you forecast 4% to 6% per annum for Low Risk for example when in the last five years you have delivered less than that?

This is another good question. The first point to note is that the question is factually correct. We have had two negative years of returns in the last 10, and they came in 2018 and 2022. Both were linked to rising interest rates, or in the case of 2018, simply the fear of them rising.

As so often is the case, when there is a negative annual return from markets there is an opportunity. Our Low Risk Portfolio produced a 9.15% return on the back of 2018 (where the return was -3.67%). By the end of 2019, inflation was running at 1.5% and interest rates were close to 0%. During Covid, inflation turned negative, and economies were kept alive by government policy. Then, as economies began to recover (in 2022) and the war in Europe/supply chain issues kicked in, inflation spiked, with interest rates moving from 0% to 5.25% over 18 months to counter. This caused a significant market response in 2022, with global investment markets falling markedly. The key point here is that we’ve had two very tough years in five, which makes a big difference to the average. So, whilst our Low-Risk Portfolio is now up over 17% from the market bottom in October 2022, it is still below our target over the last five years.

As we constantly say, investing is a long-term commitment because there are times when one-off events cause significant valuation changes. We believe we have taken advantage of the opportunities created in 2022, to the point where we revised forward our five-year return expectation to 20-30% for our Low Risk Portfolio (commensurately increasing targets for other portfolios as well) from the start of 2023. To date we are running slightly ahead of this forecast, and we continue to work hard to ensure our excellent long term track record remains ahead of our peers and delivers the right outcomes for our clients.

Are my bond investments within the portfolio really doing as well as you stated in the May commentary? I understand income returns of 5% plus look good but how are the capital value of bonds holding up? I read that markets are pushing back on when the Federal reserve and Bank of England might start to reduce rates. Will this offset some of the income being provided or do you see overall bond performance improving in the 2nd half of the year?

There are some interesting points here, and you are absolutely right to note that there continues to be a lot of uncertainty around when interest rates will come down and how quickly.

To be more specific, after a very strong finish for bond markets in 2023 it was forecast that interest rates would be reduced by 1.5% in 2024 (i.e. from 5.25% to 3.75%). At the time we felt this was unlikely and that the market had become too optimistic. As it sits today, interest rates are now forecast to end the year at 4.75%, around 1% higher than was expected just 5 months ago. That move out in expectations has caused capital losses on bonds, on average of 2-3% so far this year.

Despite those losses, our bond allocation is still up around 1.5% so far this year (after being up 8% last year), in the main thanks to the strong income yields and the management of our bond allocation. Our view looking forward is that market expectations for the path of interest rates are now much more reasonable. This should mean no more capital losses, allowing income to be the primary source of returns from here. Assuming the forecasts are now accurate I would expect around 5-7% from our bond allocation this calendar year, with the same likely next year. This is a good foundation for total portfolio returns.

Despite there not being any clear consumer demand, stock indices have recently been driven by the valuation of companies building AI capabilities. Do you have an evolving strategy for investment in this sector or do you see it as a potential bubble?

This is a really well-timed question, as it is something we are actively debating. As you note, a significant portion of equity market returns in the last 6-12 months have been focused within the part of the market most likely to benefit from the huge investment into AI. To put the size of the investment into perspective, the market capitalisation of Nvidia (the world’s leading AI chipmaker) has increased by $2.7 trillion in 12 months. This is greater than the combined size of the FTSE 100 index.

The big questions now are 1) will the huge investment put into AI be productive, and 2) will it happen quick enough to justify current market expectations.

Although we believe the technology has huge potential, it is concerning that since the adoption of chatbots like ChatGPT, to now we have seen no market leading application that is a significant improvement on current technology. That said, there is enough early signs and promise to remind us of the potential, so like anything it is a risk reward balance.

Overall, we have so far benefited from exposures to the US technology sector across all portfolios, though the longer we go without seeing positive outputs from this investment the more cautious we are becoming. That isn’t to say we think it is a ‘bubble’, but more that unless things are delivered reasonably quickly there is potential for markets to be disappointed. In short at the current valuation point, our strategy is cautious short term, but opportunistic long term.

Where do DB Wood stand on technology investments such as Nvidia, which would have increased a £10k investment to £2m over the last 10 years?

Probably the first thing to say here is we always want to provide clients with exposure to the best ideas across all asset classes, and we have had exposure to Nvidia through a number of US funds for some years. However, one of our core investment principles is diversification, so we would never commit a significant portion of client money to a single idea. For every Nvidia winner, that looks fantastic looking backwards, there will have been 100 competitors that looked similar at the time but have subsequently gone bust.

Instead of trying to select the one or two outsized winners, our objective is to provide clients with consistent returns that make their financial plans work and to that end the portfolios should never rely on one or two holdings.

Thank you once again to everyone that submitted questions, and we hope this blog made for interesting reading. If we haven’t answered your question directly, we will be back in touch to provide an individual response in due course.