Dermot Hamill is Head of Wealth Management at
Collins Stewart Wealth Management, Isle of Man
There are many uncertainties in today’s economic and investing
environment, but it is certain that interest rates will remain at
current levels at least for this year. I believe it is likely that
UK interest rates will remain low for the foreseeable future, and
indeed the anecdotal evidence is that the rates being offered by
many major UK banks are beginning to fall, heaping more pressure on
investors who rely on their bank savings.
If the current low rates do persist, they also pose big dangers
for fiduciaries that are entrusted with managing the wealth of
others. It is likely that not only will the return on such assets
be negligible, but there will also be a loss of the real value of
such funds, as inflation will remain relatively high. Consequently,
the maintenance of a (conservative) cash-only or cash-heavy
investment strategy could lead to problems in later years for
trustees and fiduciaries. Advisors should be actively looking for
ways to improve the returns from cash or, alternatively, look to
invest that cash to at least maintain its purchasing power.
The interest rate outlook
Current consensus is that the UK base rate will remain at or
close to its current level throughout this year and the next, and
that any increase thereafter will be moderate and gradual. The
table below is from the Bank of England’s November 2012 Quarterly
Inflation Report.
The conclusion that must be drawn from the term structure of UK
money market rates is that UK cash rates are likely to remain very
low in absolute terms and negative in real terms for another three
years, at least. With the UK economy enduring a technical second
recession and 2013 GDP growth anticipated to be no more than 1 per
cent, expectations for the timing of any potential increase in UK
base rates are being pushed further into the future.
How long can rates remain so low?
There is a striking similarity between the interest rate
environment since 2007 and that following the Wall Street crash of
1929 (see graph below).
In both cases interest rates quickly fell below 1 per cent. They
have fallen from 5.5 per cent at the beginning of the
financial crisis in 2007 to virtually zero currently in the US. In
1932 rates went below 1 per cent but didn’t rise above 1 per cent
again until 1948. Indeed, over this period inflation remained
relatively high and cash investors would have lost over 38 per cent
of the nominal value of their capital if they remained in cash.
Many believe an increasing reliance on unconventional monetary
policy and a lack of a clear path to sustainable fiscal policy
raises the long-term risk, particularly of rising inflation. The
current expectation is for Consumer Prices Index inflation to
remain at 2 per cent until 2015, although Retail Prices Index (RPI)
will be higher.
One thing is certain: the more cash portfolios hold, the greater
the loss will be in real terms for investors. It is my view,
therefore, that investors should begin to tilt their portfolios
towards real assets such as index- linked gilts, commodities,
property, infrastructure and higher-yielding (but lowly leveraged)
equities. This will entail accepting higher short-term investment
risk, but over the long term will offer greater investment
protection.
So where should investors focus their attention?
Gilts
The Bank of England has been active in its pursuit of
non-conventional monetary policy, undertaking two additional
programmes of quantitative easing since last October despite UK
inflation having stayed stubbornly above its 2 per cent target rate
since November 2009. Gilt yields have consequently reached
unprecedented lows. I expect that the current policy of ‘yield
repression’ (the deliberate forcing of yields lower than would
otherwise be the case) will be with us for some time yet.
Once this policy ceases, however, there is potential for a
strong upward move in yields. Gilts are expensive (2 per cent for
ten years and 3 per cent for 30 years), but quantitative easing is
likely to remain supportive for some time. Eventually, yields are
likely to rise and return closer to long-term averages.
The current ten-year UK gilt is yielding 2.09 per cent, having
hit a low of 1.43 per cent in August 2012. While gilts undoubtedly
offer solid risk management and diversification benefits in a
multi-asset portfolio, there is better value in the corporate bond
market.
Yields in the corporate bond market currently vary from 2.9 per
cent for AAA paper to 4.4 per cent on BBB issuers. In turn, these
reflect higher yields of 0.8 per cent and 3.18 per cent over the
comparable UK gilts. The spreads relative to gilts have also
narrowed in considerably over the past 12 months, reflecting the
continued demand for such instruments from yield-hungry investors
and the general improvement in global sentiment. In fact, the lower
down the credit spectrum one goes, the higher the returns have been
in recent months. In addition, the recently reported relaxation of
Basel III capital requirements has proven to support those bonds
issued by financial institutions and bonds generally.
Index-linked gilts
Investment in index-linked gilts may also be regarded as a
strategy intended to reduce or mitigate the risks associated with
holding cash. Index- linked issues provide some diversification and
protection against a potential increase in inflation that would
undermine the real value of monetary assets.
For example, the 2024 index-linked gilt was originally issued in
December 1986 at a real yield of 2.5 per cent. Over time, investors
have been willing to buy index-linked gilts at much lower
yields.
Index-linked gilts protect against UK RPI inflation because both
the interest payments and the capital value that will ultimately be
received at maturity are increased in line with inflation over the
life of the gilt. The value of the UK RPI when the 2024
index-linked gilt was issued was 97.67. The current index reading
is 243.
This equates to approximately GBP248.8 as an ‘indexed’ or
inflation-adjusted value of the capital. As the capital value, i.e.
the price, is currently approximately GBP334, this is roughly 34
per cent higher than the inflation indexing earned to date.
Essentially, the value of capital invested now will be protected
from future inflation only after the inflation indexing has caught
up with this premium – i.e. about 34 per cent higher than now. The
income is unaffected as it is automatically calculated and paid
according to the original terms.
Historic returns from equities
In a period of relatively low economic growth, I believe that
dividends will provide a greater proportion of total return.
Moreover, if growth over the next few years proves relatively
anaemic, those companies paying high, safe and growing dividends
will outperform.
Since 1931 dividends have accounted for over 40 per cent of the
total return on stocks (in the US). In lower growth environments,
however, dividends actually made up a greater proportion of the
index’s return than capital appreciation – for example, in the
1930s, the 1970s and the 2000s, the latter being a decade of zero
capital appreciation.
Historically, equities have provided investors with positive,
long-term real returns, although in recent years they have been
mixed with negative returns on several occasions.
Despite recording a sharply negative return in 2011, equities
have still provided positive historic returns over longer periods
in real terms and have comfortably exceeded returns from cash over
the past 20 years, albeit eclipsed by gilts over that period as
yields have fallen to multi-decade lows.
The table below illustrates the performance of equities against
cash and gilts. For example, the first column illustrates that over
a two-year holding period, equities outperformed cash 74 times out
of a total 111 times in the entire sample, or 67 per cent of the
time.
The incidence of equity market outperformance increases as the
time horizon is extended, with equities outperforming cash 99 per
cent of the time over 18-year holding periods and outperforming
gilts 88 per cent of the time.
I believe investors should focus on stocks that have a high,
well-covered dividend, preferably via companies that are not highly
leveraged.
I am focused on global equities with strong dividend growth
prospects, global listed real estate, and selected infrastructure
projects linked to ‘inflation plus’ returns.
Summary
In spite of all the current economic uncertainties, interest
rates will remain at current levels at least for this year and
probably much longer. Given this, it is vital that advisors and
investors actively manage their cash positions to at least maintain
the real value and avoid issues in subsequent years. For those of a
lower-risk disposition, gilts, index-linked gilts and corporate
bonds will be suitable alternatives, but for those with a longer
investment horizon exposure to higher yielding equities,
infrastructure, commodities and healthcare should be
considered.