How do you expect markets to perform.

Friday, 14th September 2018 08:39 - by David Harbage

Following on from the past two articles “How much of my wealth should I put in shares?” and “What should I choose to own?” the author has been pressed to answer the above question, with particular focus on the assets mentioned in the last script.

As always, no personal recommendations are made in these blogs and the reader should consult a qualified professional adviser if seeking advice specific to his or her circumstances and needs.

My current (near consensual) view is that interest rates will rise very gently over the next year on a global basis and inflation will usually exceed local rates, delivering negative real (inflation beating) returns to holders of cash. For instance in the UK cash rates of say 0.75% lags inflation closer to 2.5%. In such an environment, to hold large sums of one’s liquid, long term savings in Cash is unappealing and conventional government stocks are similarly struggling to deliver real total (income, as adjusted by capital movement) returns, especially after deduction of income tax. By contrast inflation-linked bonds provide some relief, offering the prospect of appreciation in capital (and income coupons) to match liabilities that are inevitably increasing for most of us. Interest rates in the US are expected to gradually rise over the next year (the key Federal Funds rate is set to increase from 1.9% to 3%) but slower, below-trend economic growth in the UK and the Eurozone will mean that we will not see the same magnitude of hikes (predicting that UK Bank or Base rate rises from 0.75% to 1.0%, Eurozone from 0.0% to 0.25%).

With limited appetite for bonds or cash (which is typically held in private client portfolios in order to be available to meet investment opportunities, as they arise), real asset ‘bricks & mortar’ in the form of commercial property has appeal. Driven by supply-demand, the domestic market has limited space, especially in the South East of England, and therefore well-located assets are likely to appreciate over the longer term. Offering a rising rental stream and the prospect of exceptional capital appreciation as a result of landlord or management improvement (for example: change of use), property merits a position in portfolios. Some readers, owning one or more residential properties and perhaps their own business premises may be loath to commit more of their savings/retirement wealth to commercial property, but it is important for a portfolio to own differing kinds of asset to achieve diversification and reduce its risk profile (in particular not own too much equity).

Company stock and share investment appears attractive compared to the alternatives: ten year yields currently available on conventional government stocks are US 2.9%, Eurozone 0.4 %, UK 1.4%, Japan 0.1%. For your interest, these rates can be expected to rise over the next year to reach 3.4%, 1.1%, 1.8% and 0.2% respectively. The capital worth of corporate bonds are likely to suffer alongside ‘govies’ or ‘gilts’ as rates rise, but should benefit from on-going company or credit health – as the prospect of defaults recede against the backdrop of a reasonably healthy global economy. Accordingly, taking a significant position in corporate issued debt or bonds, alongside its inflation-linked (backed by government) exposure, has merit.

Back to the equity exposure, most stockbroker managed portfolios are overweight – relative to their neutral positions (which in itself will depend on whether a client’s risk-profiled objective is cautious/conservative, balanced or growth-oriented). However, in terms of equity asset allocation, most discretionary portfolios will possess a clear bias to the domestic market - in part based on the probable presumption that the majority of investors will be UK, £ based and most of their liabilities will arise in sterling. Beyond that, the UK equity market appears undervalued compared to other bourses (the US in particular), acknowledging that the greater part of the FTSE100 index constituent worth is made up of international – rather than local - businesses. While economic health is clearly stronger beyond the UK’s shores, the valuation of each major country or continent’s stock market is equally critical in making selections. Besides GDP growth projections, a twelve month view on the relative strength or weakness of currency – as compared to the £ base – should also be considered. As regards the latter, most fund managers expect sterling to remain stable at its current depressed level and barely move from its current US$1.30 and Euro1.1 over the next year but, if pushed, the writer envisages some ‘hardening’ in the pound to reach 1.35 and 1.15 respectively by the end of 2019.

The current macro-economic landscape features a lot of political headwind – notably uncertainty surrounding trade wars (US-China, US-Europe) and, closer to home, Brexit. Despite the ‘noise’, overseas equity markets have made reasonable progress with strong earnings driving the US equity market to new highs. By contrast with heady Wall Street (in valuation terms, by reference to the dominant high technology but low profitability ‘Fangs’ companies), the author likes the UK market, currently believing it to be undervalued -  especially its non-FTSE100 and domestic businesses, who have been neglected as Brexit fears drive traders and momentum-chasers to switch into non-£ earners. The dispersion in rating (think in price-to-earnings multiple terms) between UK-listed multinational and UK-focused domestic stock has probably never been greater in our memory – reflecting the protracted uncertainty surrounding the UK’s probable future outside of the EU trading bloc.

Looking out a year or so, one can expect to see Brexit-tensions ease and the outlook for the UK economy (which, in any event, is probably stronger than many appreciate, as the High Street’s woes are not indicative of the wider picture) - become clearer. We anticipate the FTSE100 index beginning with an ‘8’ in a year’s time (say 8,200, from current 7,280), the S&P 500 index to begin with a ‘3’ (circa 3,100, up from current 2,870), MSCI Europe to flirt with the ‘2’ level (at 1,950, up from 1,550) and MSCI Emerging Markets to achieve a double-digit rise to 1,250 (from 1,020). Slowing economic growth (albeit from a strong pace) and high levels of debt in the US and especially China may prompt demand for gold (to reach US$1,400 per ounce, up from $1,200), while increasing spend on infrastructure could lead to higher industrial metal commodity (copper $7,800 per ton, up from $5,900) prices. With overnight and longer term cash rates remaining subdued, UK and European equity can progress further driven by higher distributions to shareholders (dividends and earnings-enhancing buybacks), while the US de-rates as tax-driven profit growth impresses. 

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.