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Tuesday, 1st September 2020 07:07 - by David Harbage
The above saying, often cited by economists and money managers, has particular credence following the statement made by the governor of the Federal Reserve Bank (the ‘Fed’) yesterday. Financial markets pay particular attention to any advice from the central bank of the United States of America because it can have a profound influence on economic activity and developments across the globe. History suggests that businesses that choose to ignore what the Fed is saying, or investors who take a contrary path, are unlikely to succeed.
Last night’s announcement that the Fed would keep interest rates low to support the Covid-19 weakened US economy and, critically, would allow inflation to rise above the 2% level is important. Essentially, after seeing the rate of inflation below its target level for a number of years, the central bank will countenance higher prices (without intervening with hikes in the cost of money) for the foreseeable future. Even as the authorities continue to prop up the ailing economy (US unemployment is currently 10%), the seeming disconnect between the performance of the real economy and the valuation of the US equity market – to the disbelief of many observers – is growing.
How should individuals and investors respond to the prospect of near 0% returns on Cash for the next few years? As regards longer term savings for the former, the writer would refer the reader to previous blogs covering the merits and shortcomings of the prime different asset classes – including cash, fixed income or inflation-linked bonds, commercial or residential property, stock exchange listed company shares, private equity, commodities and other alternatives – and the factors that can influence their worth.
Investors in equity (company stock or shares in a business) will take encouragement that the attraction of the most obvious competing investments - cash and bonds (which can be viewed as longer term interest rates) – will diminish. In addition, those who choose to put their long term savings into non-income paying assets – such as gold, silver, other precious metals, rare minerals or other esoteric investments like art or vintage motor vehicles – will not have to suffer a cost of investment (in the form of foregoing an income).
Beyond the appeal of equity based on the immediate income return of alternatives, the debate surrounding the relative merit of Value (company stocks typically offering reasonably priced profits and income) and Growth (which often featuring non-dividend payers) investors in stock market listed businesses will be reignited. There has been further dispersion of returns (dominated by capital performance, as many companies have cancelled dividends to bolster their balance sheets) over the past few months – most obviously seen by comparing geographic markets, but also to reflect a post-Covid world. While the UK equity market has recovered by 20% from its March 2020 low, US equity indices (led by NASDAQ’s technology dominated, low or no-dividend paying growth businesses) have advanced by more than 50% to reach new all-time highs.
Taken together, America’s five largest businesses – featuring Apple, Microsoft, Amazon, Alphabet (Google) and Facebook - account for a quarter of the US equity market’s capitalisation, notwithstanding a distinct lack of proportionate earnings or dividends, and each would seem to be a beneficiary of this year’s acceleration in the internet-facilitated world. Traditional means of assessing the equity worth of big businesses would include scepticism about the ideal size of long term success – by reference to when barriers to competitor entry are breached, by natural trading competitors or externally enforced by government or regulators – and the prospect of returns on capital reverting to a sustainable mean. However, the arithmetic surrounding valuation (notably anticipating declining returns via discounted cash flows or other means) is being challenged by the new technology-driven paradigm and prospect of low yields for longer.
This is evident from the Bank of America survey of fund managers, published this week, which has shown increased enthusiasm for share ownership over the past month (46% of managers believe that we are in a bull market compared to 40% in July), with US technology favoured by 59% of the 181 respondents), allied to a marked reduction (from 50% to 34%) in those who expect the equity market to suffer an imminent setback or to falter in the short term. This fits with a fall from 4.9% to 4.6% in the Cash positions held within fund managers’ portfolios (primarily for opportunistic purchases rather than for the asset’s own merit, one presumes).
Increasing appetite for passive investment represents a significant driving force in embedding trends, evidenced by the expansion of technology growth at the expense of traditional cyclical segments (such as the banking sector) of an economy. Illustrating the changing values being placed on ‘old world’ assets, Exxon Mobil is due to be ejected from the Dow Jones Industrial Average index at the end of this month. However, this latest BoA survey suggested that a meaningful number of active fund managers were expecting some rotation from technology into more attractively valued equity, including smaller companies, in the near future.
Uncertainty surrounding the pandemic and its economic impact is likely to continue to dominate investor sentiment over the remainder of this year and into 2021. As ever, the stock market is looking beyond today’s news and anticipating a future which is likely to look rather different – as Covid-19 changes consumers’ behaviour (in shopping and office working, to name just two aspects) and investors’ perspective (evident in portfolio and intra-asset positioning) from that which would have been envisaged at the beginning of the year.
Reflecting the fact that financial assets, including the make-up and valuation of equity indices, anticipate their future relative appeal – fund managers have a difficult task as they ‘aim at a moving target’ when they endeavour to outperform an index benchmark. Holders of an index-tracking exchange traded fund (an ETF), such as the i share FTSE100 ETF, will necessarily own the fast-changing constituents and do not have to be concerned about the risk of underperforming the index. Many private investors would struggle to keep pace with the changing persona, as well as the constituent firms, represented by the hundred largest UK listed businesses. For example, over the past month the FTSE100’s top performer (+23%) was Aveva Group, a global leader in engineering and industrial software, and worst (-11%) was the international alcoholic beverage group Diageo. The shares of another high tech and rather better known, grocery distributor Ocado Group came second (+22%) in the positive stakes, while ITV appears set to be relegated from the blue-chip index next month – along with Centrica and perhaps easyJet. Replacements may include the cyber security firm Avast and the medical device business Convatec – both of which might be relatively unknown to many readers.
Looking at actively managed funds which reflect the market’s increased appetite for business segments which appear well positioned to succeed in the next decade, the author’s 1 June blog highlighted Edinburgh Worldwide and Smithson investment trusts for their global technology-biased portfolios - of medium and larger sized companies, respectively. By contrast offering an attractive, double-digit discount to the underlying worth of its portfolio of technology businesses, (with a clear bias to less demandingly valued UK listed firms), is Herald investment trust mentioned in the 18 June article.
While this commentary focuses on the positive market sentiment towards highly valued, technology-biased growth businesses – which could continue, if the particular market mantra in this article’s title holds true – the author would encourage readers to be vigilant to the very real risk that a deterioration in the news flow (be it in regard to the pandemic, political (3 November election in the US, or trade related US-China or Brexit) could see significant risk aversion – prompting profit taking and a ‘re-run’ of the bursting of the TMT asset bubble which was seen at the turn of the millennium. Wise investors will regularly challenge their own future expectations of circumstances and needs, be unafraid to change their opinions on the announcement of new developments affecting anticipated outcomes, and invariably seek greater diversification to comfort any disappointment.
While an optimist by nature, and not a worrier by temperament, your writer continues to anticipate that equity markets are more likely than not to experience a further setback over the next six months. Everyone must carry out their own due diligence in terms of assessing what is most appropriate for their particular circumstances and comfort levels – certainly no personal recommendations are made in this blog – but owning conservatively managed, attractively valued (by reference to balance sheet strength as much as earnings potential) equity continues to have appeal to this long term investor. An anticipation of major global financial dislocation prompts the ownership of gold, and gold miners, as a safe haven asset (US dollar weakness, on low interest rates, allied to a pick-up in inflation is supportive for the precious metal, incidentally) or as quasi-cash - pending an expectation that the investment horizon will become clearer as we turn into 2021. Perhaps adding a little more equity – and exposure to growth, via the internet-facilitated technology sector – may seem more appealing at that time.
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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