Quarterly Investor Report 30 September 2016

Economy & Outlook

Markets over the last few years have been becalmed, particularly of late, with the volatility of daily returns stagnating.  Post the 23rd June EU referendum vote, when the UK voted for Brexit, it was pleasing to see life being injected into an otherwise moribund summer.  Bond yields, usually the arbiter of any fundamental changes afoot, slid from 1.22% to 0.86% in the UK with a similar reduction in the USA from 1.65% to 1.46%.  Investors typically bid bond prices higher (and so yields lower) when fear is in the air and the uncertainty surrounding Brexit gave investors reason to head for the hills.  In an attempt to ward off worries, the Bank of England reduced interest rates to 0.25%, indicating further reductions were possible.

Similarly, the pound has fallen relative to most other currencies and in particular the dollar and the euro.  For FTSE 100 companies which generate much of their sales and profits outside the UK, this means that their UK profits are given an immediate boost.  Expect dividends for such companies to increase sharply over the next couple of years.  The stock market has of course immediately marked up the share prices of these businesses and despite the initial fears over Brexit, equities of large companies have in fact performed positively.

There remains the question of whether the longer term profitability of UK plc has been adversely affected, but we believe that while short term issues exist (the precise terms of Brexit), longer term the outlook is favourable.  For overseas investors buying real estate (commercial or residential) in London, prices are 15% cheaper due to Sterling’s demise, ultimately making such purchases better value and so we expect prices to hold up.

Outside the hustle and bustle of markets, The Great Muddle Through continues, with investors on the one hand hoping for continued economic growth and so profits growth and on the other, battening down the hatches and seeking shelter in an inflated bond market.  Once again we repeat that debt is still rising (The IMF estimate a new $152 trillion global record) and whilst affordability of debt has again fallen, normality cannot return until markets believe that the deficit will be balanced and a credible debt reduction strategy is in place.

More economists have been questioning the current economic plan and with the anaemic growth so far experienced, it has been suggested that Governments borrow more to stimulate the economy in a rather more Keynesian response.  The paradox with the need for a credible debt reduction plan is clear.  However, with interest rates at the level they are, there is a good argument for using debt to totally replenish our infrastructure.  Our favourite example would be to scrap the current HS2 London to Birmingham rail project and replace the idea with a bigger and bolder project with a line from London to Aberdeen with spurs connecting all parts of the UK.  By using today’s technology (SC Maglev in Japan) the journey time from Glasgow to London could be cut to 1 hour 15 minutes and we would have a transformational world class rail system to hand over to the next generation.  By planning ahead, you could connect our version of HS2 to a new UK Central Hub Airport, replacing Heathrow, within Northamptonshire with better access for everyone.

hs2-map               hs2-map-keills-v-2

HS2 as Proposed                                                 Keills HS2

http://interactive-map.hs2.org.uk/

We are sure that there are other worthy projects but if infrastructure spend is to be considered, we would urge Governments to think BIG, and beyond the electoral cycle.  Infrastructure investment on the scale we have suggested would be welcomed by large pension funds seeking long term indexed linked assets to help them meet future liabilities. The creation of legacy infrastructure assets must be preferable to simply recording another QE book entry in a Bank of England ledger.

UK politics has calmed down a bit although PM May has used the Brexit vote to make quite a few changes both to her cabinet and Government policy.  On the other side of the House of Commons, Jeremy Corbyn was re-elected with a slightly larger mandate, but there doesn’t appear any risk to the Conservative majority at the current time.  Election focus is now turning to the USA election on 8th November where the result is not a given.  In Europe, Germany and France have elections next year and with Theresa May announcing that Brexit will be formally triggered before the end of March next year, we expect immigration and trade to feature as manifesto issues for the parties involved.  Growth in Europe remains weak with Draghi continuing to promise he will ‘do what it takes’ and meanwhile German bunds are trading at sub-zero.

Japan has embarked upon yet another attempt to reboot its economy.  Longer term investors will remember that Japan has been trying to reflate its economy for over 20 years, with little progress.  At every turn so far, debt has been increased and by some measure and it remains the most heavily indebted economy on the planet.  With a falling population and an anti-immigration psyche, the longer term prognosis does not look good.  Previously, Japan has managed to export its way out of these problems through revolutionary ‘tech’ but not much of this has been seen recently.

UK Property

The Brexit vote has cast a cloud over the UK property market

london-in-clouds

We were surprised at the reaction by some fund houses to make arbitrary valuation adjustments to fund prices at June and note that in most cases trading in these funds has resumed.  The fund level price adjustments, apparently being imposed by some fund groups were to curtail the so called ‘stampede out’ by investors, has now been all but reversed.  Keills’ approach was to reflect the difficulties of investing in the underlying asset, principally liquidity, and move the redemption period from 3 to 6 months.  Most investors understand that UK real estate is not that liquid.  The same is true of selling (or buying) a large chunk of a REIT.  To effect such a transaction without affecting the price, you need time.  Time is exactly what longer term investors have in spades; these guys are looking for a stable yield that pays out on a regular basis.  If the market stopped to think, it may make better decisions…the words of Roosevelt ‘the only thing we have to fear is fear itself’ resonate.

Property has experienced increased volatility following Brexit and we think the risks have probably increased marginally for conventional portfolios.  MSCI (formerly the Investment Property Databank) advise that their Monthly Index for August was showing an income yield of 5.14%.  All property rental growth was running at 2.95%p.a. but is on a downward trajectory.

Comparing this with 10 year bond yields (UK 0.80% and USA 1.60%) suggests that UK property still offers reasonable value and whilst rental growth seems to be slowing, the property yield premium over the 10 year gilt rate does seem extravagant, particularly if tenants can be persuaded to pay a rent which is indexed to inflation.

The pathway that markets adopt from now on is becoming less clear and we expect nervousness in the run-up to the US election.  The big question is how markets will react when the US Fed increases rates again.  Watch this space.