Investment Report – Risk Assets – August 2016

12 August 2016

Introduction

Both risk and cautious assets have risen together in price in almost a straight line for over eight years in a row. This is unusual if not unprecedented.

Thus it may seem strange to suggest that a further and significant gain in risk assets is expected from these levels.

There are enormous changes taking place – a paradigm shift that will probably allow interest rates to stay at exceptionally low levels sine die.

August is usually a very quiet month due to holidays. In the absence of activity, prices could drift lower providing investors with an opportunity to add or increase their risk asset exposure.

This report outlines our rationale for the expected gains in risk assets.

We will, as normal, be contacting individual investors in the coming weeks with personalised recommendations to make appropriate fund switches.

A number of people have contacted us during the year considering a move from cash to risk assets. We suggest that now is a good time to review this.

Should you wish to discuss this please contact us on 01-6144362.

 

Background

Both risk and cautious assets have been rising in value for the past eight years with only occasional minor setbacks. This is unusual, if not unprecedented:

  • Both asset classes rarely if ever move in tandem for such lengthy periods of time.
  • Risk assets (as categorised by shares) rarely if ever move higher in almost a straight line without occasional, 20% plus, setbacks known as ‘bear markets’.
  • Cautious assets (categorised by Government State Bonds) have in fact been rising in value for over 30 years with their attendant drop in yield to near zero or below. In fact 70% of all bonds on issue worldwide are giving a negative return – Government Bonds are known as Gilts in Ireland and UK, Bunds in Germany and Treasuries in the USA. There is an inverse relationship between the price of a bond and its yield, so as the price rises the yield falls and vice versa.
  • The Swiss Government 50 year bond now offers a negative yield. In other words investors are prepared to tie their money up and give their money over to the Swiss state for no return at all.
  • Investors are also prepared to lend money to the Irish State for up to and including five years for no return, in fact at a small loss. The return on a 5 year Irish State Bond is minus 0.036% per annum.

The foregoing has enormous implications for investors and savers worldwide.

Government Bond markets are by far the largest and most sophisticated in the world. They set the benchmark for all other interest rates including borrowing cost, saving rates, etc. They are regarded as risk free. Therefore it is worth spelling out what negative interest rates on bonds actually mean since, at first sight, it seems irrational that a sane person would buy State Bonds in the certain knowledge of making a loss.

If a person invests in a 10 year German Government Bond today it costs 106.55 euro per 100. The holder gets a dividend or fixed coupon each year (paid twice yearly) but only €100 back in 10 years time. Combining the coupon and the certain capital loss at the end of 10 years translates into a loss of minus 0.18% per annum each year for the next 10 years. If this situation maintains then we are heading to a point where banks in Ireland, across Europe and elsewhere will start charging for looking after one’s money, i.e. instead of banks paying interest on deposits banks will charge customers for keeping their money on deposit. Again this is not unprecedented having occurred in the 1930s. The commercial banks themselves are being charged to place their money on deposit with their respective Central Banks at -0.4%.

There are both technical and fundamental reasons why interest rates are at zero or negative:

  • Financial institutions and others are by law required to buy/hold Government Bonds for prudential reasons.
  • Central Banks worldwide are buying up State Bonds in return for cash.

This latter policy is known as Quantitative Easing – commonly referred to as QE.

The policy was adopted worldwide in response to the financial crash or great recession of 2007/2008. Also known as the Lehman moment when the US authorities decided not to rescue Lehman Brothers bank from going bankrupt. QE works through Central Banks buying up Government Bonds from commercial banks, in the process converting bonds into cash through increasing the balances the banks hold in their accounts in the Central Bank.

The increased amount of cash held by banks should in theory allow them to lend more money to customers, allowing them to invest in real assets, shares, property, etc. thereby pushing up their value, increasing the feel good factor of customers, known as the ‘wealth effect’, increasing their confidence and thus leading them to spend more. Businesses were also supposed to respond to their increased demand by investing more money in plant, equipment, technology, etc. employing more people etc. to satisfy the increased demand.

QE has certainly met its objective of boosting the value of assets. Property values have risen and shares are at or close to record all time highs in many countries. This would normally indicate that ‘everything is rosy’ in the global economy. Paradoxically though, Government Bond markets are also at record high prices with accompanying very low, zero or even negative interest rates. This indicates the opposite – that global economic growth is subdued and likely to remain so for a very long time.

So, how do we as investors resolve this conundrum of booming asset prices and collapsing interest rates?

In fairness it is correct to point out that QE was an experiment which had never been fully tried and tested.

The authorities in the form of Central Banks were inadequately supported by politicians in implementing structural reforms and providing fiscal stimulus, they would claim and were thus forced to ‘make it up’ and amend their plans along the way. Politicians would argue they were, for example, constrained by their constituents, by inadequately re-capitalising the banks – a situation which has returned to haunt European countries today. Imagine the fate of an Irish politician who announces a further and proper recapitalisation (putting X more billions into the banks).

“We cannot change the past but we can change the future” is an old quote. So Mr Draghi, ECB President, has extended QE so that Central Banks in Europe are now buying the bonds issued by large companies. In effect this means that companies can now borrow the money required to pay their dividends to ordinary shareholders at virtually zero rates.

Prime Minister Abe of Japan has gone even further allowing his Central Bank to buy company shares through exchange traded funds. US Central Bank Governors, embarrassingly, race to TV studios to predict a return to normal interest rate levels which fail to materialise.

Defenders of QE ask what would the economic situation be had QE not been introduced? After tracing a downward curve for some years growth forecasts for 2016 have at least stabilised in recent months, albeit at very low levels. Notwithstanding, several economic indicators remain depressingly poor. While official employment figures in the US are back to almost average levels those who have given up looking for a job and left the workforce are at record levels. For example, unemployment in Spain has improved significantly but it is still close to 20%.

So, to recap briefly:

Economic growth has picked up a little but is well below normal levels despite massive stimulus in the form of QE. Low risk assets in the form of Government Bonds are at all time highs as are, paradoxically, risk assets in the form of shares.

The reason for this conundrum is a paradigm shift – in other words a fundamental change in approach or underlying assumptions that are taking place.

Up to now authorities in the form of Central Banks have been stating clearly that interest rates would stay low for as long as it took to achieve a resumption of normal economic growth rates. This has led to the mantra of ‘lower for longer’ amongst the investment community. This mantra is beginning to be replaced by ‘interest rates lower sine die’ – no set date for resumption of increases, or even ‘lower forever’. If correct, it means the current modest economic growth rates are as good as its going to get. There are sound economic reasons why this may be so although the jury is still out – such as (producing) lower (amounts) for less (inputs), technology impacts, the sharing economy, e.g. Uber, Airbnb, etc. These have profound social and economic policy implications, also for risk and indeed lower risk assets.

In effect it means there is likely to be a large and significant upward movement in risk asset prices.

This is because the value of a share / risk asset is equal to the discounted value of its future cash flow, or in more straightforward terms, its future dividends. The discount rate used is dependent on many factors but particularly the current and likely future level of interest rates. If interest rates are to stay low sine die then the average cost of capital currently being assumed for business is too high. If capital is assumed to be cheaper sine die the value of future cash flows in today’s money must rise pushing share prices significantly higher.

In other words share prices can continue to rise even if earnings remain flat as has been the case in very recent years. Through multiple expansion price earnings multiples can expand from current forward levels of about 21 in the US into the mid 20s, 30s (as was the case in previous decades) which implies gains from current index levels in the range of 20% – 40%.

In markets there will of course always be winners and losers, out-performance and under-performance.

Part of my function as your financial advisor is to identify the out-performers and winners.

Currently India is in the out-performance category. Its economy is the fastest growing large economy in the world. This economy has probably the best economics in the world although its politics leaves a great deal to be desired. India’s prime minister has recently increased public servants’ salaries by 20% – a great short term boost but perhaps not so in the long term. Reforms continue but at a very slow pace.

Other countries in the emerging markets are also benefiting from more relaxed Federal Reserve policies on interest rates, keeping a cap on dollar levels and reducing pressure on their currencies and borrowings. Commodity prices have picked up sharply and they are major beneficiaries. An Asia Pacific fund captures exposure to the general area without excess exposure to any one country – such as China.

The Standard Life Global Smaller Companies fund is also recommended given its manager’s expertise in picking winners worldwide and it high exposure to the US.

The Standard Life European Smaller Companies fund completes the list.

Mr Draghi’s latest policy measures of purchasing corporate/company bonds has yet to show its full impact. He and other Central Bank chiefs have ‘helicopter money’ to come if and when required. This refers to a temporary fiscal stimulus financed by permanent monetary expansion – money printing.

Alternatively if Central Bankers’ policies start to really work and is complimented by fiscal policy and structural reforms then economic growth should start to return towards its potential with its consequent increase in incomes, demand, investment and company earnings allowing P/E (price / earnings) ratios to expand to reflect the new scenario. Interest rates and inflation rates would also increase but rate increases can move higher 4/5 times particularly from abnormally low levels before affecting risk assets.

Under either scenario risk assets seem to be well underwritten at current levels.

Please always be aware that equities are risk investments which can fall as well as rise in value and investment choices should be made bearing your personal circumstances in mind.

Note – some of our clients have asked to receive a Pdf version of these reports. If you would prefer to receive a Pdf version, please let us know and we will be happy to arrange this for you.

_________________________

Stephen McCarthy

Phone 01 6144362

Email:  stephen@alchemi.ie

12 August 2016