Investment newsletter - April 2016

Investment Newsletter April 2016

Blossoming Markets?

Mike Deverell Investment Manager

The past month or so has certainly been quieter than the previous months of this year.

After its volatile start to the year, the FTSE 100 recovered above the 6,100 level at the beginning of March. From there until 13 April, it stayed largely within the range of 6,100 to 6,200, with volatility dropping off a cliff.

In our recent investment committee meeting we remarked that it was quiet, perhaps too quiet! In fact, after the deluge of new information to digest over the first couple of months of the year, there have been surprisingly few new developments over the past six weeks.

Essentially, what we have seen is a trend of each new piece of data being slightly better than the last, leading to more stability in markets if not stellar growth.

We had remarked that the events of January and February were a result of a perfect storm where various issues all happened at the same time. Each one of the things concerning markets at the start of this year has improved recently. The storm has passed and perhaps we are now seeing the green shoots of recovery.

For example, the global economy slightly picked up after its weak start to the year. In particular, we saw better news from China and from US manufacturers, two areas which had been concerning markets.

This has been helped by a weakening dollar and a stabilising Chinese currency. Partly, this was in response to indications from the US Central Bank, the Federal Reserve, that they will not increase interest rates as much this year as previously thought. Again, this was an issue worrying investors.

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

Investment Newsletter April 2016

All tied in with this are commodity markets, which have also slightly improved. The weaker dollar helped oil to recover, as it is priced in dollars. It has recovered back above $40 a barrel, well above the $28 level it hit in January, but still significantly down on the $100+ we saw until around two years ago.

our two funds gained over 5% in two days after weaker performance before that.

All in all, a variety of small improvements in a number of indicators has led to a much more stable stockmarket.

This is partly in response to a levelling off of oil production, closing the gap between supply and demand. The recovering commodity prices reduced fears of deflation.

When markets flatline like we have seen until recently, it seems like we need a new catalyst to make them move out of the range, in either direction. Low volatility usually makes us nervous for this reason, but in this instance we have seen a positive catalyst in the shape of export growth from China.

This was well ahead of expectations with double digit annual growth, and has allowed the FTSE 100 to jump above the 6,300 level.

It also led to a bounce in other markets, notable Hong Kong but also in Japan, where

QE and Corporate Bonds

Equities were not the only asset class to sell off in January and February. Corporate bonds, particularly those from lower rated companies, also sold off.

When you buy a corporate bond you lend money to a company for a fixed period of time and for a fixed level of interest. The price of a corporate bond will depend on how attractive that interest rate is to an investor.

This will be affected by what return an investor can get elsewhere, such as the interest on cash or on safer government bonds (or gilts).

It will also be affected by credit risk. If a company were to go out of business then they may not be able to repay the loan. The higher the perceived chance of that happening, the higher yield investors will require. As a result, when perceptions of credit risk rise, the price of a bond falls meaning its yield will increase.

Earlier this year, investors became worried about a global recession. They also noted that the number of defaults on bonds was starting to rise, particularly in the US. The prices of many corporate bonds therefore fell, increasing the yield for purchasers.

At the same time, expectations of future interest rate increases declined. Gilt yields fell to record lows as investors decided that the Bank of England was unlikely to put rates up at any time in the foreseeable future.

Meanwhile, the European Central Bank and the Bank of Japan cut rates into negative territory. The yields on German and Japanese bonds with maturities up to 10 years turned negative. If you lend money to one of those governments, you have to pay them over the course of a decade for the privilege.

All this meant the difference between the yield on a corporate bond and a government bond widened dramatically. In February last year, a 10 year gilt yielded around 1.4% pa, whilst the main corporate bond index had a yield of around 3% pa, a difference of 1.6%.

By February this year, with gilts again around 1.4%, the yield on the corporate bond index was around 4.1%, a difference of 2.7% pa.

We felt that this was a very attractive premium and at the beginning of March we topped-up fixed interest for

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

Investment Newsletter April 2016

the first time in a couple of years. We have previously been very light on fixed interest and held additional property instead. We have since reduced property and topped up corporate bonds some more.

So what of the possibility of default? We think the risk is overrated and, like stockmarkets, has been driven by issues in the energy and mining sectors.

The chart below shows the default rate of American high-yield (HY) bonds; those considered less secure.

The blue line shows the overall default rate, and the red line shows defaults in the commodity related sectors. The black dotted line shows the default rate excluding energy and mining:

Whilst the overall default rate (blue) has increased, this has been almost entirely driven by commodities (the red line, which is measured against the right hand axis). If we exclude that sector, defaults remain extremely low.

As with equities, the specific issues in commodities have had a knock-on effect onto other areas. The recent stability in China and in global manufacturing has helped commodities stabilise, and that helps both equities and fixed interest.

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

Market Views April 2016

General Economic Overview Global growth is weak but remains positive. Weak commodity prices have weighed on the growth of emerging markets and this has fed through to concerns regarding deflation in many developed economies.

However, the recent bounce in some commodity and energy prices have served to assuage some of these concerns and investors’ appetite for risk has returned, reversing some of the trends seen in January and February. Improved growth data from China and the withdrawal of supply have underpinned the commodity price movements.

Inflation will increase as the effects of last year’s oil price fall start to drop out of the calculation. The Bank of England is unlikely to tighten interest rates this year although the Federal Reserve is expected to raise rates at least twice in 2016.

Asset class key + positive - negative = neutral (normal behaviour)

+5 strongly positive -5 strongly negative

Asset Class

Score

Equity Markets This score is unchanged since last month. Most stockmarkets are fair value but corporate earnings growth remains patchy and this is likely to limit the level of returns we can expect from equities. We continue to prefer Japan and smaller companies in the UK.

-2

Fixed Interest Our score remains at -1. The ‘spread’ between the yields on corporate and government bonds had become very wide in early 2016. As markets have risen over recent weeks, this spread and the overall level of yields have fallen (given the inverse relationship) but still offer attractive value.

-1

Commercial Property Our score has remained at -3. Returns from commercial property are slowing as demand and supply are reaching more of an equilibrium. As such, future returns from property will be driven primarily by the level and growth of rental income.

Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.

-3 -5

Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest, equity and property. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.

A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.

These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed.

Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.