Standing back from the Eurozone
Standing back from the Eurozone
The media is currently dominated by news and comment about financial stress within the Eurozone. The television pictures showing riots in Greece, withdrawals from banks in Spain and the increasing popularity of more extreme political figures contribute to a pretty gloomy mood. This, combined with the resumption of recession in the UK, is undoubtedly affecting investor sentiment and explains why markets have retreated sharply April and May.
We cannot help but be influenced by this negative news as we are immersed in it, but it is very important that as professional investors we stand back from the media noise and take an unemotional and analytical look at events and opportunities in order to ensure that we make rational judgements.
Interest rates are at 320 year lows and remain much lower than inflation. Over the last three years which, the UK Retail Prices Index has risen by just under 15% and returns on cash have been 2.6% (based on UK three month LIBOR rates). This equates to a 12% loss of real spending power by arguably taking the ‘safe’ option. Interest rates are likely to remain low in an environment where the debt burden is still substantial, and indeed, the Bank of England has certainly left the door open to the possibility of further quantitative easing to keep interest rates as low as possible and thus to manage the costs of servicing our debt burden.
UK Government bonds have performed spectacularly well, rising by over 30% during the last three years which adjusted for inflation, equates to a 15% increase in real spending power. The returns on offer from ten year gilts are now only 1.5% before tax. Corporate bonds have been producing much more attractive income returns and some capital appreciation, albeit much more modest than that of sovereign debt as they do not offer the same safe haven status.
Equities offer fundamental value relative to cash and gilts and certainly fair value in the context of history. The UK market stands on a price earnings ratio of 10x, with the FTSE 100 offering a yield of 4.3%. Over a ten year period, even without any dividend growth, the FTSE 100 Index would return 52.7% in income terms versus a ten year gilt producing a return of 18.3%. In theory, the FTSE 100 Index could fall by over 34% during the ten year period and the net returns would be the same as they would for the ten year gilt, so it seems fair to argue that the equity markets offer some opportunities for the brave.
The difficulty as far as equity markets are concerned is that they are likely to remain volatile due to current uncertainty. The Eurozone is clearly the dominant theme, but other concerns include the slowdown of growth in China and whether or not corporate profitability is at a high and therefore subject to disappointments going forward.
Equities considered to be defensive are performing reasonably well, such as drugs companies and tobacco stocks, whereas any stocks exposed to the financial sector, or which are very sensitive to the economic cycle, have been hit very hard as growth expectations are reined back.
Amongst alternative investments, which should behave differently to stock markets, many have disappointed in the last few years due to high fees, poor liquidity, a reduced ability to use leverage and more restrictive regulations.
So what should investors do?
We know that economic uncertainty will persist, as there are no easy solutions to the Eurozone problems. It is still not clear whether the action being taken will lead to inflation or deflation and so this appears to be an impossible environment for most investors. Given so many uncertainties, it is essential that we focus on what we do know.
Index linked gilts will offer a degree of protection against inflation. High quality equities offer good value and in the alternatives investment arena, a small number of trading funds run by high quality organisations that have proven themselves to be capable of adapting to today’s environment will continue to make steady gains and help to manage risk in clients’ portfolios.
The most important point to focus on at times of stress is that investors must give themselves enough time for investments offering reasonable value and protection against inflation to prove their worth. Investors who have a short term need for cash should ensure that they have sufficient available to them to get them through the next couple of years. Beyond that, provided the investments held are appropriate to an investor’s circumstances both in terms of type and proportion, then taking a longer term view is essential since trying to respond to short term market movements is an impossible task.
We do believe that there are reasons for optimism amidst the unremitting – negatives, on longer term valuation techniques favoured by renowned investors such as Benjamin Graham and his acolyte Warren Buffett markets are approaching fair value to in many cases looking cheap. However an ability to withstand some volatility will be crucial to making reasonable returns over the medium term.