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Investments

Should VCTs be part of your portfolio?

By | Investments

It probably hasn’t escaped your notice that a range of taxes have increased over recent years, in part due to the economic effects of the pandemic. In March of this year, the Office for Budget Responsibility projected that 37.1p in every pound generated in the economy will be subject to tax by 2028. The date of the first Budget for the new Government has been set for 30th October, and media speculation is rife, suggesting potential changes to tax legislation that could increase the overall level of tax take further.

As a result, tax-efficiency is high up the wish list for many investors. The most popular options to increase the tax-efficiency of an investment strategy is the use the annual Individual Savings Account (ISA) allowance, or make pension contributions, which qualify for tax relief. These popular choices are, however, only two of a range of options that investors can consider to reduce the level of tax they pay. Investors who are comfortable accepting higher levels of investment risk may wish to consider Venture Capital Trusts (VCTs), which have grown in popularity over recent years. A qualifying VCT investment can provide a helping hand to small and growing UK businesses, but can also reduce your Income Tax bill, and provide you with a tax-free income stream.

Tax benefits

VCTs were introduced in the Finance Act of 1995, to encourage investment into Britain’s small and entrepreneurial businesses. VCTs are collective investments, with a fixed number of shares in issue at any one time. There are restrictions in place to limit the type of investment that the VCT can make, without risking their qualifying status. These include a £15m limit on the gross assets of the investee company, which must also not have more than 250 employees. In addition, 80% of the holdings within a VCT must be invested in these qualifying assets.

VCTs raise money regularly via the issue of new shares. Purchase of new shares via an offer provides the investor with up-front Income Tax relief of 30% on qualifying investments. This tax relief is retained as long as the investment remains qualifying and is held by the investor for at least 5 years.

In addition to the Income Tax relief, dividends paid by the VCT are tax-free. Most VCTs aim to pay regular dividends, and some actively look to arrange special dividends, in addition to the regular dividend schedule, subject to the performance of the underlying investments within the VCT. Finally, any gains made on disposal of a VCT are also free from Capital Gains Tax.

The need to accept higher levels of risk

It is important to recognise that the Income Tax relief provided on investment in new shares is given as compensation for the investment risk taken when investing in a VCT. As only fledgling unquoted companies qualify for investment, investors need to be aware that individual companies could fail; however, VCT investment has helped a number of household names, such as Zoopla, Secret Escapes, Gousto and Graze, take the next step in their growth story.

Investors in VCTs also need to bear in mind that their investment may be difficult to sell, as there is a very limited primary market. As a result, most VCT managers set aside cash funds within their portfolio to permit share buybacks, where the VCT company buys back shares from investors. Such buybacks are usually set at a small discount to the prevailing net asset value of the underlying VCT portfolio, and larger and more established VCTs offer buyback opportunities regularly. That said, the availability of VCT buybacks is dependent on the trading performance of the VCT, and there is no guarantee that a buyback opportunity will be provided.

Choose the strategy wisely

Given the potential risks and range of outcomes from an individual investment made by a VCT, selecting a VCT with a portfolio approach is of key importance. Generalist VCTs usually invest in at least 20 companies, with many offering greater diversification across a wider range of positions.

There are other variables that can adjust the level of risk within the VCT portfolio. Investee companies that are already established can offer greater stability than those that are at an early stage in the growth cycle. By investing in companies across different sectors of the economy, VCT managers can try and avoid systemic risks affecting the portfolio. By their very nature, most VCT investments will be within companies involved in new technology or e-commerce; however, by adding industrial manufacturers, healthcare and leisure companies, greater diversification can be achieved.

Some VCT strategies add other investments into their portfolio, such as those quoted on the Alternative Investment Market (AIM). Whilst these investments are potentially more liquid, they remain smaller companies that still carry greater levels of investment risk.

Wide variance in performance

Analysing the performance of VCTs launched more than five years ago, shows a distinct variance in performance. Taking into account the initial Income Tax relief, dividends paid during the investment period, and the net asset value after five years, the best performing VCTs have produced an annualised rate of return of over 20% per annum, which is highly attractive; however, this strong performance is certainly not universal. There are a number of sizeable VCTs where the annualised rate of return achieved is between 6% and 8% per annum, which is barely above the level of Income Tax relief available on purchase. A handful of VCTs have fared even worse, losing money over the five year period, and eating into the Income Tax relief gained on investment.

Why advice is critical

Whilst the tax advantages are attractive, it is important to recognise that VCTs are a high risk investment, and should only be considered by investors who are willing to accept a significant risk of capital loss. Whilst many VCTs have produced strong returns over the long term, when factoring in the tax relief on investment and dividend income, others have performed poorly.

Given that this is a specialist market, we recommend seeking independent advice before considering any investment in VCTs, to assess whether a VCT investment is appropriate for your circumstances, needs and objectives.

Our independent advisers can provide you with unbiased and holistic advice to improve the tax efficiency of your investment portfolio, and the FAS Investment Committee has full access to independent expert research on available VCT offers. Speak to one of the team to start a conversation.

Where next for global markets?

By | Investments

Any long term investment strategy will enter stormy waters from time to time, with the Covid-19 pandemic, Russian invasion of Ukraine and inflationary spiral amongst the factors that have made for a bumpy journey over recent years. Since last November, market conditions have felt considerably calmer, with investors enjoying a period of solid returns. Over recent trading sessions, however, the swell has picked up again, with volatility increasing across global equities markets.

Why have markets outperformed?

The gradual decline in inflation and prospect of easier monetary policy, corporate earnings reports that have largely beaten expectations, and stronger-than-expected economic data have proved the catalyst for the positive market conditions over the first half of this year.

After the hangover from the Covid-19 pandemic, and the Russian invasion of Ukraine, central banks around the World were forced to raise interest rates to head off an inflationary spiral. With inflationary pressures now easing, investors have been eagerly anticipating a change in direction from central banks, as rate cuts are generally perceived as being positive for both companies and consumers alike.

Corporate earnings have also supported the rally seen through the first half of the year. According to Factset, 78% of US quoted companies reported better than expected second quarter earnings, with earnings reports from technology giants reinforcing the positive market sentiment.

The final factor behind the strong performance had been the continued strength of the US economy. Investors have been increasingly hopeful that the Federal Reserve manage to steer a course where inflation moderates, without tipping the US economy into recession.

Reaching the pivot

Recent economic data has, however, stoked fears that central banks could have left their restrictive policies in place for too long. The European Central Bank cut rates by 0.25% in June, and the Bank of England followed suit this month. The Federal Reserve has been keen to ensure that inflation remains in check, and are yet to cut rates, potentially increasing the risk of recession.

Recent US unemployment data has been much weaker than expected, and market consensus now expects that the Federal Reserve may need to take more drastic measures over coming months, to avoid a stall in economic growth.

Where strong earnings reports propelled markets higher over the first half of the year, forward guidance from a handful of tech giants over recent weeks has painted a more mixed picture. The valuations on major tech players are somewhat challenging, and earnings disappointments are likely to weigh heavy on market sentiment.

Away from the tech sector, the first signs of a rotation into more traditional industries have emerged, and renewed focus on value and mid-cap stocks could be a dominant feature over the remainder of 2024.

Seeking value globally

Whilst the performance of US markets sets the tone for global equities, there are always regional variances that provide opportunities. The outlook for the UK remains modestly positive, with an improving picture for growth over coming quarters, and UK equities continue to look inexpensive when compared to global peers. European markets also remain mixed. French stocks remain under pressure due to recent political instability, and general sentiment not helped by tepid Eurozone growth figures.

After a strong start to the year, the Nikkei 225 index of Japanese stocks has seen significant volatility of late, largely due to the strength of the Yen against the Dollar and the impact this may have on exporters. Despite the sharp technical moves in recent trading sessions, Japanese stocks remain attractively valued.

Chinese equities have struggled over the first half of the year; however, there are increasing calls for further stimulus, with additional Government intervention to help boost economic growth becoming more likely. The continued weakness in the beleaguered property sector may however, keep any outperformance in check, at least in the short term.

Geopolitical risks remain

Perhaps the biggest risk to global markets is the outcome of the US election in November. Investors have been weighing up the potential impact of the Trump-Harris showdown with the withdrawal of President Biden closing the gap in the polls. Markets had priced in a convincing Trump victory over recent months; however, the early surge in support for Harris could lead to an increase in market volatility, should momentum for the Harris ticket be sustained as election day draws closer.

The election result is likely to have implications for the conflict between Russia and Ukraine, which remains an ongoing risk to global stability and commodity prices. The US election result will also dictate the future path of US-China relations, where trade tensions continue, and the ongoing threats over Taiwan remain.

Conflict between Israel and Gaza, and wider unrest in the region, have yet to have any material impact on market sentiment. Any wider escalation could, however, push oil prices higher, damaging global economic prospects and fuelling inflation. Any surge in prices could, however, be tempered by weaker global economic growth.

Bond rally to continue?

Weaker economic data over recent weeks has seen bond yields fall (which pushes bond prices higher), and with markets now expecting a series of rate cuts by Western central banks over the next 12 months, the outlook for bonds appears broadly positive. Bond investors will, however, need to consider credit quality, in the event that economic growth slows significantly. The additional yield offered by sub-investment grade bonds does not appear to offer sufficient additional return to compensate for the increased risk of an economic slowdown.

A broadly positive outlook

After enjoying a calm and positive first half of 2024, we have seen greater levels of volatility over recent weeks, and we expect this to continue through the remainder of this year. US equities continue to offer good value over the longer term, although the short-term performance may well be dominated by actions taken by the Federal Reserve. UK and European markets remain cheap when compared to the US, and any renewed focus on value equities could shrink the performance gap between the UK and US.

Diversification remains ever important, and whilst equities markets may see further volatility in the short term, holding an allocation to other asset classes can aid stability. After being adversely affected by the inflationary pressures of recent years, government and corporate bonds look attractively priced, given the monetary easing expected over the next few quarters. Lower interest rates may also prove positive for both commercial property and infrastructure investments, which have underperformed since 2022.

With more volatile conditions seemingly set to return, we feel this would be a sensible time to review the investment strategy within pension or investment accounts that you hold. Speak to one of our experienced advisers to discuss your existing portfolio strategy and consider whether any changes would be appropriate.

Signs of recovery in commercial property

By | Investments

Commercial property has traditionally played an important role in portfolio diversification. Direct Property funds that invest in UK physical property assets, such as warehouses, office and industrial space, has traditionally found a place in many portfolio strategies, as it tends to produce consistent returns, that show little in the way of correlation with other assets, such as Equities (shares).

Challenging markets

It is fair to say that the commercial property sector has faced a number of challenges over recent years. Many property holdings experienced void periods during the Covid-19 lockdowns, with the office and retail sectors particularly badly affected. In the aftermath of the lockdowns, commercial property has, again, struggled to spark interest from investors due to the spike in inflation which led to the rapid increase in interest rates during 2022 and 2023. The graph below shows the performance of the Investment Association UK Direct Property sector over the last eight years. Consistent returns were enjoyed until the Covid-19 outbreak, and following a rapid recovery as the economy reopened, the sector has faced serious headwinds as inflation and interest rates climbed.

Improving outlook

There is, however, increasing evidence that the prospects for the commercial property sector are improving. The Bank of England appear ready to press ahead with the first of a number of base interest rate cuts in the coming months. This could well prove positive for commercial property assets, as the returns achieved from property investments are particularly sensitive to monetary policy decisions. As base rates fall, and inflation settles around the Bank of England’s target, the rental income received from commercial property becomes relatively more attractive.

Further evidence of the improvement in sentiment can be found in the Royal Institute of Chartered Surveyors (RICS) UK Commercial Property Monitor, published earlier this year. The RICS research indicated that demand for retail and office space – two of the sectors of the property market that have been hardest hit – had seen the first tentative signs of increased demand. Furthermore, there is growing confidence amongst those surveyed that rents will increase over coming months.

Liquidity issues

Aside from the pressures of lockdown and adverse monetary policy, collective funds investing in direct property have also had to face liquidity issues that first surfaced immediately after the Brexit decision to leave the EU in 2016, which led to increase demand from investors wishing to sell their investments. As direct property funds hold large bricks and mortar property investments, that cannot easily be realised, increased demand from investors at the time exhausted liquid funds, and as a result, leading commercial property funds managed by the likes of M&G, Janus Henderson and Legal & General closed their doors to withdrawals temporarily.

Most funds reopened after 2016, and could be traded without restrictions, until the Covid-19 pandemic caused a further round of suspensions and liquidity concerns. Several funds have limped on, but a number of leading players in the industry have taken the decision to wind-up their property funds. M&G announced the wind-up of their Property Portfolio last October, with the process ongoing. Janus Henderson sold their entire property portfolio to a single buyer in 2022 and repaid investors, and St James Place’s property fund remains gated since the decision was taken to suspend withdrawals in October 2023.

Evolving strategies

Despite the loss of a number of funds within the sector, investors can still select from a range of direct property funds; however, those that remain open typically hold a higher allocation to cash, to mitigate against liquidity concerns. One of the largest funds in the sector, Legal & General UK Property, has taken the decision to make more fundamental changes to their portfolio, and have asked shareholders’ permission to alter the asset allocation, in an attempt to provide adequate liquidity and avoid holding excessive levels of cash, which can dilute returns. The Legal & General fund will continue to hold direct property assets; however it will also aim to hold an equal allocation to Real Estate Investment Trusts (REITs). These are quoted companies that hold a portfolio of direct property, from retail parks to student accommodation. As the shares are quoted and actively traded on the London Stock Exchange, their inclusion should alleviate future concerns over liquidity.

Additional considerations

There are, however, significant differences between a REIT and a direct property unit trust, which investors need to consider carefully, as the introduction of REITs changes the risk profile of a commercial property fund.

Firstly, a REIT can borrow money to purchase securities. This leverage is not present with a direct property fund and does introduce additional risk. Secondly, the buying and selling price of a REIT may not reflect the value of the underlying property portfolio, and the shares can trade at a discount or premium to the underlying value of the portfolio. Currently, many REITs stand at a discount to their net assets, reflecting the difficult conditions seen over recent years; however, an improvement in the fortunes for the sector could see these discounts narrow.

Is a hybrid approach the answer?

We wait to see the response to the changes made to the Legal & General Property fund, and whether other property funds may consider similar changes to their portfolios. It is clear that the ongoing liquidity concerns have cast a shadow over the sector and any measures taken that remove barriers to investment should be seen as a positive step. Investors will, however, need to carefully consider the impact of any changes within the asset mix within property funds.

Diversification remains the key

Commercial Property investments have traditionally helped diversify investment portfolios, and the improving market outlook, together with changes being made within the sector to alleviate investor concerns, may see fund inflows improve. We always recommend that investors adopt a diversified approach to investment, and hold a precise mix of assets that match your objectives and tolerance to investment risk. This is where our experienced advisers can add significant value, by considering your exact circumstances to determine the correct asset allocation for your investment or pension portfolio. Speak to one of our independent advisers to start a conversation.

The investment case for China

By | Investments

After a decade of rapid growth, China has offered scant reward for investors since 2021. Where developed western markets have enjoyed strong returns since November, Chinese Equities continue to forge a contrarian path lower, despite a growing number of reasons why China appears to offer good value to investors. The graph below demonstrates the very different performance of the CSI China 300 index (shown in blue) compared to the S&P500 index of leading US companies (shown in red), priced in Sterling, over the last 3 years.

We take a look at some of the factors that have led to the underperformance, and outline reasons why we feel an allocation to China deserves a place in a diversified portfolio.

Continued growth

The Chinese economy has traditionally expanded at a rapid pace, with annualised growth of between 6% and 10% per annum achieved between 2010 and 20191; however, the rate of growth on an annualised basis has slowed over recent years. Covid-19 caused Gross Domestic Product (GDP) growth to dip, as was the case across the World, although the Chinese economy rebounded last year, growing by 5.24%. This rate of growth compares favourably to the US, which itself expanded by an impressive 3.1%, and very appealing when you consider the meagre growth achieved by the UK and Eurozone last year. Although the rate of growth predicted for the Chinese economy over the next five years is lower than pre-Covid levels, economists predict an annualised growth rate of around 4% per annum, which may well look attractive when compared to other leading economies.

Consumer recovery overdue

The Covid-19 pandemic was particularly damaging to the Chinese economy. Harsh lockdown rules capped economic activity to a large extent, and when the restrictions were eased in November 2022, economists expected a rapid acceleration and recovery, as domestic consumption rebounded and consumers spent money saved during the pandemic.

The reality has been very different to expectations, as consumer confidence remained stubbornly weak post-pandemic.  Very recent data has, however, indicated a slight improvement, with retail sales for May growing by 3.7% year on year2, reversing the downward trend seen over recent months.

The need to reflate

Most western economies struggled to contain spiralling inflation during 2022 and 2023, caused by increased demand for goods and services post pandemic, and the impact of war between Russia and Ukraine, which pushed commodity prices higher. Given the sluggish recovery in consumer confidence seen in China, inflation was barely positive for 2023, and the International Monetary Fund (IMF) predict Chinese inflation will only reach 1% this year.

Beijing has already taken measures in an attempt to stimulate demand, such as offering trade-in subsidies against the purchase of new cars and white goods, and cutting base interest rates late in 2023. It is likely, however, that further monetary stimulus will be needed, which could prove a fillip for investors.

Unemployment levels amongst young people also remains a concern, with 14.2% of those aged 16 to 24, who are not in full time education, looking for work2. That being said, this has steadily fallen from the 20% level seen last year, and we expect to see further measures to boost productivity and employment prospects, in particular in areas such as technology.

Property Market woes

One key reason behind the underperformance of Chinese Equities since 2021 has been the continued struggles seen in the real estate sector. Land and Property development, which according to analysts accounted for almost one third of China’s GDP at one point, boomed during the last decade, with much of the growth fuelled by debt. Overdevelopment saw a glut of unsold properties, spawning ghost cities amidst a buyers strike. Lack of consumer confidence in the wake of the pandemic, and demographic shifts are often cited as the key reasons for the extended slump in real estate prices.

As demand eased, and debts mounted, pressure began to bear on the largest property enterprises. Evergrande, a key player in the Chinese property market and at one point the most valuable property company in the World, defaulted on its debt in 2021, and eventually filed for bankruptcy in August 2023. Country Garden, another leading property firm, saw its shares suspended earlier this year. The company has also defaulted on loans and is facing a liquidation petition.

Concerns over the impact that defaults could have on the strength of local and national banks remain,  although the immediate prospects of a property-led banking crisis now appear less likely. China’s Government have announced a raft of measures in an attempt to arrest the decline, including the purchase of unsold homes by local authorities, although further action will almost certainly be needed to help boost confidence in the sector. Any such moves would be welcome; however, we expect the property sector to be a drag on growth for some time to come.

Transition to tech

The increased focus on new industry, such as electric vehicles, is a good example where Chinese companies have the potential to dominate global supply. A slow but steady move towards net zero will require change on a colossal scale, and a gradual move away from traditional manufacturing to added value could halt the decline in industrial production seen over recent years.

Good value for the patient investor

The poor performance of Chinese Equities since 2021 has led to valuations becoming increasingly cheap when compared to other developed markets. Estimates of the forward price to earnings ratio suggest that the MSCI China Index stands at between 11 and 13 times earnings, which is roughly the same level of market valuation as the UK, despite the fact that China is likely to grow their economy at more than double the pace of the UK over the next five years.

Despite the apparent inherent value, investment in China is not without risks. Continued pressure from the ailing property sector, ongoing tensions with the West and the potential for regulatory interference temper our enthusiasm, and given the outflows seen from Chinese Equities over the past two years, investment at this point would be considered a contrarian move.

Taking all factors into consideration, we see the potential for a rebound in the fortunes of Chinese Equities over the medium term. Investors will, however, need to show patience, and volatility may well be uncomfortable at times. We therefore feel that an allocation to China could be appropriate; however it is important to hold a diversified portfolio of assets, and our experienced team can provide advice to tailor your portfolio to suit your tolerance to investment risk, whilst ensuring diversification is maintained. Speak to us to start a conversation about the asset allocation within your investment or pension portfolio.

Sources

1 World Bank Group

2 National Bureau of Statistics of China

The drawbacks of a passive only investment approach

By | Investments

First available to investors in 1975, a passive fund aims to offer a low-cost method of replicating the performance of a specific market index, rather than actively selecting individual assets within a particular market. Over the last decade, passives have grown substantially in popularity, with Morningstar research confirming that passive funds saw higher inflows than active funds during 2023.

The rise in the popularity of passive strategies is also evident from our own market analysis. Our Investment Committee regularly undertakes a comprehensive review of managed portfolio solutions offered by discretionary fund managers, to ensure that we can demonstrate that FAS clients receive good value for money. Our analysis clearly demonstrates an increasing bias towards passive investments, on which many of our competitors’ products and services are founded.

The rationale behind the increased use of passive investment funds is that the ongoing cost of a passive investment is usually cheaper than an actively managed fund. This helps passive only strategies maintain a competitive total cost of ownership. A key drawback of such an approach is that investors may be missing out on additional returns generated by strong active management. In our opinion, many portfolio managers are confusing “value for money” with “cheap”, with the focus on costs being the dominant factor.

Drawbacks of passives

Many investors fail to take account of two key disadvantages of a pure passive investment approach. The first is that, by definition, a passive investment will not outperform the representative index or market it is trying to replicate. Indeed, due to costs and potential tracking errors, most passives return just below the index return. As an investor, we contend that you should be seeking outperformance where possible, as long as the level of risk being taken remains commensurate with the prospects for superior returns.

A second key risk of a pure passive approach is that replicating an index will mean producing returns in line with that index. When market indices fall, the value of a passive investment tracking that index will fall by a similar amount. Unlike a fund with an active manager, who could potentially take avoiding action by reducing allocations, increasing the percentage of cash or possibly using derivatives, the passive fund will simply track the index on the way down.

Our approach

Within our investment strategies, we try to seek out good value for our clients, and our independent status allows us to take an unbiased approach as to the precise blend of funds we select. This allows us to select passive funds, where this is appropriate. We will, however, also look to use active funds if we feel this is likely to result in outperformance.

Our Investment Committee undertake considerable research on a sector and region basis when conducting the regular review of funds that we recommend to clients. This research, which has been carried out for many years, allows us to better understand areas where passive investment is likely to be sensible, and where selecting an active investment approach may produce superior returns.

The most commonly cited example of a sector where passive investments perform well is US Equities. Our own analysis has shown that index funds that track the S&P500 index of leading US companies tend to produce consistently strong returns when compared to actively managed US Equity funds. There will, of course, be active funds that do beat the market; however, the key is whether this can be achieved on a consistent basis.

One of the main reasons for the attractiveness of passive funds in US markets is the dominance of a small number of mega-cap stocks, where performance has been positive compared to the wider index for some time. Our analysis concurs with research carried out by S&P Dow Jones, who suggest in their recent SPIVA report that 60% of active large-cap US Equity funds failed to beat the representative S&P500 index during 2023.

A good example of an area where passive investment has shown historic weakness is in Fixed Income investment. Whilst many investors would associate passive funds with Equity investment, a wide range of passive bond funds are now available, which track a particular UK or Global bond index, and typically replicate hundreds or potentially thousands of individual bond positions. Bond investment is an area where adopting the correct strategy can yield significant outperformance, and an active bond fund manager can alter the duration of bonds held, the credit quality and sector or geographic allocation, to try and generate superior returns over the benchmark index. These additional levers available, which can adjust the allocation within the fund, can help a skilled fund manager generate superior performance to a passive fund, which simply holds the constituents of an index.

At FAS, we view ourselves as conviction investors, and therefore when selecting an active fund, we prefer to select an investment manager or team with a clear vision as to how their fund is to be positioned. This can often mean a concentrated portfolio, when compared to the representative region or universe of stocks available. All too often, we come across funds that employ an active manager or management team, who take an approach that allocates their portfolio closely to the benchmark index. In most instances, such funds fall between two stools, carrying high charges without the prospects for outperformance.

Summary

With the increased focus on costs across the industry, many portfolio management services are leaning towards a passive only investment approach, with the ultimate aim of highlighting a competitive pricing structure. We feel such an approach is highly inflexible and potentially means that opportunities for outperformance from active managers is being missed. We prefer adopting a hybrid strategy, using passive funds in areas where index tracking funds should perform well, combined with actively managed funds where we feel the prospects for outperformance justify the higher costs of active management.

If your investment manager is using a passive only approach, speak to one of our experienced advisers to discuss whether adopting a different strategy would be appropriate.

Scaling the wall of worry

By | Investments

Recent events in the Middle East have once again led to increased concerns about the impact that World events can exert on global financial markets. In such times, it is important to remain focused on the long-term trend, and to try and avoid taking short-term decisions that could prove detrimental, as history tells us that the initial knee-jerk reaction to global events is often short lived.

Why markets react to conflict

It is true to say that investment markets crave certainty at all times. Calm waters allow investors to focus on the prospects for the global economy and individual companies, without the need to consider the disruptive impact of global events, such as major conflict. One of the key reasons why recent conflicts have caused consternation from an investment perspective is the potential impact on commodity prices. For example, as Middle Eastern nations are key players in the global oil market, the recent heightened tension between Israel and Iran have forced oil prices higher. Likewise, the Russian invasion of Ukraine caused a significant spike in natural gas prices due to supply shortages.

What history tells us

Looking back through history provides clear evidence that investor pain following a global event is relatively short-lived. The Russian invasion of Ukraine in February 2022 led global markets lower, as inflationary pressure rapidly increased and caused investors to re-think economic projections. Despite reacting calmly to the initial outbreak of hostilities, the S&P500 index of leading US stocks moved decisively lower a few weeks later, and took just over one year to recover to a higher level than at the start of the Russian invasion. For those investors who correctly took the view that investment is a long-term process, this period of uncertainty will now be little more than a memory, as the S&P500 now sits relatively close to new all-time highs.

Other major conflicts and acts of terrorism have caused a sharper short-term market reaction,  which then quickly corrects once markets have had time to assess the impact. Following the suspension of global markets in the wake of 9/11 attacks in 2001, the S&P500 index fell over 11% in the space of seven trading sessions, as investors digested the US reaction and potential impact on economic prospects. The downturn was, however, very short-lived, as by October 12th 2001, the S&P500 had recovered the ground lost immediately following the terror attack and ended the year a further 5% higher.

It’s not just war

Of course, geopolitical risk does not necessarily increase as a result of conflict. The outbreak of the Covid-19 pandemic created the largest global economic crisis for a generation, as lockdowns caused significant damage to public finances and global commerce. Between April and June 2020, UK Gross Domestic Product fell by a record 19.4% during this period, only to rebound by 17.6% in the following three months, as the country slowly emerged from the first wave of lockdowns.

Investors had nowhere to hide during the early stages of the pandemic, with stock markets around the World moving rapidly lower during March and April 2020. The S&P500 index fell by 29% from 1st January 2020 to the low point on 23rd March 2020, but had recovered to stand higher than at the start of the year by the end of July, just four months later.

Many investors will vividly recall the unprecedented sense of concern at the time of the Covid-19 outbreak, and the economic damage to public finances around the World will take many years to repair. Global Equities markets, however, corrected rapidly once the initial panic had subsided and investors began looking at the fundamental recovery in business confidence and economic performance to follow.

Climate related events also have the potential to be a greater source of concern to investors over years to come. The changing weather patterns and increase in extreme weather events have the potential to reduce economic output and cause widespread damage, including disruption to supplies of raw materials, food and energy. Our view is that climate related risk may also prove to be an opportunity for those industries who are able to adapt, and the impact of such changes could be far more gradual over a number of years than the immediate impact of conflict or other global events.

Why markets bounce back

As demonstrated by recent precedents, global markets tend to be resilient and often shrug off an initial overreaction to unexpected global events. Once the initial shock of the event has subsided, investors are able to take a measured view of the impact on corporate earnings and economic growth, with markets often rebounding quickly following an initial sell-off. One of the primary reasons why this may be the case is that central banks can invoke a monetary policy response, and Governments can provide fiscal stimulus, which can boost investor confidence. It is also often the case that the global event will do little to damage future earnings, although of course depending on the nature of the event, some sectors of the economy may be more adversely affected than others.

Keep the long-term view in mind

When investing in Equities, it is vital to focus on the longer term objectives. Equity markets are volatile, and from time to time, global events push risk levels higher and can cause periods of underperformance. Whilst we cannot predict the future, we can learn from the market’s reaction to past events, and it is evident that markets often rebound shortly after the initial shock of a global event has passed. Even a once in a generation event (we hope…) such as the Covid-19 pandemic, only caused markets to retreat temporarily. Comparing index values today to the depressed levels seen in March 2020, is a potent reminder of the need to stay calm and stay invested through turbulent times.

It is at times of major concern that the ongoing advice of an independent financial adviser can prove invaluable, both to provide counsel on actions that need to be taken and reassure and aid you to focus on the longer term prospects. Our advisers at FAS are highly experienced, and through regular contact with clients, can provide ongoing advice in all market conditions. Speak to one of our friendly team to start a conversation about your financial planning requirements.

Going big in Japan?

By | Investments

For many years, Japan has been considered as “tomorrow’s story”, where there is much promise, but returns disappoint. That is until this year, where the Japanese Equities market has shown considerable strength. There is good evidence to support further outperformance; however, investors would be well advised to look to the past to understand why Japanese markets have struggled over an extended period, and the steps that policy makers need to take to avoid treading a similar path in the future.

Learning from history

The Japanese stock market has endured over 30 years of underperformance, following a significant economic bubble that formed in the late 1980s. At the time, Japan was growing more rapidly than many Western economies, and spurred on by lax monetary policy and growing investor appetite,  the Nikkei 225 – the most widely reported stock index in Japan – increased from an index value of 13,000 in 1985 to reach a high of 38,915 in December 1989. Across the board, asset prices rose, with the bubble spreading to other asset classes, such as real estate, where values of stocks and property reached overly optimistic levels of valuation.

Asset bubbles tend to end in a disorderly manner, and following the boom, the Nikkei 225 fell heavily in the early 1990’s. Following rapid acceleration during the previous decade, the Japanese economy moved into an extended period of low growth, due to the lingering effects of the asset bubble. The Bank of Japan moved to reduce interest rates to near zero, a level at which rates have broadly stayed ever since, in an attempt to reignite economic growth.

Economics and demographics

One of the reasons why Japan’s economic performance has been an outlier, when compared to other Western economies, are the demographics of the Japanese society. Population levels in Japan are in decline, and the World Economic Forum reports that more than 1 in 10 people in Japan is aged over 80. This has helped keep a lid on domestic consumer demand and there has been a tendency for the population to save, and not spend, despite receiving little in the way of interest. As the population ages, those in working age could see wages increase, leaving consumers with more money in their pockets to spend.

Deflation has been a constant threat that the Bank of Japan have had to deal with. Elevated inflation around the World has been seen as an enemy over the last two years, and whilst high levels of inflation generally harm economic prospects, extended periods of zero inflation, or deflation, have a similar negative effect.

The last year has, however, seen a change in fortune for the Japanese economy. Partly due to the global effects of the pandemic, Japan has seen the first significant bout of inflation for decades, with inflation rising from close to zero in early 2022 to reach 4.3% in January of this year. Whilst inflation has now moderated to stand at 3% in September, the return of meaningful inflation is welcome news and may see domestic demand increase and consumer confidence grow.

Regulatory reform

In addition to the welcome return of modest levels of inflation, Japan is embarking on a number of initiatives to boost investor demand. Traditionally, Japanese companies have been keen to hold large amounts of cash on their balance sheets, and regulators have announced measures to encourage these companies to return funds to shareholders, in the form of increased dividends or share buybacks. There have also been announcements improving the tax breaks offered to encourage Japanese households to move away from traditional cash savings and invest in their economy through share ownership.

Valuations are attractive

When using recognised metrics, Japanese Equities appear to be attractively valued when compared to most other global markets. This may well see a spark in overseas buyer interest, after many years where investors have been reluctant to hold significant allocations to Japan. Indeed, Wall Street veteran Warren Buffett’s announcement that he intends to increase allocations to Japan in April was seen by some as an endorsement of the value in Japanese Equities.

Artificial Intelligence and advanced manufacturing have been drivers of global markets over the last 12 months, and Japan is well placed to benefit from the quest to achieve further automation of human tasks, given the nation’s strong history in areas such as robotics. Japan also has a number of companies who provide solutions that can meet demand for a more energy-efficient and greener future, such as Toyota and Honda.

The importance of diversification

There are several reasons that support the view that Japanese Equities look attractive; however, risks do remain, and whilst the regulatory reforms may prove helpful, there is still significant pressure on central bankers to steer a successful course as inflation slows around the World. This is why we recommend allocations to Japan are held as part of a diversified investment portfolio, which is an important method of controlling investment risk. Allocating funds to different regions, where performance does not necessarily correlate, and to different asset classes – such as Government and Corporate Bonds and Alternative Investments – can help reduce overall portfolio volatility.

Speak to one of our experienced financial planners to discuss the asset allocation of your portfolio.

The quest for real income

By | Investments, Savings

Base interest rates have increased sharply over the last 18 months, as Central Banks aim to tackle high levels of inflation. As a result, interest rates on cash deposits have increased and those who look to produce an income from savings and investments can now generate relatively healthy levels of interest from deposit accounts.

On the face of it, cash is a risk-free investment, as the initial cash balance deposited does not fluctuate in value; however, the hidden risk in holding cash is the eroding impact of inflation. Let’s look at a typical savings account that is paying 4% annual interest before tax, which was opened one year ago. At face value, holding a deposit in this account will have earned 4% return and you will still hold your capital value. The hidden risk is that the real value of the cash deposited – i.e. adjusted for inflation – will have fallen. At the time of writing, the rate of UK inflation over the last 12 months has been 6.7%, which means that the amount deposited will be worth 2.7% less in real terms than when the account was opened. There are other risks of cash too, as the highest paying accounts restrict access to your money, and attention needs to be paid to the limits afforded by the Financial Services Compensation Scheme.

As we move into 2024, we expect interest rates to fall as inflationary pressure eases further, and the eye-catching rates on offer now may be a distant memory in twelve months’ time. This leaves investors who are holding cash needing to find another home as a way of generating income. This is where Equity Income investments have a real advantage over time, and as part of a diversified portfolio, can look to generate an attractive and rising income yield.

Look to dividend income

Part of the return from holding Equities are the regular distributions of excess profits, in the form of dividends. Most mature companies declare dividends to shareholders at regular intervals, and a company that enjoys a strong performance may well look to increase its’ dividend payments over time, which could potentially offset the effects of inflation.

There are a number of global stocks that have a track record of increasing dividends year on year, with the likes of Coca- Cola, IBM and Johnson and Johnson being prime examples of US listed global companies who have consistently raised their dividends each year for the last 25 consecutive years. The UK also has a smaller list of companies who have consistently raised their dividends, such as British American Tobacco and Diageo.

Dividend income is only one part of the potential return that can be achieved from holding Equities, as holding company shares can also offer scope for capital gains over time. Whilst Equities will introduce short-term volatility – which is not a feature of cash accounts – the long-term track record of returns generated by Equities markets highlights the capacity for Equities to significantly outperform returns achieved from cash deposits.

Spreading the risk

Dividends are, however, not guaranteed, and by holding individual Equities you introduce stock-specific risk. Changes in the fortunes of the company in which shares are held can not only impact the share price, but also the potential for dividend growth. Indeed, a company that begins to struggle may look to cut its’ dividends, or cancel it altogether.

As a way of mitigating this risk, we would suggest that holding Equity Income funds is a more appropriate way of gaining access to companies that pay an attractive dividend stream. This can help avoid the potential for issues with one particular company or sector having too great an impact on the overall fund value. Whilst there are a limited number of passive investments that specifically target stocks with increasing dividends, the majority of Equity Income funds are actively managed. This is where a manager or management team will look to select positions and build the portfolio, with a view to holding companies that offer an attractive and increasing dividend yield, and good prospects for capital growth over the longer term.

Equity Income funds cover most geographic areas of the World, providing access to dividend producing companies from the UK, US, Europe and Far East. There is also a wide range of Global Equity Income funds, where the fund manager can select the most appropriate positions from anywhere in the World.

As the performance of an actively-managed Equity Income fund relies on the skill of the manager, it is important to select the right fund – or blend of funds – to seek out the best performance. The level of income, and overall return, achieved from within the Global Equity Income sector can vary significantly from the best to worst performance over time, and this is where careful analysis of the fund, portfolio strategy and management style are crucial. The FAS Investment Committee regularly meets with leading fund managers from all sectors, including those who manage Equity Income funds. These regular meetings strengthen our quantitative approach to fund selection, so that we can truly understand the methods and rationale behind the portfolio selection process.

Equities as part of a diversified portfolio

It is important to point out that Equity Income funds are one of a range of different options for those seeking an income from their savings or investments. Cash deposits absolutely have a place in most sensible financial plans; however, the amount held in cash needs to be considered carefully, as the hidden eroding impact of inflation over time can easily eat into the real value of deposits.

Speak to one of our experienced advisers to discuss the options to generate an income.

Background illustrating bond market data

Time to revisit Bonds?

By | Investments

After the very difficult conditions for Bond investors seen last year, we are seeing growing evidence that a change in direction is now likely. This could herald an improved performance for an asset class that has struggled over the last 18 months and suggests that good opportunities exist in Fixed Interest markets at the present time. We take a closer look at Bonds as an asset class and why now may be a good time to consider Bonds as part of your portfolio.

 

What is a Bond?

Bonds are issued by governments and companies when they want to raise money. By buying a bond, you’re effectively loaning your capital to the government or company, and in return, they agree to pay you back the face value of the loan on a specific date, and pay you interest during the life of the Bond.

The characteristics of a known redemption date and a fixed rate of interest should mean that Bonds produce less volatility than Equities (shares) and are also more predictable. Other factors that influence the risk of a Bond include the financial strength of the government or company issuing the Bond. The more secure and financially stable the issuer, the more likely the Bond is to be repaid in full. The length of time before the Bond matures is also a key factor. Bonds that are due to be repaid in a relatively short period of time (say 5 years or less) are less volatile than those that redeem in 20 or 30 years’ time.

 

Why was 2022 so difficult?

Bond markets tend to do well in periods when interest rates are low, as the yield (the return offered by a Bond) looks attractive compared to the rate of interest you could obtain through a bank or building society. Last year was, of course, dominated by the sharp rise in inflation, which was caused by the aftermath of the Covid-19 pandemic and exacerbated by the Russian invasion of Ukraine. Central banks across the Western World began hiking rates from the end of 2021, in an attempt to slow the rate of inflation. Indeed, the speed at which rates increased caught many by surprise.

As interest rates rose sharply, the only way for Bonds to remain competitive with overnight money is for the price to fall, which in turn increases the yield. There was nowhere to hide within Fixed Interest markets, and whilst some protection could be found in shorter dated Bonds – in which we held good exposure throughout the last 18 months – the value of Government and Corporate Bonds fell. Whilst this led to disappointing returns last year, it does not mean that Bonds are attractively priced.

 

Why is the outlook brighter?

The Bank of England and US Federal Reserve have both now paused their rate hiking cycle, bringing to an end a run of successive rate increases. Whilst there remains a possibility that either or both could raise rates again, we feel this is unlikely. Firstly, we expect inflation to continue to fall over the remainder of this year and into 2024, and the speed at which inflation returns to more normal levels could be a surprise. UK inflation data in August was weaker than expected and in the US, inflation rests just above 3%.

Secondly, economic growth is likely to slow through the next 6-12 months in many Western economies. Ratings agency Fitch recently reduced the outlook for global growth next year, and the OECD projection is for the US economy to rise by only 1% during 2024. Consumer confidence is expected to weaken and the housing markets in both the US and UK are both under pressure given the impact of higher mortgage rates.

As a result, the next substantive move in interest rates may well be down. Economists and market participants are currently weighing up whether rates will be eased gradually or potentially more aggressively, depending on the pace of economic growth. Central banks are adopting a policy whereby their decisions are being led by inflation, unemployment and growth data. Should data remain strong, then there is a case to suggest that rates will only fall gradually, but in the event that data is weaker than expected, then calls will grow for central banks to take more rapid action. There is also discourse as to the timing of rate cuts, with some suggesting the first cuts could come in the first half of next year, whilst others seeing the easing cycle starting in the third or fourth quarters of 2024.

Just as increases in interest rates are generally negative for Bonds, cuts in base rates may well prove positive. At the time of writing, a 10 year US Treasury Bond is currently yielding 4.6%, which doesn’t appear overly attractive when compared to overnight interest rates available on cash deposit; however, a yield of 4.6% could look very attractive should base rates fall over the medium term, say to between 3% and 4%.

 

Time to revisit Bonds?

After a very difficult 18-month period, Bond prices are attractive, and we feel there is good reason to see value in Bonds at current levels. Investment Grade Corporate Bonds (i.e. those Bonds issued by companies who credit rating agencies deem to be financially stable) and Government Bonds may well see a slow re-rating, as the economic landscape changes over the coming year. Despite the fact that the default rate (that is to say the number of Bonds who fail to repay capital or interest to investors) remains low, a slowing economy could lead to an increase in defaults from more speculative Bonds.

Diversification is a key component of a successful investment strategy, and any allocation to Bonds should be balanced with other assets, according to your attitude to risk, objectives and time horizon. This is why taking advice on the correct asset allocation for your circumstances is an important step for most investors to take.

Speak to one of our experienced advisers here about the outlook for Bonds and Fixed Interest investments, and how they could fit into your investment portfolio.

Graphic of a hoodie covered with dark stormy skies being unzipped to reveal sunny blue skies, representing a brighter future.

The end of the cycle

By | Investments

As traders head back to their desks after the summer break, thoughts turn to the prospects for markets over the remainder of the year. What is apparent is that the conditions this Autumn appear to be calmer than one year ago. It is perhaps easy to forget that almost 12 months ago, then Chancellor Kwasi Kwarteng had just delivered a controversial budget that spooked markets. At the same time, inflation was climbing month on month and Equities and Bond investors took flight to safety, amidst high levels of volatility.

Looking back, it is no understatement that 2022 will be remembered as a tough year for investors. It was also highly unusual, as the impact was felt across all asset classes. Indeed, according to a study carried out by Blackrock, last year was one of only three years in history where both Equities and Bond markets returned a negative performance in the same calendar year.  It is important to remember that markets always look forward, and whilst we can ruminate on the difficult conditions of last year, the future prospects for corporate earnings and government and monetary policy will shape the performance of markets in the months ahead – and the prospects are certainly looking brighter.

 

The end of the cycle?

Much of the market’s attention since early last year has been focused on the actions of central banks in their attempts to curb inflation. As expected, inflation is now falling quite quickly in some parts of the World (i.e. the US) and a little more slowly in others (i.e. the UK). As inflationary pressure eases, so does the rationale for central banks to continue to raise rates. In addition to the fall in inflation, other important economic measures are adding weight to the suggestion that we are close to the peak of the cycle. Unemployment data, which has been resilient over the course of the last year, has softened over recent weeks in both the US and UK, and the outlook for the UK housing market is gloomy. These trends are likely to continue and as a result, economic growth may well slow in the next few months.

We have long argued that central banks may have been too aggressive in raising interest rates, given the lag between policy decisions being made, and the time taken for these decisions to impact on the economy. As a result, as inflationary pressure eases further, we feel markets will focus on the timing and speed of rate cuts as we head through 2024.

Both Bonds and Equities should benefit from easier monetary conditions. High inflation and rising interest rates work against Bonds and Fixed Income investments as they make the yield offered by the Bond less attractive when compared to cash rates. As expectations rise that monetary policy will pivot, Bonds should gain more attention, and many are currently priced attractively. Lower borrowing costs over time should also help ease the pressure on corporate borrowing, and help companies finance their operations.

As ever, risks remain. It is possible that inflation doesn’t fall as quickly as expected, which could lead to central banks delaying their expected pivot to lower rates. The recent jump in Crude Oil prices, for example, is one of a number of external shocks that could sway the course of interest rates. China’s debt-laden property market and slow recovery post-Covid could also have an impact. We do, however, feel markets have, to some extent, already priced in the “higher for longer” narrative.

 

Corporate Earnings remain positive

One of the key drivers of the improving outlook has been the strength of corporate earnings. The recent US reporting season saw over three quarters of companies announce profits ahead of expectations, confounding some predictions that earnings reports could be lower. Whilst there have been a handful of notable companies where earnings disappointed, many others have seen estimates for their future earnings increase.

Equities performance in the first half of 2023 was dominated by what we would identify as “growth” investments, which are often involved in technology and new industries. As the landscape changes, we would expect to see the focus shift in favour of companies with good levels of dividend yield and more value-based characteristics. Corporate balance sheets largely remain healthy and dividends are generally well covered. The contribution to overall investment returns achieved by dividends over time should not be underestimated.

 

Political risks and opportunities

As we move forward to next year, investors will need to consider the impact politics can have on market sentiment. There are, of course, key Elections in both the UK and US next year and the sitting administrations will be keen to see their economies in reasonable shape, as the electorate’s personal financial position is usually one of the key drivers of voter intention. History would suggest that election years tend to be broadly positive for markets; however, we need to be alert to the potential risks that a scenario such as that seen in the US in 2020/21, where no clear winner was apparent for some time, is not repeated, as this has the potential to cause a spike in volatility.

 

Brighter skies ahead?

Investors have had to negotiate rough seas over the last 18 months, but the end of the rate hiking cycle could well be in sight. A shift in monetary policy may well see calmer waters return over coming months, and evidence is building that 2024 will see us move to less volatile market conditions.

If your portfolio is not regularly reviewed, now is an opportune moment to consider your existing assets to see whether they are well positioned for the expected market conditions. Speak to one of our experienced advisers here to start a conversation.