Today's view on the market opportunity

Wednesday, 3rd April 2019 09:58 - by David Harbage

The author has provided an update, on an every other month basis, on what has been occurring in financial markets. As we reach the turn of a new tax year – with its opportunity to use new ISA and pension allowances – it may be helpful to follow up the two previous articles dated 3 December 2018 and 6 February 2019 by sharing current thinking. In particular, on the prime issues or concerns that long term investors in stock exchange assets face, brief feedback on the performance of previously mentioned investments in 2019 to date and comment on the outlook.  

This blog will resist the temptation to write at length about the current state of political shenanigans at Westminster (little has really changed in respect of Brexit since writing, somewhat hopefully, that ‘The fog may be lifting’) two months ago. Essentially, the immediate outlook for the UK’s financial markets remains clouded by political and economic uncertainty, amid the potential for seriously negative news for business (in the form of a left wing Corbyn-led government emerging from the current hiatus in the domestic political landscape).

Owners of stock market listed companies should always be taking the longer term view – with a minimum retention period of five years or ten years, but perhaps more probably ‘an indefinite, foreseeable future’ should be considered as an appropriate time horizon. However, on an occasional basis (say once in a decade), a major local event will present itself worthy of investors’ special attention. The current domestic political situation, featuring Brexit and its consequences, is one such instance.

It is appreciated that our typical UK private client reader will be focused on this local landscape, rather than on international issues (such as the potential fall-out from current US-China ‘trade wars’) and prospects. However, the prudent investor should be taking a global perspective when looking at the relative attraction of the various investible assets – ranging from cash (sterling versus other currencies) to bonds (longer term interest rates or loans), through to equity (company shares, both UK based and overseas, stock exchange listed as well as well as private, unquoted) – in terms of potential returns over the next year or so.

The major international broking houses, the institutions that invest and the financial press usually take stock of the global and local economy at the beginning of each calendar year before re-assessing and making asset allocation calls and predictions. Economists, market strategists and research analysts within active fund management firms will have rigorous processes to maintain a close watch on any change in the macro-economic landscape and in ‘bottom-up’ news on specific areas of individual investment. They will be monitoring consensual thinking as well as documenting any contrarian views that they adopt.

The writer’s current thoughts, which may contain few surprises, would include reference to:

1. United States-instigated action to address its trade imbalance, with China in particular, is likely to prompt a slowdown in economic activity.

2. The rise in populist, parochial political power – reversing the trend for greater globalisation in trade - is also set to act as a drag on business and consumer confidence, as well as raise unhelpful tensions between nations and peoples.

3. Closer to home, any resolution on Brexit – to say nothing of making any meaningful judgements on its impact – seems distant.

4. Risk assets such as equity had sold-off in the last three months of 2018, beyond that which could be viewed as reasonable – essentially markets had crumbled as investors succumbed to fear.

5. Such a risk-averse environ was evident in seeing negative real interest rates – in overnight money, but also across government and highest credit rated corporate debt issues of any maturity in the world’s developed financial markets.

6. If global economic growth had peaked in 2018, the need to raise interest rates in calendar 2019 was abating which would reinforce the relative value of credit and equity.

7. Corporate profit growth, aided by lower rates of taxation, had been exceptional last year – but further progression is forecast in 2019, alongside higher dividend pay-outs and share buybacks.

8. When top-line revenue growth slows, financially strong companies will often seek to grow their businesses via acquisitions and trade purchases (typically of less highly valued assets).

9. A bounce-back (from such oversold levels) in investors’ appetite for risk is predicted for the year ahead, which included UK equity incidentally, as many of the current ‘clouds of uncertainty’ would be likely to have cleared by the second half of 2019.

10. An exceptional catalyst for corporate merger and acquisition activity arises when markets seemingly misprice assets – often at times of heightened volatility, uncertainty or emotion. For instance the de-rating of (a) sterling could make UK companies appear inexpensive to overseas predators, and (b) the dispersion of valuation or rating across thematic or industry sectors could prompt the opportunistic buyer. As regards the latter, the market’s perception of whether or not a firm is impacted by Brexit will have been a primary influence on its valuation over the past two years or so.

One can be reasonably confident that global economic growth will be robust this year (real GDP +3.1% – that is gross domestic product to rise 3.1%, after inflation, compared to 2018), but ease in 2020 and 2021 (GDP 2.9% and 2.8% respectively) as trade tariffs potentially impact to dampen confidence. Anticipating such an environ, interest rates will only rise very gently (by contrast with expectations three months ago) - if at all - on a global basis and, with inflation will typically exceeding local rates, deliver negative returns to holders of cash. For instance in the UK, cash rates of say 0.75% lags the rate of inflation which is closer to 2.5%.

The same scenario applies in the US, Japan and in the Euro area. In such an environment, to hold large sums of one’s liquid, long term savings in Cash is unappealing and conventional UK government stocks are similarly struggling to deliver real (inflation beating) returns, especially after deduction of income tax. The current gross of tax yield to redemption of a ten year conventional British Government stock is just 1.0%. By contrast, inflation-linked bonds provide some relief, as they offer the prospect of appreciation in capital - and via the income coupons - to match liabilities, that are inevitably increasing. Investors can expect interest rates in the US to barely rise over the next year (Federal Funds is likely to increase from 2.4% to 2.5% to March 2020) and slower, below-trend economic growth in the UK and the Eurozone will not prompt central banks to hike. UK Bank rate and Euro rates are unlikely to change from their current respective 0.75% and 0.0% but, as an outlier possibility, a rapid soft Brexit resolution could see our domestic base rate rise to 1.0% by March 2020.

In terms of future performance, after the first quarter’s significant rebound, one can expect to see equities make further but slower progress over the remainder of 2019 – with an approximate 5% appreciation in capital terms, enhanced by income distributions. This is based on the current macro factors (notably international trade disputes and Brexit uncertainty) continuing close to their current state. Any major positive breakthrough on the US-China talks could see markets achieve that 5% advance overnight, and then advance further. While a positive outcome on Brexit would benefit domestic businesses most, the FTSE100 index’s multinationals would be less affected (as foreign exchange benefits would come to a halt with a recovery in sterling). Negative new ‘news’ or protracted uncertainty on the political or trade front (for example the announcement of a general election) would not be well received by financial markets.

The writer is often asked about the merit or otherwise of property investment (via stock exchange, rather than buying another house or other real estate) and, against a backdrop of having limited appetite for bonds or cash, real asset ‘bricks & mortar’ in the form of commercial property has appeal. 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, property merits a position in long term portfolios. Some readers, owning one or more residential homes and their own business premises may be loath to commit more of their savings or retirement wealth to commercial property, but it is important for the portfolio to own differing kinds of asset to achieve diversification and reduce its risk profile (in particular, not own too much equity).

In terms of property assets, the author’s favoured area within the industry would be the big warehouses being used to fulfil the explosive growth in demand for online grocery and most other areas of retail. Tritax Big Box real estate investment trust is one such asset: owning 54 London-biased properties and development land worth £3.4billion, its asset value rose 4.7% in 2018 and its dividend distribution equates to an income yield of 4.6%. It is not surprising to learn that the global online retailer Amazon is the trust’s biggest tenant – accounting for 13.6% of this REIT’s rental income last year. Taking the appropriate longer term view, property rental income should rise, leading to dividend progression and an upward revaluation of the asset’s capital worth.

The desire to incorporate other alternative assets in a stock exchange based, long term savings plan or portfolio also prompts consideration of investments which feature flexible strategies in their choice of asset type. Caledonia investment trust is such an example, as it features unquoted private companies (where management can manage with less interference or influence – something that can be viewed both positively and negatively, in respect to time horizon and other factors) along with other types of asset. The trust is currently invested: Unquoted investments 34%, Funds 27%, Quoted securities 22%, Debt & Cash 17%; its assets are primarily located: UK 34%, North America 28%, Europe 20%, Asia 14% and the shares currently stand on an appealing near 20% discount to its net asset value. Caledonia aims to grow assets and dividends while avoiding permanent loss of capital (which, no doubt, fits with many of our readers’ objectives), as it seeks to beat both UK inflation and the total returns produced by the FTSE All Share index. The trust has managed to do this over the past ten years – achieving annualised returns of 10.8%, as compared to RPI’s 2.8% and the All Share’s 9.9% to 30 November 2018.

Another alternative investment worth investigating is Harbourvest Global Private Equity investment trust designated’ Flexible’ within the industry’s categorisation. A well-regarded financial institution based in Boston, Massachusetts, with more than 100 staff managing US$55 billion out of offices in nine countries, it has a strong track record of growth - notably in progressing net asset value. Somewhat surprisingly, the shares of this FTSE250 constituent stand at a near 20% discount to NAV – by contrast with the better known to UK investors, FTSE100 private equity group 3i, whose shares are priced at a premium to their asset worth. The trust aims to produce long term capital growth and its portfolio of unquoted businesses is well diversified – both by reference to the stage of these companies’ development (invariably firms are acquired in their infancy or when distressed, close to being broken and improved to the point of being sold or re-floated on the market), geography and industry.

As regular readers of this blog will know, the author is a fan of investment trusts – which have historically performed better than equivalent open-ended funds, in part due to their lower costs and greater flexibility (not forced to sell assets when investors flee the market). However these investment vehicles have to be closely monitored as their value (by reference to the share price) can move irrationally as compared to the net asset value (NAV) of the underlying portfolio of investments. As an example of this, one could take a view on two UK smaller company investments: Aberforth Smaller Companies and Standard Life Smaller Companies investment trusts and consider switching from one to the other. The former has rallied strongly over past three months or so, to the extent that its shares’ valuation now appears stretched as compared to its historical norm: a tight discount of 4% to net asset value emerged last month, as compared to the double-digit discount which had typically applied over the past decade. Aberforth shareholders had also received entitlement to a regular and special dividend. By contrast, the shares of another Edinburgh-based domestic smaller cap investing trust - Standard Life - appears relatively neglected as its discount to NAV (historically trading close to NAV) widened to 8%. Managed by Harry Nimmo since 2003, the City appreciates his peer-beating track record - achieved through following a particularly rigorous stock selection process (incidentally, its largest holdings currently feature Dechra Pharmaceuticals, Abcam and Fevertree Drinks) - and a cautious top-down investment approach.

It might be helpful to indicate how the author would currently view the prime kinds of asset a long term portfolio might possess (actual proportions would depend on individual circumstances and needs):

1. Underweight bonds - owning government, risk-free inflation linked domestic and international bonds (but having no exposure to conventional gilts) across all maturities, along with investment grade (BBB rated or higher) sterling-denominated company bonds and global higher yield corporate bonds. The latter in expectation of the continuation of higher economic growth in emerging economies, allied to the prospect of falling delinquency rates in developed markets. Achieved by the use of diversified ETFs in order to minimise default risk. Mindful that interest rates are low, as compared to history, and have limited scope to fall further - but that inflationary pressures are reasonably benign and are likely to be peaking.

2. Underweight property – owning commercial and residential property funds, featuring a mix of active management, an index tracking vehicle and a sub-sector specialism. Mindful that ‘brick & mortar’ enjoys a scarcity, supply-demand benefit in the UK, but that demographic and cultural change casts uncertainty over the ability of landlords to raise rents (notably in retail and away from London) in the short term.

3. Overweight UK equity - in acknowledgement that UK company shares are enjoying an unprecedented income yield advantage, relative to government bonds and cash. Brexit-recession fears have driven significant dispersion in industry valuations, with domestic sectors and smaller company segments appearing particularly inexpensive.

4. Underweight overseas equity - as UK listed multinationals frequently appear better value (based on earnings and asset backing). A rebound in an oversold sterling also persuades for this position.

5. Overweight Flexible assets – essentially investing in undervalued investment trusts (by reference to share price compared to net asset value) and entrusting these fund managers to select the appropriate alternative assets to deliver to their capital preservation perspective.

6. Underweight cash – given the low absolute return on offer compared to the other selected assets. Mindful that retaining a cushion can enable the investor to take advantage of buying opportunities for the portfolio as they present themselves. In extremis, the low yielding inflation linked government bonds also provide a further source of funds should an exceptional opportunity to add to another (probably equity) investment arise.  

Finally, we take a look at the shorter term capital performance of a typical portfolio’s constituents – based on collective and individual company investments mentioned in previous recent blogs - and proffer a few comments on the first quarter of the year’s returns:

1. i share UK Inflation-linked government bond ETF progressed from 18.1 to 18.8, as yields fell - notwithstanding Brexit-£ induced volatility.
2. i share Global Inflation-linked government bond ETF progressed from 119.7 to 121.9, as fears of further US rate hikes recede.
3. i share UK Corporate Bond ETF progressed from 93.9p to 96.4p, as fears of further domestic rate increases are replaced by expectations of a monetary stimulus should a No-deal Brexit emerge.
4. i share Global High Yield Corporate Bond ETF progressed from 71.6p to 72.5p, aided by encouraging company trading news and evidence of rate expectations easing in many regions (US) or basement levels continuing (such as in Europe and Japan)
5. Picton Property investment trust progressed from 84.7p to 90p, in recognition that its late 2018 valuation appeared oversold
6. i share UK Property ETF advanced from 529p to 590p, aided by reassuring trading updates (including its largest constituent, Segro) which frequently highlighted widening discounts to asset worth.
7. Tritax Big Box REIT progressed from 130p to 144p.
8. Mercantile IT jumped from 175.2p to 201.6p, as medium sized UK companies (primarily FTSE250 index constituents) bounced back from the previous quarter’s weakness.
9. Aberforth Smaller Companies IT advanced from 1136p to 1254p.
10. Standard Life Smaller Companies IT progressed from 407p to 450p.
11. Henderson Smaller Companies IT similarly enjoyed a recovery in sentiment towards domestic firms, and rose from 766p to 842p.
12. Barclays progressed from 148p to 155p, as better than expected full year results were clouded by concerns surrounding management strategy, with US activist Bramson ‘in the wings’.
13. Bellway jumped up from 2493p to 3042p, as interim trading results from the house builder, featuring strong financials and an optimistic outlook, reassured investors.
14. Legal & General jumped up from 226p to 276p, the life assurer is a geared beta play as both equity and bond markets firmed in the quarter period.
15. Royal Dutch Shell progressed from 2331p to 2448p, aided by a rising oil price.
16. i share FTSE100 ETF advanced from 653p to 722p, as investors saw the UK Parliament rule out a No-deal Brexit.
17. Edinburgh IT progressed from 591p to 648p, with its bias towards UK larger companies with attractive dividends proving beneficial
18. JP Morgan Global Growth & Income IT progressed from 284p to 315p, a double-digit return reflecting increasing appetite for risk assets and fears of higher rates receding. The same drivers typically applied across the other overseas equity selections.
19. JP Morgan Emerging Markets IT, aided by economists’ selective upgrades to country GDP, made similar progress as its ‘stable mate’ from 841p to 920p.
20. Blackrock World Mining IT, encouraged by measures to stimulate the Chinese economy, progressed from 333p to 365p.
21. i share Core MSCI World ETF also delivered teen % capital returns, advancing from 3808p to 4296p.
22. Vanguard All World High Dividend ETF was a very respectable performer, given its income bias, progressing from 3852p to 4195p.
23. i share MSCI Europe ex-UK ETF advanced from 2463p to 2704p, despite growing evidence of a slowdown in Germany and France.
24. Vanguard Asia Pacific ex-Japan ETF progressed from 60.3p to 66.8p.
25. Caledonia IT advanced from 2820p to 2975p, with its returns being more pedestrian than a listed equity investment - as news flow on the Flexible or alternative asset types (such as unquoted) is slower with lower visibility and less of requirement to provide a valuation.
26. Capital Gearing IT progressed from 4056p to 4155p, similar comment applies (per Caledonia), but it met its aim of beating 3 month LIBOR - if not UK equity returns – in search of preserving shareholders’ real wealth over the medium term.
27. Harbourvest Global Private Equity IT progressed from 1355p to 1430p in the first quarter of 2019.
28. Henderson Alternative Strategies IT made a small advance from 266p to 272p – in-line with its espoused objective of delivering a total return of 8% per annum.
29. Cash was barely changed (£1 = £1.002)

As an aside, we have often commented on the higher risk inherent in individual company shares – as compared to collective or pooled funds - and this can be seen when viewing the past quarter’s performance. While in a strong period for risk assets and equity in particular, the best performers amongst our list were Legal & General and Bellway (whose shares have risen 24% and 22% respectively in 2019), this could readily reverse in more testing times. Finally, it should also be noted that the above returns takes no account of income – which will be significant on the higher yielding assets, in particular the high yield corporate bond ETF, the property and the UK equity investments.