Economic Commentary – January 2018
‘Where HAS all the economic growth gone – who exactly has benefited?’
Firstly, a new year’s greeting. On behalf of all of us at Gould Financial Planning may I wish you and your family best wishes, good health and a wealthy 2018.
During the festive season, the Resolution Foundation released some not so festive news. They state that employee wages fell behind inflation for yet another year in 2017, thus maintaining the trend since 2008 and they say this is expected to show no improvement in the coming year. Pretty depressing!
Meanwhile the government continues to run a deficit, albeit a smaller deficit, and the mountain of debt accumulated by successive UK governments continues to grow, albeit as a proportion of Gross Domestic Product (GDP) it appears to remains stable at about 87%.
This got me thinking.
‘Where HAS all the economic growth gone – who exactly has benefited?’ It’s not being passed down in wages to private sector employees, and public sector workers are still subject to a pay freeze. Some of the growth has translated into lower unemployment levels as the number of jobs has increased – and this has helped cut the state payment of unemployment benefits – but that only accounts for a small part.
Most of the growth over the last decade has gone to big business and to the UK’s wealthiest. Depressingly for the Chancellor of the Exchequer, many of these big international businesses have repatriated the profits away from the UK to a lower tax regime or contrived to pay no tax at all anywhere.
This is worrying. An increasing divide between the rich and the rest has consequences. At best a redistribution of wealth will come about peacefully through a change of government policy, and a tax attack on international ‘unicorns’ such as Apple, Google, Amazon to name a few will provide the money to improve services. At worst, as the divide widens there will be civil disobedience and social unrest – the impact of which will be felt by all.
The risks to our economic prosperity are well known; increased debt, ageing populations, increased robotics and the offshoring of jobs have not gone away, but these four horsemen of the economic apocalypse could well be joined by a fifth – social unrest.
Not surprisingly, with the increase in corporate profits, the equity markets in the UK and elsewhere in the developed world are at record highs. But, the sharp increases in share prices in recent years have run way ahead of the increased profits. The price to earnings ratio has increased. In short shares have become more expensive and this might, just might, suggest that the buyers of these shares think that profits are expected to continue to increase over the coming years – through increased automation perhaps, or through wage stagnation or through excess capacity? Whatever the reason the outcome is the same, the world economic order continues to grow but the people fail to share in the increased prosperity.
At Gould Financial Planning we adopt the ‘Jimmy Connors’ approach to portfolio design. We love winning – but we hate losing more. Yes, we want our clients capture the upside growth in their portfolios when markets rise, but we are more concerned with trying to limit the downside damage when markets fall.
As share prices and other asset values increase the chances and the scale of further rises diminishes. At the same time, the risk and scale of a price correction increases.
As we start 2018 we should be optimistic for the future, but at the same time we should be aware that it was 10 years ago that the last major economic correction took place, and 45 years since the last catastrophe and collapse of 1973.
So what do we want our clients to do?
We continue to believe that the safest protection of client’s wealth and futures is diversification. We make no apologies for continuing to bang this drum, but in a world where nothing is certain “hedging bets” must surely be the safest approach. This has caused us to slightly lag the benchmark during the rising markets of 2016 and 2017 but is likely to offer far more ballast and relative outperformance if, or when, there is a market correction.
Pay off the Debts
As ever, we will remind clients that debt reduction is another form of saving. Just now interest rates remain lower than the rate of inflation, but this cannot be sustained forever. So, we urge you to pay off the credit cards, buy your cars and luxuries for cash rather than hire-purchase; reduce, or better still clear, the mortgages, and help your children clear their debts too.
Hold some Cash – but not too much
The UK financial regulator still takes the view that cash and national savings are risk-free. This is simply not true. Cash at the bank may well not be subjected to daily volatility, but in a world where interest rates are running considerably lower than the rate of inflation this asset class is falling in value year upon year.
Nevertheless, it is sensible and prudent to ensure that you hold enough cash to cover all known, and even some unknown, expenditure without having to resort to selling at-risk assets.
Verdict: as we identify more investment opportunities that offer sufficient returns to at least match inflation and at a low level of investment risk, there is no need for us to recommend clients being overweight in this asset class.
Loans and debt
Until a few years ago, this space was predominantly filled with fixed interest and inflation linked loans to governments and big businesses. And whilst interest rates were falling and inflation rates fell and then stayed low, these assets enjoyed growth rates without the commensurate level of risk. The table has now turned, or at least bottomed out, and with interest rates more likely to rise and inflation drifting upwards, the reward opportunity is limited and the risk of capital loss higher.
We have to be more creative to fill this space and do so without taking undue risk. We now therefore look to commercial ground rents, long term infrastructure lending, and floating rate notes to provide ballast to portfolios.
Verdict; neutral – but concentrate holdings in investments which have a smaller correlation to interest rate movements than more traditional debt-based holdings.
There is little to suggest that 2018 will bring anything other than a typical investment return for this sector – although residential properties may fall, especially in the south east, commercial property values look fair.
We take the view that property should be included in virtually all investment portfolios and tend to only exclude them from portfolios we supervise where we know our clients hold property investments under their own supervision.
We look to diversify this asset class into commercial and industrial investments both in the UK and overseas, and through investing in businesses that own rental property. We also take the view that infrastructure plays a part in this sector.
Property offers the opportunity for above inflation returns as the capital values should in the long term rise with prices and the rental income provide the annual income. However, there are two risks that we have to be particularly concerned about. The value of properties can fall, and second if too many people want to sell at the same time and there are not enough buyers, fund managers have to suspend the redemptions until they source sufficient cash to make the payments.
Verdict: Neutral but with a bias towards infrastructure. Property is a long term investment. We don’t expect any out-of-the-ordinary investment returns or losses in 2018. We look to this sector to produce an investment return of inflation plus a rental return.
This sector of our portfolios is designed to provide stability. Our clients should expect to underperform in rising markets and suffer lower losses when markets fail. This goes to the heart of the ‘Jimmy Connors Approach to Investments’. We achieve this by dividing the allocation into three sub-sectors: -
These managers tend to have flexible mandates with highly researched and qualified teams, able to shift between the various segments of the market at short notice and in large quantities. This aspect of a portfolio provides ballast so that some of the riskier calls are able to fulfil their roles within a diversified portfolio.
Verdict: at a headline level we remain neutral for 2018.
The value of UK equities is at an all-time high with the FTSE 100 index now trading around 7,600. But we are not on our own here; the European, American and other world markets are trading at or very near their all-time highs also. The price / earnings ratios are well above their historic average which would suggest that there is an expectation for profits to increase further – both in the UK and overseas.
The question is where; home or abroad?
In an increasingly global world, where the registered stock exchange or country of origin is becoming less important, the UK in general, and the London Stock Exchange in particular, will become less significant. The movement away from the UK could become even more pronounced when the UK leaves the European Union, if international global companies move their head-quarters to another jurisdiction.
The inevitable consequence of this drift to you, our clients, is that the proportion of your wealth regarded as a UK investment should decline in favour of overseas and global equity funds.
Does this matter? Will this impact on your investment performance or the risks that you are exposed to? Traditional thinking might have suggested that an additional risk - currency risk - would impact on the volatility of performance. If sterling strengthens, then the sterling value of overseas denominated funds will fall – and vice versa. But, as we have seen in the Brexit aftermath the impact of a currency movement impacts both UK and overseas investments in almost equal measure: -
And the opposite is true too: -
It seems therefore that the exchange rate movements do not represent much of an additional long term risk when deciding whether to invest in the UK or overseas.
At Gould Financial planning therefore our Investment Committee has elected, for most clients and their portfolios that we will look to reduce the proportion of UK holdings in favour of increased allocation to global and overseas investments at your next review. For most of this decade our yardstick has been that for every £40 we invest in UK funds we would invest £60 in global and overseas funds. As we review your portfolios in 2018 we will be looking, in most but not all cases, to move to a 35% UK and 65% overseas split.
But there is one exception to this rule. For some clients, the overriding objective is wealth preservation though tax saving. The UK tax system offers particularly generous tax incentives for investing in smaller companies in the UK. Business Relief from Inheritance Tax is compelling for many of our more senior clients, Venture Capital Trust and Enterprise investment Schemes for high earners offer tax incentives that cannot be ignored – if we can find suitable investments to invest in. For these clients, and these clients alone, there is a compelling case for an increased allocation to the UK financed by a reduced global holding. For clients where the tax incentives are the overriding objective, we may well look to bias the equity holdings more in favour of the UK, in order to make best use of the exemptions available to you.
Over the past few years the one sub-asset class that has outperformed all others has been the UK smaller company space. In part, this increase has come about through an increase in demand for shares in UK smaller companies – precisely because of the tax breaks they offer, but there is another underlying reason. Quite simply, the additional risk of investing in smaller companies requires additional prospects for reward and smaller growing companies offer the prospects for increased reward. What is essential here for sure is good research into the target companies.
Verdict: Except where the tax incentives are the overriding priority for client, we will be looking over the course of 2018 to reduce UK holdings. Whilst index-tracking passive funds may be well suited to the mainstream markets, good research is essential in the smaller company space.
History repeats itself, regularly! Yes, risk capital needs to be rewarded and over the long term it is the risk capital element of clients’ portfolios that have delivered the strongest investment returns. However, share prices will take a tumble from time to time – and it is now nearly 10 years since the last fall.
Whilst there appears to be no real compelling reason to expect a fall; there is surplus liquidity; surplus capacity; US and North Korea apart, no real international threat; there is a growing ground swell of the western population who feel they are being left out from their share of economic prosperity and there could be a reaction.
There is, therefore, a risk that share prices will fall, and our portfolios should be designed to offer some protection and limit the downside risk. This is achieved by investing a proportion of our client portfolios in assets that (a) do well in uncertain times or (b) invest in businesses that produce or deliver things that people need to survive or (c) catch a glimpse of the future. Examples of this in the modern day world are
Verdict: Overall we are expecting to increase the proportion of client wealth that we invest in the global and overseas sector.