Investment Commentary – November 2011

November 29, 2011

In my April 2011 commentary, I commented that little had changed from our previous views.  We continue to see high volatility in equity markets, low interest rates, robust corporate profits and value in equity markets.  We now also see daily news flows about concerns for the Eurozone with Ireland, Portugal, Greece and now Italy suffering political change driven by excess government debt.  It is difficult to imagine how the solution offered to Greece (effectively writing down some government debt by 50%) could work in Italy given that the latter’s Government debt is about 6 times the quantum of the former’s [Source: Invesco Perpetual October 2011] – the effect on the European banking system would be catastrophic.  Instead, Europe may look to some form of prolonged austerity programme or full fiscal union.

Given all these unknowns, it is impossible to predict the short-term future.

UK investors remain in a very difficult situation.  Interest rates remain low and are predicted to remain so for at least the next 2 years [Capital Economics 17.8.11].  In relative terms, inflation remains stubbornly high and is not reducing significantly.  Capital Economics predict sharp falls in 2012 but such predictions (from governments) have, so far, failed to materialise.  Recent economic data is negative with exports falling (especially to EU countries) and industrial production weakening to such an extent that Capital Economics predict an industrial sector recession [8.11.11]. 

This is a very negative backdrop. The obvious catalyst to stimulate a positive movement in equity markets is a resolution of the peripheral Europe sovereign debt situation. However, the timing of this is difficult to identify and the methodology of implementation is currently unknown. Markets need EU leaders to have and implement a plan. 

Our view is that this is probably one of the best opportunities for investment for the longer term.  If future positive movement was predictable, markets would already have bounced.  Long term returns in equities are shown in the table at the foot of this commentary to be 9.3% p.a., handsomely beating every other asset class.  Markets perform in cycles with investors in 1969 seeing 13 years of, on average, 1.8% p.a. negative returns followed by 18 years of, on average, 13.6% p.a. positive returns.  Investors in 2000 saw 10 years of, on average, 1.2% p.a. negative returns [Schroders February 2011].  The question is – what might drive markets positively like the run from 1982 to 2000 once a coherent plan is in place for the peripheral European sovereign debt issues (causing markets to stabilise and sentiment to turn)?

• Clearly banks need to start lending again to kick start economies.  In the US, a study by Arbuthnot Securities [16.9.11] suggests that US banks are two thirds of the way through the process of repairing their balance sheets.  This suggests that normality may recur sooner than the market currently believes? (The same study suggests that UK and European banks are not as advanced as their US counterparts in this repairing process)
• The Irish economy is managing to recover and restore some stability.  A favourable tax system and multinational companies with strong exports are driving the economy forward.  It would be very positive to see similar success in other economies.  If Portugal manages to replicate this success, belief might return that the current situation is reversible.
• Statistics suggest that the UK stockmarket is currently better value than it was in the 1980s.  One measure of stockmarket value is the ratio of share prices to company earnings (the Price/Earnings ratio).  In the 1980s, the average P/E ratio of the UK stockmarket was 14.7.  The figure is now 11.8 (the lower this figure, the lower the current price, hence better value).  This measure underlines the strength of UK companies whose earnings remain very strong.  (Incidentally, the P/E ratio in the Eurozone is currently 10.2).  [All data sourced from Cazenove 1.10.11].  A modest change to sentiment could drive investors back to equities given these obvious statistics.
• Even if we do enter a further technical recession, history suggests that equity markets perform well in recessions increasing by, on average, 8.7%.  (There have been 14 recessions between 1926 and 2001 with an average length of 11 months) [Cazenove 1.10.11]
• UK Pension funds are heavily invested in Gilts which are currently delivering negative real returns (data in the NAPF’s 2010 annual survey show UK pension funds own more than £100bn of gilt holdings, amounting to about 11 per cent of total issuance – [Source: FT.com 7.3.2011]).  Some pensions are obliged to keep pace with inflation and it is difficult to see how long this investment strategy can continue.  Any move from gilts to equities would be positive for equity markets.

In the more immediate future, the process of deleveraging (paying down debt) at government, corporate and individual levels is likely to result in slower growth in the developed world.  In turn, this is expected to have a negative impact on investment returns which are likely to be lower than have been seen in the past.  Our current view is that investors should consider investing in stocks and funds with higher dividend streams (provided investors capacity for loss and risk profile is suitable for this type of investment).  Fortunately, recent developments in fund management are exploiting the growing trend for businesses around the world to pay out dividends and these have produced a number of high quality funds not only investing in the UK but also in global equity markets.  In an environment where growth is lower on average, reinvestment of a 3 or 4% p.a. dividend could add substantially to long-term investment returns.  However, businesses that internally reinvest should not be ignored.

Our other central view is that investors need to consider taking on more risk than they might have accepted in the past if they want to avoid erosion of capital in real terms.  It is important that investors understand that this risk is volatility risk and not the genuine risk of losing money (although this is always possible under very unusual circumstances).  Long term investors in equities have rarely seen capital losses, particularly over rolling 10-year periods.  They have experienced considerable volatility and investors who are not prepared to accept this are now in a very difficult position.

Pearson Jones advisers are well placed to discuss this dilemma with our clients.  In 2008, Sir John Templeton wrote “A diverse portfolio of stocks with proven global earnings power remains the most certain path to continued prosperity in these difficult times”.  We support these views and encourage clients to discuss risk with their advisers at their reviews.

To plan finances sensibly, clients and Pearson Jones’ Consultants must make educated assumptions for the future.  To provide a basis for this, the following “House View” should prove useful.

Past performance is no guide to the future and no statement in this commentary constitutes any form of individual advice or guarantee.  The value of investments can fall as well as rise.

Information in this document represents a consensus of views from various sources including those of Pearson Jones plc.  Readers should not act on the comments made in this document without the benefit of Independent Financial Advice from a Pearson Jones Consultant.

PETER HECKINGBOTTOM FCIB APFS
Chartered Financial Planner
Deputy Managing Director & Investment Director
peter.heckingbottom@pearson-jones.co.uk