RSJ Financial Planning
RSJ Financial Planning
RSJ Financial Planning

Investment Review

OVERALL ON MARKETS

Performance of our portfolios over the last 12 months has been hindered by exposure to SE Asia, Emerging Markets and Fixed Income. When compared to UK FTSE 100 which is up 17% both Emerging Markets and Asia Ex Japan have moved sideways (markets over past 6 months have fallen by some 7%) and Fixed Income with income reinvested down some 4%. The APCIMS Balanced Index, against which many stockbrokers use for private clients, is up 13% which includes income being reinvested. However this is only the last 12 months and for most of us we are investing for the Long Term.

Overall Comments We still subscribe to the philosophy that the world is growing and there are more consumers so those need to be satisfied. In reality this can only be achieved by products sold by companies i.e. equities.

Employment growth continues to be strong in developed and most emerging markets and before long, this will feed through into higher earnings. This should sustain economic growth but limit the potential for higher profit margins and may result in moderately negative inflation surprises (i.e. inflation moving up). The suggested implication for investors is not to take current low inflation rates for granted. Higher inflation than expected means caution towards interest rates everywhere, and underlines the importance of looking for strong, sustainable real yields.

Stockmarkets – is a discount mechanism and looks into the future (about 6 months). I am confident that most of the bad news is already in the share price. If we do have in the future low GDP growth rates, history has shown it does not relate to low Stock Market returns. Most UK and European companies, unlike the Government, are cash rich (except the Banks), well exposed to the fast growing international markets and are cheap by historical standards.

The effects of reducing QE will mean that the market will be in the short term volatile but much is in the price so the "downside" is limited". Over the next few years the asset class to probably suffer most will be fixed income especially the UK, USA, Europe and Japanese Sovereign Debt instruments (Gilts for us). Equities, though volatile, will "ride" through for the reasons set out below and in the Annex.

Deficit and Gross Debt levels - for:
1. On the retreat except for India!
2. UK is not reducing its ratio as fast as Greece, Spain and Ireland
3. from this one could deduce that UK austerity will last longer.

Why we Favour Equities:
1. Levels of Equity Market Confidence:
Confidence indicators for both manufacturing and Consumer indices are rising
Global Purchasing Manager index for Manufacturing (PMIs) for UK, USA and Japan are good and for Europe fair
VIX index ( a USA volatility) is below long term averages
Price Earnings Ratios are also below long term averages especially in UK and Europe

2. the overall share price is relatively low – as an example from a 10 year rolling data over the past 40 years if you look at the "starting" valuation of shares (Price Earnings ratio) being the key to future returns it looks from UK and from the international point of view that the average annualised return for the next TEN years is likely to be about 8 times over inflation.

3. UK pension and institutional funds have been very underweight in equities over the past 14 years and with the problems facing fixed income will have to raise their equity exposure. So even small amounts will lift the market (this is called the "rotation")

4. the markets, according to the press, are approaching their all time highs, but that pre-supposes that the market moves relative to a flat line which it should not. This line should be on 2% upwards trajectory to reflect inflation at least. If that is the case the stockmarket is well below its previous highs. This confirms the point above.

5. Yields around the world are better than cash for income seekers and there is a strong likelihood that dividends will grow better than inflation and historically capital values follow upwards over time.

CURRENT COMMENTS ON THE WORLD ECONOMICS AND MARKETS

Bertrand Russell once said - "The trouble with the world is that the stupid are cocksure and the intelligent are full of doubt."

"Experience is never limited and it is never complete" Henry James.

It is prudent to forget the media hype and let us be of the "half full" brigade rather than the "half empty".

The world's population is still growing and all are wishing to have a better life so more annually are becoming consumers.

Unit Labour Costs - It is vital that the west especially remains competitive in the global market as companies have the ability to move production where they see fit, ie costs have to be world competitive.

In UK, USA, Japan and Europe over the log term Inflation will rise and wages are unlikely to keep pace so I feel that our quality of life cannot really get a lot better so we will suffer. Yes those now in retirement have had the good years. However for those in China, Latin America India, and Africa etc. quality of life will improve so the goods they make will cost more, hence if we import them our inflation will rise.

Hence World trade will continue to grow as will the world's GDP but not always in a straight line. As a country's economy gets bigger, their GDP will never be able to sustain large growth rates hence seeing China's figures dropping.

We are and will always be in an "interconnected" world and in my view it would be foolish to think you can have a substantial slowdown in the Old World without it having an effect on economic growth in the New World. The new world's population is becoming a bigger consumer and as they improve their "lot" they will purchase more luxury goods all of which are produced in the old world.

Effects of Easing of QE - We feel that we cannot place too much in the perceived wisdom of 'experts' as many have never been here before!! There are macro-economic challenges that face investors today and if there's one lesson of the credit crisis it is that no one knows what the hell is going on. But we expect there will be volatility but at the end of the year the equity market will be higher than it is currently.

FIXED INCOME

Opportunities in credit and emerging market debt - consensus, 2014 looks like being a difficult year for corporate credit and a modest one for emerging market debt.

Investment grade - So how does it look for quality investment grade bonds in 2014? In summary, the market has taken the tapering much better than expected and is looking at the fundamental positives rather than the technical negatives, which were a driving force when tapering was first put on the table. It is also worth remembering that we have all seen this coming for 2 years and much of the increase in yields has happened.

While yields on government bonds remain unattractive, those on investment grade corporate bonds offer a modest pick-up in yield and those on high yield a more significant one. However, the additional yield offered by credit is unlikely to be sufficient to compensate for a rise in government bond yields.

Issuance of both investment grade and high yield bonds has been significant, implying no shortage of supply. The opportunity for credit upgrades is diminishing as companies with the potential to improve balance sheets have mostly done so. Credit may be a disappointing investment until government bonds have adjusted.

The opportunity in EMD looks better, with many currencies having weakened significantly, yield spreads over developed market bonds reasonable and opportunities for adding value more extensive, though emerging market currencies may need to weaken further in the short term.

Hence we are moving for income seekers to more High Yield bonds and keeping faith in Emerging Market Bonds and for Growth using Strategic Bonds, but overall reducing fixed income exposure.

EQUITY INVESTING

Long Terms Themes to support Equity Investing:

1. Globalisation of Companies – companies can have their HQ anywhere and their production units can be anywhere in the world for labour costs and where their sales are generated

2. Market and Asset Correlation – more and more correlated so we have to be more diversified globally to out perform

3. Consequences of the Emerging markets populations requiring higher standards of living – take Fridges:
In Hong Kong 99.8% of the population own a fridge
In China 61.9%
In India 18.5%

4. Consequences of Ageing Population – amongst many issues more drugs will be required

5. Food production:
not just the land, but equipment and fertilisers,
distribution of the products both for the farmer and the retailer.
Growing wealth is driving demand for richer diet.
Chocolate consumption is growing at 10% per annum in Asia and Africa
Hence Inevitable need to raise agriculture yields

6. Inevitable need for better and more consistent water supplies.
Water scarcity is just one complex trend that can hinder the development of the "food" chain.
In 2012 China imported 55 mm tonnes of soybeans which equates to 1276 bn m3 of "virtual" water

7. Better management and need for sustainable timber – house building

Growth Rates (GDP) versus Equity Returns - higher GDP growth rates in the "new world" does not follow that their stocks give the highest returns for equities, in fact historically low GDP growth rates have given the better the long term returns.

Why we are now looking International for Equity Income – for diversification, as in the UK there is a concentration hence risk of a few quality stocks with good yields whilst looking overseas increases the number of stocks giving good sustainable dividends.

American Equities - America is the home to some of the world's very big successful companies. Their economy though very indebted is less regulated than Europe and they seem to be able to manage their economy better and be able to recover from recession faster.

Japan – for the first time in some 25 years there seems to be optimism as the new waves of QE and inflation is picking up.

Historically Japan has:
1. not had an equity owing culture but this is changing and the saving funds are moving more into equities.
2. had to deal with deflation – in the 1990s the Japanese Royal Palace was the same value as the whole of the state of California
3. for the average Japanese family to be debt free of the property it took up to 3 generations to pay of the mortgage
4. so stockmarket returns were poor and they saw better returns in owning US Treasury's.
5. not been suited to long term equity investing as the locals do not own shares BUT this is changing and the Institutional funds are increasing allocation to Japan.
6. The Japanese Government for the first time as of 1 January 2014 offer the equivalent of our ISA (JISAs) for investing in Equities for about £11,000 per person per annum
7. the institutions/pension funds etc are now purchasing shares

They have many quality exporting companies and have invested heavily over seas – take Car production most of the Japanese cars are now made overseas – look at them in UK so their profits are repatriated and with a weakening Yen that is good for Japan.

Age profile is increasing and Japan has the largest population in old age and they need income!

EuroZone – there cannot be fiscal union without a top down Federal Government and Federal Tax system i.e. the European Parliament will have to be above all the elected parliaments of the States that make up the EuroZone. I am not sure that I can envisage that in my lifetime!! Some may say that Germany has "won" the third war by purely economic reasons but I feel that even they have debt problems especially with their far better state pension benefits that will have to be funded out of future taxation.

But most forecasters expect Eurozone inflation to be below 1% for much of 2014. It could be quite possible for inflation in the periphery countries to dip into negative territory.

Greece and Cyprus have been living with falling prices for some time. Italy's inflation rate has fallen from 2.8% to 0.8% in the space of a year. By 2014, Greek real wages will have fallen by more than 20% since 2009.

Spain:
1. inflation rate was also zero in October,
2. productivity, measured by hourly output, has risen by more than 9% since the start of the crisis,
3. got rid of a 10% of GDP current account deficit in just five years.
4. In 2014, the Organisation for Economic Co-operation and Development expects the country to run a 1.6% of GDP current account surplus.

Why Positive on UK Equities - though we are all over indebted it does not mean that companies are indebted in fact most are cash rich. Many UK Companies are exporting goods especially in the high tech area. From an Equity investment point of view we have had one of the worst 14 year periods for equity investing (since January 2000 the Dotcom bubble burst when the PE was 26):

1. PE Ratio (PER) - is less than the long term average – now 14

2. Starting PER Equity Valuations – being 14 is predicting the average annualised returns over the next 10 years to be over 8% above inflation

3. Relationship between Yields on Gilt and Equities:
Over the past 50 years yields on Gilts were above that of Shares, currently Gilts actually yield half that of equities not seen since the 1950s.

With all the Quantitative Easing forcing Gilt Yields down, it is very likely in the future that Gilt Yields will rise so the capital value of Gilts will fall. This will also be good for Equities

Why are we looking at UK MultiCap (i.e. Mid Cap and Smaller Companies) for Income diversification:

1. in the interest of diversification I feel it is important to not just look at the old favorites in the income sector to provide a dividend as there are:
95 companies in the FTSE 100 providing a dividend
500 in the Mid Cap, the Smaller companies and those on the AIM market.

Indices (ex Investment Trusts) No of Companies Dividend payers with Yield over 2% COMMENTS
FTSE 100 100 75 10 companies equates to 50% of the dividends
FTSE 250 mid cap 204 171  
FTSE Small cap 201 95  
AIM Stock 807 203 Income Stocks Tend to be family owned and yes they like an income

2. Though smaller companies are more volatile in capital terms, even the Blue Chip stocks can come unstuck and stop paying dividends – take most of UK banks and even BP though their dividend is restored.

Overall we tend to look at Income funds, including international income funds, where the yield is not too high (3.5+%) so there is a stronger potential for companies giving:

1. better dividend growth
2. hence better long term capital growth
3. as opposed to higher yield stocks where there is a chance that the company can afford to pay that high yield hence profit warning hence reduction in share price – called the "value trap"

Global Companies:

SIZE OF COMPANIES By Capitalisation By number of companies  
Large cap 77% 25% Many large companies can get too big and loose moment and revert so share price more likely to under perform
Mid cap 13% 13%  
Small Cap 12% 62% Many are under researched and suddenly they becomes the stars of the future

Why Positive on EuroZone Equities – many European Companies have strong balance sheets, have good long term order books exporting to the new world especially in the luxury goods market such as BMWs Louis Vuitton and Drug companies. Remember that you are buying companies not countries.

Emerging Markets – why am I still keen?

1. Infrastructure development - Governments across the region are now significantly accelerating infrastructure investment programs to address the poor quality of infrastructure, some of the worst in the emerging markets. These increased levels of investment are offering many opportunities to Latin American companies and also, given the long-term benefits of these schemes, we believe they will shelter the companies involved from any short-term global growth concerns. For example Mills, one of Brazil's largest engineering services providers, is very well placed to benefit from the country's increasing expenditures in infrastructure, as well as being a key supplier to 10 out of the 12 stadiums to be used in the 2014 World Cup and a number of projects for the 2016 Olympic Games in Rio de Janeiro.

2. The emerging middle class - Low unemployment rates and strong wage growth has seen the lower and middle classes rapidly increase their levels of disposable income. Latin America remains one of the more unequal regions in terms of income distribution but this gap is narrowing as poverty levels decline and incomes rise. Companies manufacturing apparel and managing department stores are very well placed to benefit from this trend – one that we believe has a long way to go.

Why invest in Natural Resources – this covers Mining, Energy and Agriculture all of which are needed in the long term. I feel there is a stronger case for Agriculture which have included Timber and Water for the following reasons:

1. Land - is a finite source – possibly shrinking!

2. Food - with the world's population becoming more middle class, they now eat more meat and animals require corn. This leads to increasing demand for seeds, potash, and farm machinery.

3. Timber – increasing demand for home building and paper but decreasing availability. But is more energy efficient and recyclable

4. Water – only 0.25% of worlds water is "usable" and there is an increasing demand for water

5. Mining – Infrastructure - for all the talk of slowdown in China, the country is expected to double consumption of most metals in the next decade. Current mines cannot hope to meet global demand after 2015, suggesting supply gaps for most base metals

American "Fiscal Cliff – still here and unlikely to go away so we have to live with it!

1. This the term - refers to issues of the Government debt ceiling, a series of tax hikes and spending cuts – this is still an issue but the Debt is a % lower than last year as their tax revenues is increasing. There are still problems with the Obama Care issues and this could create huge debt issues.

2. Why – the Democrats and the Republicans have deeply divided ideology and the former wants the tax cuts commenced by George Bush in 2001 to be reversed i.e. increased taxation, whilst the Republicans want tax cuts. If it is not agreed then on implication is those employed by the State cannot be paid!!

3. Likely outcome – as always the "warring" parties will continue to compromise. The Republicans have been "hurt" over the most recent "battles. They will continue to fudge the issue because if they do not agree, it will damage the Politician's reputation and that will not help their next election prospects.

Fixed Income – there are several factors of investing in:

1. Long Maturity Bond funds - (the majority of funds you invest in) – have a maturity duration of between 5 and 15 years and they are interest rate sensitive, so if the holder holds the bond they could probably see the capital value fall as these interest rate rise. On the other hand there is a still receive a good yield.

2. Sovereign Debt of Mature Countries is UK, USA and Europe – currently low yields but with high levels of Government debt which will have to be refinanced. In UK:
Gilt Yield has dropped by about 60% from 2006 to 2012 – to 1.9%
Gilt Yield has risen by about 50% from 2012 to now 2014 – to 2.8% (was higher 6 months ago)
If we cannot stop the increasing level of Government debt the Credit Rating agencies will lower our AAA rating with the implication being that it will force up yields so refinancing will be become more expensive and another drain on Government expenditure/finances
Forecast yields in say 5 year time are likely to be over 4%

3. Sovereign Debt of Emerging Markets - Relatively high yield and:
as inflation falls,
the interest rates will fall,
capital values of the emerging bond values have fallen with lack of sentiment over the past 12 months so from here out the capital value could rise

4. Investment Grade Corporate Bond – similar to Sovereign Debt but with a higher yield as there is a small risk that the borrower could default

5. Non-Investment Grade Corporate bond – High Yield – here the yields are higher but there is the perceived bigger risk of borrowers defaulting but that risk is currently low.

6. Short Date Maturity Bond funds - on the other hand where the bonds duration is short in nature (i.e. less than 5 years), the returns are modest with little or no income but the capital values are not interest rate sensitive so the value should fluctuate.

Why Rail – this is not an advert for HS2 but consider the following:

1. in UK passenger levels have over the past 20 year risen by some 50% on the same amount of track!!

2. a single train can:
take as many as 280 trucks off the road – equivalent to 1100 cars
can move a Ton of freight for an average of I gallon of fuel per 476 miles
is 1.9 to 5.5 times more efficient than trucks on the road depending on the commodity being transported and the length of the haul

3. hence we need:
more track
for lorries coming from Eastern Europe to have their cargo routed by rail
for ferries such as going to Ireland to take rail wagons (they used to from Dover to Calais)

In truth - we are Benchmark Agnostic – i.e. we do not follow investment benchmarks in the accepted sense as we feel that we should see where the long term potential growth by investing in a broad and diversified range of mutual funds investing in primarily Equities and taking a more "aggressive" view in having a higher weighting to International Funds investing in companies that are benefiting from sales into the New World and SE Asia and Emerging markets.

Contact us either by e-mail or phone 0151 703 1088
mail@rsjinvestments.co.uk