Investment Review
These are my personal thoughts
Overall investment outlook
The current credit crunch and banking crisis continues with the short term implication of lowering the world's economic growth. Whilst I feel it is still unlikely that all economies will go into recession from the effects of the "toxic" debt, it is still damaging confidence in the investment markets - hence current low valuations of assets such as shares, property and debt instruments (corporate bonds).
My overall strategy for geographical asset allocation - my "personal view" is that the UK is:
one of the world's most indebted nations,
a very profligate state (increasing central and local government expenditure),
has a decreasing manufacturing base
which is leading to a lower GDP growth
Thus I feel UK investors should consider shifting the weighting of their portfolios away from the UK, to economies such as USA, Europe, SE Asia and Emerging Markets, where there is a stronger economic growth.
When taking a five year view, I still prefer larger weightings in equities over commercial property, corporate bonds and cash and I also take the view that commodities will come back into fashion - there are now new funds that invest in 'real' commodity assets, rather than investing in commodities companies - see later.
Recession - the 'old' Western economies of USA, Japan, UK and Europe are in a prolonged period of negative growth - maybe 12 months until middle of 2010. The Emerging Markets of Brazil, Russia, India and China (the Big 4) will slow but will not move into negative growth. However, by slowing, these economies are detrimental to Western economic growth.
The UK Recession is expected to end in early/middle 2010 and as the stock markets normally lead economic growth by 6 - 9 months, the markets should start to move up in the summer 2009. In the next few months it is expected that companies will be reporting lower profits and lower forecasts for earnings and as the market is very sensitive to poor company news such as profit warnings, share prices could well drop more before they rise; however the FTSE 100 is currently at about 3500, which looks to be a floor to the market.
Banking crisis
We may not like it but 'Boom' and 'Bust' scenarios are all part of a healthy Capitalist society. Therefore, when governments meddle in the economy, attempting to make everything look too good for too long, there is an inventible crash and the longer the boom the bigger will be the bust! - Britain has managed to avoid falling into a recession for nearly two decades, hence the magnitude of the current economic crisis.
For the past 20 years, the United States Federal Reserve has meddled in the banking system, keeping Interest Rates at a low level for too long, in an attempt to prevent recessions. This created the property asset bubble that has subsequently burst.
There has been a belief that property prices will always go up, but in reality, property prices can go up and down. This has allowed Bankers to lend to too many people/institutions without thinking of when and how they will get their money back. It also meant that too many people have believed that they can borrow lots of money, again without thinking of how they were going to pay it back, thinking that their property value would continue to rise at a greater rate than the debt and associated costs.
So it was the interference in the capital markets that has lead to the current mess.
UK Dilemma - the major conundrum facing the UK is that, on the one hand there is a need to reduce debts (including the State's), and on the other, there is a need to get the economy going again. The problem is that a major proportion of our economy, and thus government revenue, is based upon the consumer, yet the State is spending! Should the state not be cutting its expenditure and we be saving for the future?
Breakdown of investment news
UK - although my investment philosophy is not based upon being a pure 'chartist', we should consider the fact that the FTSE 100 has dropped to the 3800 level and bounced back on several occasions over the past six months. However, recently it has dropped to nearly 3500.
Coupled to that, we are in the annual reporting season and many companies, especially some Banks and Financials, are reporting bad news and more massive write-downs. However, I feel that we will soon put the bad news behind us and start to look forward to profits in the following year, and the market responding on the upside. So the market could surprise on the upside, though it is likely it will move sideways for the majority of this year. So those with little invested in the market should seriously think of investing some now.
North America - I am now keener than in the past, as I feel that the nation has a better ability to come out the debt crisis than UK and it is still very strong in manufacturing and exporting to the new world. Moreover, as the US was the first to enter the recession, they are likely to be the first to emerge.
Europe - Outside Spain, Ireland and to a lesser extent France, there has not been the credit and property bubble that we have seen in the US and the UK. Although their banks have been involved and have been hit, their economies will not feel the impact as much. Taking a long term view, the Eurozone also has a bias towards exporting capital goods to the developing countries so they can grow their economies and infrastructure. So exporting to Emerging markets will go some way to compensating for falling demand.
The Eurozone, and Germany in particular, being a primary exporter, is feeling the effects of a weak US and UK and lower growth in Emerging markets. The UK is after all, one of the Eurozone's biggest trading partners
Japan - Its stockmarket peaked in 1990 but the market has failed to recover even 50% of it peak, despite being the world's second largest economy and a major innovative exporter, as it has its own individual cultural problems. The value of assets has taken this long to come down to the rest of the world, as it took over 15 years for the banks to admit that they have bad debts and have still yet to fully write them off. The country has had negative inflation and zero interest rates.
The difference with Japan, as opposed to UK and USA, is that we have nationalised our banks and written down the debts quickly, whilst in Japan, because of current property prices, it will take perhaps three generations for their mortgage debt on the family house to be repaid!!
Emerging Markets and South East Asia - These represent over 50% of the world's population, yet only 3% of the worlds GDP and just 7% of the world's stock markets. Taking the Big 4 (BRICs), their banks have not borrowed heavily from overseas, so have little exposure to the credit problems; foreign debt held by Chinese banks as a percentage of the GDP is only 2%, 4% for India and 13% for Russia. Their foreign currency reserves are huge and on top of this, Russia and Brazil have valuable assets in the ground that the West needs!
The Emerging Markets have positive GDP growth and are trading more with each other. In the case of Russia, only 5% goes to US, Brazil 14% and China 20%, and these figures are decreasing. In China increasing amounts of is products are being sold internally. Another positive factor in the Emerging Markets is that the age profiles of the populations are considerably younger than the west - in India, the median age is 25! This supports the base of workers who are wage earners, consumers and in these countries, savers.
Financial Health - as a percentage of countries Gross Domestic Growth, the current account balances are (October 2008):
| CURRENTLY | PERCENTAGE |
| UK | -4% |
| USA | -6% |
| Euro Area | Just positive |
| India | -1% |
| Brazil | +1% |
| Russia | +6% |
| China | +10% |
| Middle East | +13% |
Currencies (The Pound £) - the major reason for the weakening of our Pound is that the world's view of us, is of a profligate State system, and with our Government trying to raise money, and the only institutions that are prepared to buy being overseas, at what interest rates are they prepared to buy us on? Our institutions cannot afford it, so this only leaves the foreigners to buy our debt, which is extremely unattractive for them.
Residential Property - I feel there is still more pain to be had and that house prices could still fall further in some areas (so far about 16%, but maybe as much as a further 9%). The reason for the further drop in valuations is that the level of mortgages has to be supported by realistic earnings and affordability based upon long term interest rates of about 5%. It could take another 7 years for residential property valuations to be back to 2006 levels.
Commercial Property - is also unlikely to recover this year with the effects of the recession
Dividends - Yields on stocks and funds are very high at present (6% as an average), and are higher than that of Gilts (government bonds) for the first time since 2003. BUT this is based upon the last dividend paid so should really be called 'Trailing Yield'. The problem lies in what companies will pay in the future and as Banks make up a significant part of the High Yield Stocks sector and will all probably suspend dividends next year, and with other companies operating in a tough economic environment, it is expected that income from UK Income Funds and UK Shares will slightly lower. A guide for what yields should be - "prospective yield" - is about 4%. Once the economy turns then I expect income from these funds will return to providing the increasing income that they have for years.
In comparison for money on deposit, as Interest Rates fall, so too will the income from money held on deposit, and this fall will probably be more than Dividends.
Gilts and Corporate Bonds - these are debt instruments and the associated investment risk is the threat that the companies/governments default on the interest payments and there is the loss of the principal (the loan). But for the UK investment grade Corporate Bonds and Gilts, defaults are very unlikely and with interest rates still falling and very wide differences between yields, there is the potential that there will be capital appreciation, so the experts are predicting that this year, corporate bonds will out perform cash.
Market Returns
If you are looking for Income - Cash returns are now at all time lows; the alternative is to consider Equity Income Funds -
UK future yield on current valuations should still be about 4.5% and there will be income growth.
Asian Equity Income Fund is currently yielding 6%
European Income Funds are yielding currently over 6%
Cash - !!
Another alternative are UK Corporate Bond funds with yields ranging from 5% to 8.5% but here the income is fixed.
If you are looking for Total Return over the next two years will be as above, but with the income being reinvested returns will be bolstered so:
Cash - 1.5%!!
UK Income Funds with dividend yield of 4.5% - plus capital of 5% per annum over a 2 year period
Asian Equity Income Fund currently yielding 6% - plus capital of 8 % per annum over a 2 year period
European Income Funds are yielding currently over 6% - plus capital of 6% per annum over a 2 year period
UK Corporate Bond funds with yields ranging from 5% to 8.5% plus 2% capital growth over a 2 year period.
UK Inflation - is a year-on-year calculation, so the excess of commodity prices last year fuelled inflation to 5%; but as commodities prices have fallen considerably this year, it is predicted that inflation could fall to less than 1% over the next 12 months.
I strongly do not support the theory of long term disinflation, and I believe that inflation will reappear in the UK in say 2-5 years time because:
Our Government is printing money (known as 'quantitative easing'), so interest rates will rise.
Government and Local Government are increasing expenditure to meet their pensions and EEC regulations!!
Inflationary pressure will come from the fact that the world is running short of commodities, it is becoming more expensive to extract them and the world's population still wish to improve their standard of living - hence increased labour costs. So the cost of our imports increases, resulting in inflation.
But inflation is healthy for any economy and the only hedge against it, is to invest in real assets such as equities and commodities.
Market Returns - it is important to get the current turmoil into perspective so:
| ECONOMIC TIMES | YEARS | MARKET PERFORMANCES |
| Great Depression | 1929 - 1931 | Fell by 40% |
| Aftermath | 1932 - 1936 | Rose by 147% |
| World War 2 | 1938 - 1940 | Fell by 13% |
| Aftermath | 1941 - 1945 | Rose by 84% |
| Oil Crisis | 1972 - 1974 | Fell by 61% |
| Aftermath | 1975 | Rose by 145% (in one year) |
| Credit Crunch Commodity Bubble |
2007 -2009 (so far | Fallen by 50% |
| Aftermath | ?? | ?? |
These figures are from October 1983 to October 2008 - 25 years
The percentage of years that equities have made you money, in relation to cash:
Held over time of...
In UK Equities made Money
In UK Equities lost Money
Average annualised returns
International Equities made money
International
Equities lost money
Average annualised returns
| Over 1 year | 78.5% | 21.5% | 12.5% | 73.7% | 26.3% | 11.1% |
| Over 5 years | 85.6% | 14.4% | 11.4% | 82.6% | 17.4% | 9.5% |
| Over 10 years | 100% | NIL | 11.3% | 100% | Nil | 9.6% |
Dated 28 November 2008
Commodities
There are two ways of investing commodities
Indirectly, through equities (i.e. companies) that make the products, extra raw materials or invest in land, but the returns are dependent upon the sentiment of the equity markets
Or directly, through a combination of long-only investments in commodities indices, swap options on indices and exchange traded funds that invest in the 'real' assets, such as livestock, agricultural land, energy, precious metals and industrial metals.
Over time these latter funds will add diversification to existing investments and they are uncorrelated (i.e. they move at different times) to other assets classes.
Why Commodities:
To hedge against inflation
Energy - the pace of supply is being outstripped by demand - it is not all in the emerging markets - consider even in UK electrical supply with power stations not being replaced and gas supply coming in from places such as Libya and Russia.
Agriculture - stocks are low, land is limited yet demand is rising
Livestock - costs of production is increasing, and so is consumption
Industrial Metals - inventories are at all time lows yet there is a continuing demand from places like China
Precious Metal - long term supply disruptions and yet with increasing wealth so demand is rising
Moral - Taking this into consideration, it is prudent to stay invested as no one can forecast when the market will turn for the better.
Intrigued - why not contact -
rlovegrove@rsjinvestments.co.uk
0151 421 2525