A view on Financial Markets: It's 'steady as she goes' on turbulent seas

Monday, 11th March 2024 16:16 - by David Harbage

This report can be summarised by saying that economic activity in most of the world’s developed economies is sluggish suggesting that inflationary forces are abating and that central banks will be cutting interest rates in the second half of the year. Stock markets are comfortable with shallow temporal recessions or low digit economic growth (as is occurring in Europe at present) and are unwilling to ‘price in’ the geo-political unknowns (notably prognosis of conflict in Ukraine and the Middle East).

The prospect of political change – as more than half of the world’s population will vote in 80 countries this year – is something that institutional investors currently have not flagged as being likely to deliver major change in economic management, and therefore is not a significant risk to financial asset valuations. The latter is particularly true of Europe (where anti-Europe integration or populist parties are expected to make gains in June’s Parliamentary election) and the United Kingdom; by contrast a probable US re-run of Biden versus Trump in November could produce more noise than substantial change.

Current consensus forecasts for global GDP growth shows little change over the period under review: 2.9% for the year just ended, easing to 2.7% in 2024 but rising to 3% in 2025. Asia remains the prime driver of economic growth in the immediate future and, based on individual countries within the G20, India (+6.1% this calendar year and +6.5% in 2025), Indonesia (+5.2% in both 2024 & 2025) and China (+4.7% this year and +4.2% next) lead the way. By contrast, a combination of OECD and IMF forecasts for real (that is after inflation) GDP growth in the G7 countries shows a respectable (in line with long term trend) 2.1% for the United States and a more pedestrian, but positive picture elsewhere: Canada +1.1%, Japan +1%, France +0.8%, UK +0.7%, Italy +0.6% and Germany +0.4%.

After experiencing a strong rally in the last six weeks of 2024, bond, equity and property prices have marked time awaiting further evidence of slowing inflation and interest rate cuts. The month of May looks critical in terms of seeing a sharp drop in domestic inflation (as April 2023’s energy price hike drops out of the comparative equation) and, in the absence of any adverse surprise, the Bank of England could be joined by the Federal Reserve and the ECB in announcing rate cuts of 25-50 basis points in the third quarter of 2024. As one should expect, real assets are already beginning to anticipate this easing with the US and Japanese equity markets reaching new heights in March.

In previous blogs, we have explained why we favour close-ended investments (better known and described as investment trusts) – most recently mentioning the financial gearing which enables those companies to assume debt in order to acquire more assets. This is typically effected for one of two reasons: when fund managers deem that the assets in which they invest are inexpensive (prompting them to increase their positions by purchasing ore assets) and also when the trust’s share price is significantly lower than the underlying worth of their portfolio of assets (which may encourage the repurchase and cancellation of the trust’s shares, resulting in higher net asset value for the shares that remain.

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History has shown that buying investment trusts when their shares are priced at a significant discount to their underlying value (expressed as net asset worth, NAV) can produce strong absolute returns and outperform open-ended (a la unit trust) collective investments. The trade body for close-ended trusts, the Association of Investment Companies (AIC) has produced analysis of past performance of its members showing how trusts listed on the London Stock Exchange – based on whether the share prices were priced at narrow or wider discounts to their NAV.

The AIC’s research recorded every five year period, beginning each month from June 2008 and ending January 2024. That represents a study of 128 five year periods. The first date is significant because the performance data does not shy aware from including a period when stock markets fell sharply (in response to the global banking-financial crisis); for local interest, the FTSE 100 index fell from 6,007 on 1 June 2008 to 3,512 on 3 March 2009. All trusts were included and an overall average discount (or discrepancy) between share price and underlying NAV was calculated.

Looking first at investment trusts when the average discount was narrow - defined as when share prices were within 5% of NAV or in excess of (or priced at a premium to) NAV – in the month when the five year performance metric began. There were 61 periods when trusts began with a narrow discount, as described, and the average total return (made up of income, as adjusted by capital appreciation or depreciation) over the five years was +56.1%, equating to +9.3% per annum.

Turning to trusts when the average discount was at a median level (considering the investment product’s longer term history) – whose magnitude was considered to be when share prices were within a range of between 5% and 10% of NAV – in the month when the five year performance metric began. There were 28 periods when investment trusts began at such a discount to underlying asset worth, and the average total return (income, adjusted by capital movement of share prices) over the five years was +70.3%, which equates to an average annualised return of +11.2% per annum.

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Finally, the AIC considered investment trusts when the average discount was significantly wider – defined as being when share prices’ discount to NAV was wider than 10% – in the month when the five year performance metric began. There were 39 periods when investment trusts began at such a discount to underlying asset worth, and the average total return (income, as adjusted by capital appreciation or depreciation) over the five years was +89.3%, which equates to an average annualised return of +13.6% per annum.

Taken that the current average discount of UK list close-ended companies is double-digit (between 12% and 17%, according to whether 3i Group (III) or venture capital trusts are included or not) - falling within the AIC report’s wide discount category - this confirms our intuitive belief that investment trusts today appear attractively valued. In particular the following trusts stand out as offering good value, taking the appropriate longer term view (which should extend to ten years, in this writer’s opinion, rather than five years), with share price discounts of at least 10% for the UK listed equity vehicles, 25% for PSH and the property trusts, with 40% for HVPE:

- UK Equity (bias towards larger businesses: Artemis Alpha (ATS), Baillie Gifford UK Growth (BGUK) and Lowland (LWI),

- UK Equity (bias towards smaller firms: Aberforth Smaller Companies (ASL),

- UK Equity (focus on medium sized companies: Mercantile (MRC) and Schroder UK Mid Cap (SCP),

- Overseas Equity: AVI Global (AGT) and Pershing Square Holdings (PSH),

- Alternative Assets: Greencoat UK Wind (UKW) and Harbourvest Global Private Equity (HVPE),

- Commercial property: Schroder Real Estate Income (SREI) and Tritax Eurobox (EBOX).

Finally, the author would reiterate the good governance message, beyond the obvious ones of minimising risk via asset diversification and seeking advice from appropriately qualified sources: that readers need to carry out their own research to ensure that they can be confident that they make selections which suit their own circumstances and financial objectives.

Looking forward into the second half of 2024 and beyond, the geo-political issues mentioned earlier could spook nervous investors. Certainly, the possibility of profit taking (amongst highly rated US technology stocks in particular) – as rising equity markets increase the prospect of investors being disappointed by any adverse surprise (from corporate trading results, political or other event) – is a growing short term risk. However, the merit of owning real assets offering the opportunity of generating a rising stream of income and, as a consequence, benefit from capital appreciation over the longer term – hopefully keeping pace with rising liabilities and producing superior returns to cash deposits - continues to appeal.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.