Market Movements
Around this time last year, we were nervous that there was a disconnect between the rate at which the Federal Reserve expected interest rates to rise and the rate of increase implied by equity and bond prices.
The result was a reasonably sharp but reasonably limited decrease in asset prices around the early part of this year.
The same set of conditions have prevailed in the last few weeks.
It is widely reported in the press that investors are reacting to a rise in the 10-year rate and to the threat of a trade war and just about anything else. In our view, these market movements are almost entirely due to price changes connected with the potential for changes in short-term interest rates.
Consider the possibility of a 1% rise in the main policy rate of interest in the US. Today, the upper limit on rates in the US is 2.25%. A month ago, bond prices implied that the probability of a Fed Funds rate at 3.25% by this time next year was just 11.5%.
At that time the Federal Reserve thought there was a chance as high as 50%. That’s a big disconnect.
And recent comments made by Jerome Powell, Chairman of the Federal Open Market Committee, have highlighted that disconnect. Jerome Powell thinks the US economy is doing very well and can happily sustain a gradual increase in interest rates. (We happen to think he’s right).
Last week, the yield on the 10-year treasury spiked higher from 3% to 3.25% – exactly as we would expect if the market was beginning to reappraise its assessment of future interest rates. Indeed, the market implied-probability of a 1% rate rise by this time next year went from 11.5% to 20.1%.
And where the bond market went last week, the equity market has gone this week. It is no surprise that those stocks most sensitive to interest rates (low-yielding, highly-valued tech stocks for example) are those that have fared worst.
In our view, a rate rise in the order of 1% a year represents some kind of ‘not-too-fast, not-too-slow’ movement. And we think there is indeed a 50-50 chance that the Fed will increase rates by the full 1% over the next 12 months, beginning with a rate rise in December.
We’d feel much more comfortable if the market was priced for something like a 30% chance. So, a little more volatility – as prices further adjust – is entirely consistent with our outlook.
If we’re right in our assessment, the extent and duration of that volatility will be limited. We might see portfolios test a 10% decline in ‘peak-to-trough’ values.
Remember though, the reason the Fed want to raise rates is that the US economy is doing well enough to sustain rate rise.
A strong US economy is good for the world economy. What is good for the world economy is good for investors.
In any case, the correct course of action is for long-term investors to stay focused on the long-term (see more below in “Complacent”).
We see nothing unusual in present-day market movements.
The UK (aka Brexitville)
Brexit has the potential to have a dramatic effect on gilt yields.
With no deal, the pound will drop 10-15% and inflation will go up as imports become more expensive. In this scenario the Bank of England will do nothing with interest rates.
A lower pound means the trade deficit should narrow. More people buying British products will improve our economy. A declining pound is not a bad outcome for a diversified portfolio. If anything, it should benefit it.
If a hard deal is made, the pound may go up slightly due to there being less uncertainty. We think the pound is priced for some sort of soft deal though.
If we get a Canada+ deal, Europe have to give Canada the same + deal. The Canadian deal is “ratcheted” – if either Canada or the EU do a better deal elsewhere then those better terms will apply to either Canada or the EU as appropriate.
Therefore the UK is unlikely to do better than the Canada deal.
The chances of there not being a deal are slim. Politicians are employed to make deals. It would be very embarrassing for the EU not to do a deal, see the UK revert to the WTO rules and do well.
The EU need to have a deal to demonstrate that conditions have been imposed on us.
The Irish border is a political side show in all of this. The Good Friday Agreement does not permit any infrastructure along the border. The EU will work a deal round this.
And, lest we forget, the things that make Britain (or any country) successful are not EU-dependent and never have been.
Those six things are the legal framework, stable politics, consumerism, industrial revolution / innovation, work ethics and property rights. They existed before the EU and will exist after the EU.
Politically there’s little to worry about either.
The 5-year fixed term parliament can be overridden by a majority vote in parliament, but this will not happen. No-one needs to give Corbyn a chance to get elected, so they won’t and 2022 is a long way off.
If there is no deal, there could be a leadership challenge which can happen without a general election. In any event, Theresa May will not be fighting the next election.
Other observations
Global growth is slowing a bit from 4.5% to 4% but all regions were growing in unison. Inflation is low, interest rates are low, employment is high.
The US / China trade war is the opening round of a broader (non-military) war between them. There are tariffs on import / exports between America and China. It is having an impact on growth for both countries. But China doesn’t import anywhere near as much from the US as the US does from China. China’s scope for retaliation is therefore limited.
The war is really to do with the US not wanting their technological innovation leaked to China. Good luck with that. The US has won 368 Nobel prizes, the UK is second with 132, Germany 107 (3rd) and France 62 (4th). Japan interestingly is 7th with “just” 26. Innovation and technological advancement are still very much in the West.
Are UK stocks undervalued?
They are not overvalued. But they don’t look cheap. They are fair value bordering on a bit attractive.
What is the opinion on Labour’s sequestration of 10% of UK companies?
It is on a sliding scale, so it won’t be a full 10% straight off. It will depress share prices, but it won’t send them into a tumble.
It wouldn’t be good for share prices, but it would not be a systematic collapse. It would put pressure on the pound though, which in turn would increase inflation.
Whether it comes to pass at all is another matter entirely. We don’t expect it to. See the note above about 2022.
US trackers
Is there an argument to say that US tracker performance is all down to 5-6 shares and therefore we should look at US funds that are underweight in those stocks?
No, not unless you really squint and perform some mental gymnastics.
At all times we want to own the biggest (read most successful) companies around the world. It is they which represent global growth. In that way you share in the best human ingenuity and enthusiasm has to offer.
How can we demonstrate we aren’t being complacent in the investments?
We are not in the least bit complacent.
There are some risks coming up, there always are and the recent IMF missive is to be expected. But there’s no big crisis like 2008 in view.
We’re always on guard which is why the overall financial plan (as opposed to the investment strategy in isolation) is key.
The best way to mitigate shocks / sudden drops is to design an investment process that allows for a crisis to happen and allows clients to let it blow over.
This is where the 3-year cash buffer is crucial to the success of the plan. Complacency would be TCFP telling you to be 100% invested without caring about or covering your short-term needs.
Portfolio changes
No changes should be made to asset allocation and none are expected unless there is a fundamental change to the long-term picture.
We are, and always will be, long-term investors. That means investing in the biggest companies around the world. They have produced the returns that are needed and there’s no reason to think that won’t continue.
In the short-term you need to sit tight and remember that the money to cover whatever you have planned for the next three years is already ring-fenced and available to you.
No TCFP client should have anything to worry about but, if you are, please get in touch immediately.
future proofing your finances
advice@townclosefp.co.uk
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