Q3 2017 Update

By Scott A. Middleton APFS BA (Hons)

Chartered Financial Planner

Comment

Once again, we have had another quarter of continued positive returns for equity investors with both UK and Global Equities moving strongly ahead. In contrast, Fixed interest investors have seen little return from corporate bonds and there was actually a small fall in the value of UK Gilts. However, the High Yield Bond sector did fare better.

Within the various equity sectors the most notable performances came from Japan, returning 7.19%, Asia Pacific Ex Japan returning 4.08% and Global Emerging Markets returning 3.90%.

This quarter marked a continuation of positive returns for most investors. After an extended period of positive returns, the question of profit taking versus continuing to expect further growth is in the minds of many investors, and we are setting out our current strategy within the context of this question throughout this update.

Investment cycles vary considerably in length from a matter of weeks to multi-decade cycles. The longest cycles can extend for more than 30 years and when these cycles change they can provide the highest level of risk and opportunity to investors.

When regulation was first brought into financial services in 1985 the most prominent warning introduced was to ensure investors were told that past performance was not a guide to future returns. Yet, more than 30 years later, the performance of an investment often remains the most significant determining factor in terms of selection.

The reason, in our opinion, is explained by the study of behavioural finance as people use their recent experience as the main basis for future expectations and current decision making. The longer the cycle, the higher the conviction, to the point where long cycles can make expectations so strong, that historical wisdom derived from experience becomes accepted as hard fact. The quote ‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so’ captures the essence of this point and appears at the beginning of the film ‘The Big Short’.

It is our view that another long term cycle has ended, but that investors are likely to continue to have expectations based on the old cycle for some time, leading to lower returns than might be available from a fresh review and interpretation of the current position. As a consequence we are reducing the value of recent past performance in our considerations, looking at much longer historical periods and closely considering the current position and prospects based on factual information rather than inherited bias.

The current bull (rising) market in equities has lasted 8.6 years to date, the previous bull markets since 1926, starting most recently, lasted 5.1 years, 12.8 years, 12.9 years, 2.5 years, 6.4 years, 13.9 years, 15.1 years and 3.7 years. The bear (falling) markets have lasted from 3 months to 2.8 years with the most recent two lasting 1.3 years and 2.1 years. This data suggests that the length of bull markets varies significantly and the current bull market is well within the range. Whilst the most recent bear markets have been towards the shorter end of the range the bull markets have been towards the longer end. Some investors are nervous that the current bull market has lasted longer than the previous cycle, but history suggests that this is not a relevant factor in determining when and if to take profits.

There is, however, a clear indication of danger within fixed interest markets at present, which we believe is being ignored in the same way as the warning signs mentioned previously in relation to the recent banking crisis.

The basic principle of investment is to invest money which is not required so as to provide greater spending power in the future. In order to be successful, the returns created must exceed inflation otherwise the spending power will be lower in the future. The current position is that fixed interest returns, particularly in gilts, are not likely to meet this basic fundamental requirement.

The problem is that fixed interest investments have enjoyed a favourable 30 year plus cycle and investors continue to have expectations based on the recent cycle. In addition, the investment community lacks professionals with experience of cycles where fixed interest returns have been disappointing. In fact, the recent cycle experience has been re-enforced with definitions of risk, which define fixed interest investments as low risk, as they generally only consider 20 years of data and disregard the fundamental lack of value which now exists.

To illustrate this, if a typical return from a fixed interest asset is 1.3%, but target inflation is 2% and inflation expectations are above 3%, risk appears high and the consideration of the historical strong returns, which caused the current position is an unhelpful distraction in determining asset allocation today. We are aware of this and will therefore continue to monitor these markets very closely.

In terms of equity markets the position appears more favourable than many commentators are reporting. Whilst valuations do appear quite high, historically there are a number of reasons to be optimistic that current levels are well supported and markets can continue to provide positive returns.

History shows that equities often outperform during periods of moderate inflation as companies are often able to raise prices providing some inflation protection for shareholders. The amount of quantitative easing injected into the global economy now exceeds $15trn and continues to rise at present. This cash is gradually filtering into the real economy and is driving global economic growth, reducing unemployment, increasing future confidence and beginning to increase inflation. The effects of quantitative easing are likely to continue for a decade or more given the gigantic size of the programme.

The US has raised interest rates 3 times, beginning at the end of 2015 and the Bank of England recently increased interest rates from 0.25% to 0.5% in the UK, which was the first rate increase for a decade. Clearly central banks are starting to worry about inflation, however both the Federal Reserve and the Bank of England have made it clear that the pace of increases will be very slow, as they are more worried about damaging economic growth than controlling inflation. While we expect further rate increases this year for both economies, we expect that the level will be modest and not enough to meet the long term inflation target which will be exceeded. Simply put, the $15trn inflationary stimulus applied through quantitative easing resembles a flame thrower, whilst the interest rate increases that are deployed to control the resulting inflation looks like a water pistol.

Whilst downside risk is important there is also the possibility of upside risk where markets move to a higher level and never re-visit lower thresholds. These periods of growth have occurred during periods of significant technological advancement, which many feel we are currently experiencing. If this is occurring it would also be likely to extend the current rise in equity prices.

In summary, fixed interest markets remain overvalued in our view and the risks in these markets are not being measured accurately by many investors. Equities have enjoyed strong returns which could continue in the short, medium and even longer term and are presently supported by synchronised global economic growth, high corporate confidence and central banks’ reluctance to raise interest rates aggressively. The key potential risks for equities are low wage inflation and high interest rates if central banks do target inflation effectively, which would reduce both bonds and equity markets and these risks are being closely monitored.

Strategy

There is no change to the strategy at this time and the portfolios remain overweight to equities whilst bond exposure is generally focussed within shorter dated bonds, which are less vulnerable to capital losses if interest rates increase.

If we believe the risks to equities increase in the future we will consider profit taking, but at this time we believe that the upside potential is attractive, especially given the low returns available from cash.

The equity funds held are generally value rather than growth in style. There have been strong returns from some growth strategies, however the underlying business models often require on-going cash investment. Therefore growth valuations are vulnerable to the tighter conditions, we expect within fixed interest markets going forward.

This article is not intended to, and does not, provide investment advice. You should always seek professional advice.

For more information on the James & George Collie Model portfolios or how you could invest in them please feel free to contact Scott Middleton on 01224 581581 or via email at This email address is being protected from spambots. You need JavaScript enabled to view it.

Finally – A Happy New Year from all at James & George Collie Financial Management!!