Whether the UK is currently experiencing stagflation (high inflation, low growth) or recession (low inflation, low growth) is subject to future statistical analysis (because you don’t generally know whether you’re in a recession until it’s nearly over). Stagflation is bad for UK equities (historically UK equities have delivered returns of only 2.2% p.a. in these periods). In any other environment, UK equities have averaged returns of 11.6% p.a. (including recessionary periods). (Source Goldman Sachs).
The question which needs to be answered in these circumstances relates to actions which investors should take now to both mitigate further downside movements and place themselves in a position to catch the upside of the market (whenever that occurs).
What investors should definitely not do is to sell out of the market now. Today, the FTSE100 index closed at 5666, when its 12 month high point stood at 6730 (Source BBC). This fall is over 15.8%. Pessimists point to the UK housing market following the US with 30% falls in house prices being a possible/likely scenario. Again, history will tell whether this is correct. Long-term investors need to consider the impact of such a scenario on their investments and I would argue that this is potentially quite slight. The UK consumer would be dramatically affected by such a dramatic fall particularly if unemployment figures continue their (very recent) upward trend. (The positive factor here is that rising unemployment should curb wage demands which should, in turn, ensure that inflation remains at manageable levels.) However, the UK FTSE100 index is not closely correlated to the behaviour of the UK consumer as the majority of earnings are derived from overseas.
So what is a sensible strategy? There is certainly a considerable weight of research which indicates that remaining invested in markets delivers better returns than trying to time investment decisions (Source Fidelity). Mitigating risk should be achieved by diversification. UK investors should look more to global markets to provide this diversification. There has been a reluctance amongst UK investors to look outside the UK for investments in the false belief that such investments involve higher risk. Yes, there is additional risk in currency fluctuations but there are strong mitigating factors. In Europe, consumers are less leveraged (i.e. they have less debt) so will be less affected by the credit crisis than in the UK. In Asia, trade surpluses are being used for investment in the future and there is a very significant potential upside in the region, including Japan. Emerging Markets continue to provide excellent opportunities for investors.
UK commercial property investments remain a worry. Values fell dramatically in the second half of 2007 but have not fallen much subsequently. Since this time, the FTSE100 has fallen to current levels and switching from property to equities is a brave but potentially profitable decision in today’s market. If investors shy at the increased volatility risk, using a Structured Product (gaining access to the market with underlying capital protection) would seem a sensible solution.
In UK equities, if the consumer is set for a torrid time, investors should avoid mid-cap equities (smaller companies where success depends on the UK consumer) and switch into large and mega-cap companies (such as those in the FTSE100). Valuations here look very attractive on any mid to long-term view. As mentioned previously, such companies should avoid many of the problems associated with the UK consumer.
Corporate bonds continue to offer very good opportunities despite potentially rising interest rates and increasing defaults. Distressed sellers (hedge funds) appear desperate to sell stock at any price; prices have been falling when interest rates have been following (the opposite should occur) and fear of defaults has resulted in further sales which have further depressed prices. The canny fund managers are picking off selective stocks keenly in anticipation of re-ratings.
Finally, the big unknown relates to commodities. Some commentators are suggesting that oil might hit $250 per barrel by the year-end (Head of Gazprom). Others are suggesting $100 (Invesco Perpetual). Such disparity reflects the position that no-one really knows the outcome. What is certain is that the market (across every commodity) is driven by speculators. The sensible strategy would be to take profits (if currently invested), avoid (if not) or protect the investment via a Structured Product (as above). The talk of a “bubble” in commodities sounds to me to be the most likely scenario. The question being “when will it burst”?
Short-term investors must brace themselves for difficult times. Hindsight suggests that, investing in difficult times produces the greatest rewards in the longer term. Investing cash now might not produce results in 6-12 months but I would suggest that such investors (and they are investors, not speculators) will look back on these investments in 3-5 years and reflect on the merit of their decisions and the very positive returns they have derived.
Pearson Jones recommends a number of funds which are suitable for all the above scenarios and clients should seek further information from their consultant.
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.
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Historic Long Term Average (Source Sarasin) since 1900
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Pearson Jones “House View” over short-medium term
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Inflation
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3.9% p.a.
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Above average; estimate 5%+
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Equity Returns
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9.5% p.a.
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Average; 9%
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Gilt Returns
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5.2% p.a.
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Above average short term reverting to average long term; 7% (short term)
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Cash Interest Rates
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5.0% p.a.
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Above average short term reverting to average long term; 6.5% (short term)
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Past performance is no guide to the future and no statement in this commentary constitutes any form of guarantee.
PETER HECKINGBOTTOM FCIB APFS
Chartered Financial Planner
Deputy Managing Director & Investment Director
peter.heckingbottom@pearson-jones.co.uk