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Adding Tactical strategy to Structural asset allocation

Wednesday, 25th January 2023 11:23 - by David Harbage

These commentaries typically focus on longer term views and an investment stance appropriate for the retirement savings of private individual investors – which could be termed structural asset allocation. This update seeks to explore the perspective of individuals who study shorter term horizons – often termed tactical strategies - be they active professional traders or fearful personal investors, who respectively welcome or fear market volatility.

Since our last blog was published in mid-October 2022, the FTSE 100 has risen from 6,704 to reach 7,877 last week, close to touching this index (of the UK’s largest one hundred listed businesses) all-time closing high on 22 May 2018. Earlier on that day nearly five years ago, lovers of statistics would be keen to tell us, the FTSE 100 peaked intra-day at 7,903.5.

While not deviating from previously proclaimed principles of investment wisdom surrounding “the market’s never wrong” through to the merit of “it’s time in the market, rather than timing the market” which matters, all investors will appreciate that returns will depend upon the price paid for an investment compared to the price at the point of exit. The longer that a sound, well diversified investment is held, the greater likelihood that any shorter term mispricing – caused by war, pestilence, other seemingly calamitous event or simply rumour - will adversely impact performance. Having said that, stock market investments – and company share prices in particular – will also move away from what might be deemed their fair value for reasons which have no connection with fundamental factors.

Fair value might be calculated by a mathematical assessment of the present day worth of future earnings, dividend income or (applying a discount – based on anticipated interest rates) – or book value for low yielding assets. Reasons for such short term aberrations could include investor emotion (fear or greed) depressing or artificially elevating share prices – often occurring in response to the closure of a particular expectation, or announcement from the media or other significant influencer. Within individual company stocks, trading updates, the arrival or rumour of a corporate event could increase trading activity, volatility or move the price (for instance where an institution is stake building or exiting a significant position) far from a consensually perceived fair or reasonable value.

The prudent DIY private investor should have established good reasons to justify his or her long term (often called strategic) asset allocation – which might feature written notes on the ‘pros and cons’ for each type of investment (if not the prospective risks and rewards of each individual security). Part of that rationale might include an informal target valuation supported by its merits relative to peers or other kinds of asset, interest rates, inflation or appropriate comparators. When carrying out a review of one’s portfolio, a written supportive case can be a useful reminder of why each selection was made and, more importantly, the proportion committed to the investment and that particular asset class. Reference to such a template can overcome the temptation to overtrade, perhaps on the fear of ‘missing out’, seeing depreciation in capital or simply upon a whim especially in volatile market conditions

Active traders or institutional fund managers are likely to monitor short term (which might be intra-day, volume sensitive and momentum-driven) price movements with a view to make a capital gain or finesse their exposures. By contrast the typical ‘buy and hold’ personal investor will probably have a greater focus on fundamental factors – while also being aware of daily changes in valuations, with many retail investment platforms now alerting investors to significant moves in prices, receipt of income and providing immediate access to their portfolio’s worth. Upon receipt of the latter, an investor can refer across to their own assessment of what represents current fair value and decide if any adjustment to their investments is appropriate. The following considerations might help in determining if tactical shorter term action – perhaps deviating, if only temporarily, from long term structural asset allocation - is merited:

1. Price of a share or pooled investment has risen or fallen significantly (say by 10% or more) away from the anticipated fair value. Consider if there are sound reasons to explain or justify the move, by reference to short term (say within recent days for an individual security, or weeks for a collective diversified vehicle) developments. Besides trading updates or results, perhaps a corporate action – such as a cash-raising rights issue to support the balance sheet or, more likely, to facilitate the acquisition of another business – has been the catalyst. Brokers’ analysts and fund managers’ opinion on the investment may have changed, a major shareholder or insider (director with intimate knowledge) might be disposing of a significant position, or a new stake is being built by a well-regarded financial institution or a predator.

2. Consider if a particular whole asset class has moved beyond what might be deemed reasonable value by reference to its comparators, developments in the current economic cycle or exceptional risks (such as geo-political tensions, demographic, environmental, disease or other factor) which could impact that investment. For example has the price or valuation of medium dated (say 5 to 15 year old) fixed interest bonds fallen or risen beyond a level justified by recent influencing factors – which would include forecasts of the relevant central bank’s minimum lending or base rate, the 1-2 year anticipated pace and level of such an interest rate, the premium demanded for the credit risk attached to the issuer and the magnitude, direction and speed of inflation trends. In terms of equity (company share) or real estate (property) investment, they will also be assessed by reference to comparable, alternative assets (as all are competing for investors’ available capital) and their valuation will be subject to a plethora of risks and potential outcomes.

3. Beyond reading widely to include fringe, non-consensual views on macro and local economic developments as well as to gain an understanding of how other factors could impact, the individual who is seeking to manage their long term monies - unaided by professional advice or management - will no doubt carry that independence into possessing their own views and forecasts on the outlook for the world and the investment opportunity. Many will naturally “think outside of the box” or consider ‘black swan’ (a term used by financial commentators to describe unexpected, unknowable, major impact) events. For example, few anticipated the Covid coronavirus or the subsequent effects and developments of the pandemic.

The writer would reiterate a belief in real assets (those capable of matching, if not exceeding, inflation – such as property and businesses) when allocating monies for retirement and the longer term, but suggest that many of the world’s major equity markets appear fully priced in the short term and, being “up with events”, may mark time in coming months. In the UK, the FTSE 100’s 15% advance over the past few months has coincided with growing concerns about public debt, the absence of growth, high inflation & interest rates and industrial unrest. Beyond the domestic ‘cost of living’ related issues, which should ease in the second half of 2023, the absence of global harmony (via conflict or lack of economic co-operation) remains a notable ‘headwind’ to further immediate progress in the stock market’s worth.

Taking some profits on more highly valued, ‘little room for disappointment’ company investment (such as US technology stocks) and favouring assets with greater downside protection – be it via companies with defensive business activities and tangible assets or in trusts priced at significant discounts to their underlying investments’ worth – would seem to represent a sensible tactical strategy. As comparatives on inflation and recessionary economic expectations (aided by a slowing pace in rate hikes) ease, a return to a more ‘risk on’ approach to structural asset allocation and investment selection might be expected as the prospects for 2024 become clearer.

Currently financial markets are focused on the pace and magnitude of inflation, together with the extent to which central banks will raise interest rates to quell higher prices. In no small part, such inflation has arisen following central banks’ largesse in increasing money supply (via quantitative easing) even as Covid-driven supply shortages emerged and consumers continued to spend. Debt in the public sector has risen dramatically: in the case of the United Kingdom, to reach levels – by comparison with the overall economy’s output, as measured by gross domestic product (GDP) – last seen at the end of World War II. Prompted by HMG’s subsidy of energy bills, today’s announcement of UK public debt of reaching 99.5% of GDP is a very real concern. Inflation is only easing slowly but the impact of Russia’s military incursion into Ukraine in February (which disrupted the energy supply to Europe, exacerbating oil and gas prices) will drop out of calculations in this quarter. In addition, strength in the US dollar - which typically enjoys defensive appeal in times of geo-political uncertainty, and meant that the rest of the world suffered additional cost price pressures via imported inflation – has reversed in recent months.

Economists and market strategists anticipate a slowdown in global and domestic economic activity this year, expecting the peak in interest rates to have occurred by the summer. Against such a backdrop, history suggests that both fixed income, property and equity (business or company share) investments can appreciate – subject to any recession being relatively shallow and short-lived. A recently published consensus of London based financial forecasters indicate US rates peaking at 5% in 2023 (with the risk to that number being on the downside), arriving as soon as the first quarter, enabling a benign economic outcome with global economic growth of 2% in the following year.

Beyond the hard economic numbers, the biggest catalyst to seeing a revival in ‘animal spirits ‘amongst investors would be an end to the conflict in the Ukraine - ideally accompanied by an easing in China-Taiwan political tensions. Such geo-political developments are of course difficult to call, especially given the emotive considerations of Russia’s actions over the past year. It is to be hoped that economic factors and consumer pressures (from both within Russia and Europe) are likely to contribute towards a negotiated peaceful settlement – aided by the Kremlin’s recent iteration that it is not seeking regime change in the Ukraine. One can also hope that pressure from China (which seems to have made a ‘U’ turn, after suffering an economic slowdown last year, on its ‘zero Covid’ lockdown policy) can facilitate a positive outcome in the Ukraine. However, politics being politics will often surprise, can be illogical and counter-intuitive – as we saw in Westminster last year - so let’s pray that the next surprise is a positive one.

In the past three months or so, investors’ ‘risk-off’ perspective seems to have abated, even as the day to day news flow remained depressing – to confirm a stock market truism that pricing of longer term financial assets is driven by an expectation of the horizon, rather than today’s, events. Although local and European inflation has reached double-digit proportions, financial markets have been encouraged by the annual inflation rate in America falling for the fifth month in succession (to 6.45% in December) encouraging an expectation that the Federal Reserve Bank could adopt a less aggressive tack in its rate tightening policy. Recent forward-looking survey evidence from purchasing managers, which already indicated a downward path for economic activity in Europe and the UK, suggest that America is flirting with the PM index’ breakeven 50 level (indicating economic contraction, rather than expansion). Such a prognosis could persuade the Fed towards 25 basis point hikes, rather than the heavy 75bps seen last year.

In our previous blog we suggested that sufficient monetary tightening – to achieve the desired goal of restraining inflation – had already occurred. This perspective is borne out by the current inversion in bond yields (essentially implying that recession – or an absence of economic growth – is imminent) and this is evident when short term interest rates are, unusually, higher than longer term interest rates). At the time of writing this, the two year US Treasury bond yields 4.2% while the equivalent credit ten year bond yields 3.5% - whereas a year ago the 0.7% spread favoured the ten year maturity. Encouragingly as mentioned earlier, investors have begun to recover their nerve from the geo-political shock of 24 February and the worldwide economic slowdown (exacerbated by the previous two years’ lockdown-induced disruption to supply chains). Whether they will continue to look further out to 2024/25, pricing into bonds and equities a more normal - in both economic performance and geo-politically stable – 2024 or focus on the immediate adverse newsflow, remains to be seen. Therein lies the investor’s quandary of whether to overlay ‘risk on’ structural asset allocation with a tactical overlay of greater caution in the short term.

- Political and Financial Market drama continues apace

Company share valuations, both of businesses listed on recognised stock markets and in the private arena, already discount a lot of bad economic news based on the markdowns seen earlier in 2022. This can be illustrated by an assessment of share prices to book (or tangible) asset worth; global equity has retreated from 2021’s level of being two times the long term average, back down to the longer term trend level. In the UK, valuations remain considerably cheaper than the global mean (prompted by stagnant productivity, sluggish earnings, sub-optimal asset growth and concerns surrounding Brexit). This has prompted disinvestment by global investors in particular, but also a high level of corporate action (featuring take-overs from global predators encouraged by cheap sterling prices) amongst London-listed businesses.

The spike in domestic inflation and political upheaval prompted longer dated government bonds to almost halve last year (reaching a nadir on 10 October). Risk assets, like company stocks and real estate, are valued by reference to the benchmark of government bonds’ risk-free return and, when that yield rises, so the price of equity and property is marked down. However the attraction of owning real (life or world) investments is that rising company profits or rental income, (if only increasing by the rate of inflation), are passed on to their owners in the form of dividend income, and means that such productive assets can appreciate in capital value. Exceptional circumstances can break that virtuous cycle – such as when government pressure during the Covid pandemic forced many companies to suspend dividend payments, in lieu of receiving employment subsidies – but this represents a blip on the longer term positive trend.

The FTSE 100 index is expected to produce record-beating levels of cash returns in 2022 of £133.4bn - made up of £81.5bn in normal dividends, £1.6bn in special one-off dividends and £50.3bn in share buy-backs. In calendar year 2021, the hundred largest UK stock exchange listed companies generated £78.5bn of regular dividends – a marked rise from coronavirus-inhibited 2020 – albeit at a time when boardroom generosity was not restrained by fears of a Russian-induced political instability, an energy shortage or a ‘cost of living’ crisis caused by higher inflation and interest rate hikes. While the FTSE 100’s income yield – as calculated by dividend pay-outs – is currently 3.6%, the index’s constituents generate considerably more cash than that: its profit or earnings yield is 7.1%, providing considerable ‘headroom’ on future dividend payments. Company updates of current trading and their prognosis for 2023 remains surprisingly positive and, for the most part, City analysts have not had to reduce forecasts for 2024’s earnings and dividend pay-outs.

It seems that the measures announced within Chancellor Jeremy Hunt’s Autumn Statement produced the much-needed stability to public finances that the financial markets (notably in pricing sterling and government bonds) crave. It is vital that the volatility and level of medium and longer term interest rates – upon which public and corporate debt (investment projects) as well as consumer debt (notably mortgages) are based – remains steady, if not ideally reduce from last year’s inflated levels. Not just for the benefit of the economy, but also to provide confidence in the valuation of financial assets (as illustrated in the media’s highlighting of final salary pension schemes’ dependence on liability driven investments, post Kwasi Kwarteng’s fiscal statement on 23 September 2022).

While the economic picture - featuring increasing calls for higher wages, within a tight labour market - is concerning, the ongoing central bank action (+0.5% rate hikes by each of the Bank of England, the European Central Bank and US Federal Reserve’s rates in mid-December) to address inflation – provides confidence that a more stable scenario (of lower rates & prices increases) can emerge in 2024. Incidentally, each of these central banks meet, to discuss interest rates, next week on 31 January. Domestic interest rates have been increased nine times over the past year, to reach a 14 year high of 3.5%. Most economists now expect the peak in this tightening cycle will be seen this summer, when base rate is forecast to reach 4.25%.

Taking the appropriate long term (for the foreseeable future, typically thinking in terms of five to ten years) view, but wishing to apply some caution from a tactical perspective what would represent a sensible current strategy? Three particular areas stand out as offering particular attractions: commercial property, smaller company shares and private equity where investment trust share prices have fallen to reach levels of between 10% and 45% below their underlying asset worth. As these REITs and flexible assets typically feature an element of debt, their appeal suffered as a consequence of last October’s spike in bond yields (which followed the ‘mini budget)’.

While being more cautious and selective on larger companies, this writer retains confidence in smaller companies – in part based on fund managers’ belief that this segment of the stock market can resume its historic track record of outperformance. In particular, they expect the experience of stagflation - high inflation and recessionary economic conditions, last experienced forty years ago – to be beneficial, as listed companies acquire failed complimentary or peer businesses at ‘bargain basement’ prices from the liquidator.

Many of the issues discussed in October’s blog continue to dominate any discussion of future prospects. In particular, the sad events in the Ukraine, which represent a return to a ‘Cold War’ relationship between autocratic and democratic regimes. The Covid pandemic, being followed so rapidly by Russia’s incursion into Ukraine, dislocated customer relationships and supply chains which has produced higher prices than most economists could have dreamt of (and not in a good way) at the beginning of 2022. A tight labour market in many developed countries raises the prospect of higher wages making inflation more embedded, leading to higher interest rates and weaker GDP for longer with the prospect of recession across many parts of the world in 2023.

Interestingly, one can look back forty years to an era of rather similar events and wonder if financial markets’ history repeats itself. Back in 1982, the oil price rose rapidly - in part prompted by the Iraq-Iran war – inflation reached double-digit levels and, to counter this, central banks aggressively put up interest rates. The US stockmarket fell by 26% in the first eight months of that year, before bouncing back as economic conditions ameliorated, to recover the lost ground. While current investor sentiment has improved, and is adjusting to the economic realities, geo-political insecurity means that the next ‘leg’ in the market’s recovery may be a little further away.

It is to be hoped that rate setters within the central banks will be mindful of the exceptional events which caused the current ‘cost of living’ crisis, are aware of current fragility in both business and consumer confidence, and appreciate the real danger of creating a more cyclical ‘boom & bust’ economy. A growing appreciation that inflation has already peaked, and activity is naturally slowing should encourage decion makers to adopt a less aggressive hawkish strategy in 2023. In addition, given governments’ recent bias towards issuing government stock with coupons and redemption values linked to inflation, the Bank of England and those in the ECB and the Fed will be mindful of the longer term impact on the public purse’s ability to service such debt.

Against a backdrop of cash rates and investment grade bond yields lagging returns offered by real, but higher risk-reward, price-volatile assets, we retain confidence in successful company businesses and diversified real estate investments for the appropriate longer term. While we expect difficult economic and uneasy geo-political conditions to prevail this year, we believe prospects for 2024 appear brighter and, in anticipation of forward-looking investor sentiment adopting a more ‘risk-on’ approach, this encourages a belief that the worst has been seen and real assets can appreciate further over the medium term. A resolution in the Ukraine, linked to a conviction that Russia’s expansionary ambitions have been quelled, would be the catalyst to adopting a more positive stance towards real assets.

- "I'm taking early retirement - how should I invest £100,000?"

- Batten down the hatches!

Finally, in response to requests, the author provides an update following the suggested asset mix and investment selections proffered in this blog’s previous “I’m taking early retirement – how should I invest £100,000?” article, (which were followed by updates “Batten down the hatches” and “Political & Financial Market drama continues”). The author would maintain the maximum allowed in Premium Savings bonds of £50,000 as a cash reserve. Beyond that, the following investment trusts offer long term appeal but, please note, these are not personal recommendations - readers must carry out their own research:

UK listed company shares – favouring medium sized listed companies via Mercantile and Schroder UK Mid Cap (SCP) (both of which are priced on a 13% discount to their respective underlying asset valuation and offer an income yield of 3.3% as at 24 January) as well as the multicap Henderson Opportunities (HOT) (on a 12% discount to its NAV, with a 2.6% income yield, as at 24 January) that invests across all UK company sizes.

Overseas listed company shares – complimenting the UK selections with a bias towards Value or Growth at Reasonable Price investing, via AVI Global (AGT), Global Opportunities (GOT) and Pershing Square Holdings (PSH) (currently priced on discounts of 8%, 10% and 31% respectively to their asset value as at 24 January).

Private company shares – via fund of funds vehicles Harbourvest Global Private Equity (HVPE) and Pantheon International (PIN) (both of which are priced on a 44% discount to their underlying asset valuations as at 31 December, but offer no income pay-out) as well as direct investor Oakley Capital (currently priced on a 32% discount to its NAV, with a 1% income yield, as at 30 September).

Real estate – via diversified UK commercial trusts Aberdeen Property Income (API), Schroder Real Estate (SREI) and UK Commercial Property (UKCM) (currently producing income yields of 6%, 6% and 5.6% respectively, and priced on discounts of 36%, 34% and 41% respectively to their 30 September 2022 valuations), along with industrial warehouse specialist Tritax Big Box (BBOX) (currently yielding 4.5% income and priced on a 38% discount to its 30 June 2022 valuation).

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.

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