Does a Simple Equity/Bond Asset Allocation Still work?

When sitting in my office, I often try to imagine what questions my clients might like to ask me if they were sat with me and that is often how I come up with the material for these regular communications. This week I have been pondering whether clients might understandably be asking the question posed in the title?

Over the past few weeks, I have written that low risk investments have been falling at the same pace, if not faster than high risk investments and that being the case, it seems reasonable to question whether a portfolio containing equities (to provide long-term growth) and bonds (to smooth out volatility) is still a sensible mix.  

The following article written by Giulio Renzi-Ricci, head of portfolio construction at Vanguard, Europe, answers this question:

“It has been a difficult year for equity and bond markets.

With inflation at record highs, sharp reversals in monetary policy and a perfect storm of events driving down prices, it is understandable that investors want to be sure their investment strategy is appropriate for the times.

Indeed, it is particularly in times of volatility that advisers can help investors consider the bigger picture and retain focus on their long-term goals. We believe the evidence is clear that a well-established approach to asset allocation – in which a balanced, risk-adjusted portfolio of equities and bonds is held for the long term at a low cost – continues to serve investors well.

Share-bond diversification in historical context

Some investors have been unnerved by equities and bond prices declining in lock step over the course of the year. In fact, brief, simultaneous declines in shares and bonds are not unusual, as our chart shows.

Viewed monthly since early 1995, in GBP terms, the nominal total returns of both global shares and investment-grade bonds have been negative around 13 per cent of the time. That is a month of joint declines a little over every seven months or so, on average.

Historically, once the market has had time to adjust, the negative correlation between bonds and equities has re-established itself within a matter of months. Our analysis of recent prolonged market downturns suggests the longer a crisis drags on, the more likely bonds are to play a stabilising role.

Bonds as ballast

This is particularly important, as the primary role of bonds in an investment portfolio is not to drive returns but to act as a stabiliser. We are cautious of proposed alternatives to investment grade bonds as the main counterweight to equities in a balanced portfolio.

Asset classes such as real estate (property) introduce cost and liquidity concerns. Sectors such as commodities and high-yield debt can help with hedging unexpected inflation but exhibit equity-like behaviours.

Hedging strategies such as put options introduce complexity, while still being exposed to considerable drawdowns. This is not to say there is not an investment case for these approaches in particular circumstances. Rather, there is not a compelling substitute to the benefits high-quality fixed income provides with regard to diversification, transparency, relative simplicity and cost.

Equally, it is unlikely that long-term investors will be able to preserve returns simply by coming out of the market. Short-term market timing is extremely difficult even for professional investors and, we believe, doomed to fail as a portfolio strategy.

Markets are incredibly efficient at quickly pricing unexpected news and shocks, such as the invasion of Ukraine or the accelerated and synchronised central bank response to global inflation. Chasing performance and reacting to headlines tend not to work in the long term since it often amounts to buying high and selling low.

What might the future hold?

It is also important to remember that, with the painful market adjustments year-to-date, the return outlook for the 60/40 portfolio has improved.

Driven by lower share valuations and higher interest rates, our forecast for the 10-year annualised average return outlook for the 60/40 portfolio is to 6.7 per cent. That is more than three percentage points higher than at the start of the year.

Over the next 30 years, we predict the average return of a 60/40 portfolio to be around 6.9 per cent in GBP terms. The inherent volatility of markets means these returns will always be uneven, comprising periods of higher or lower – and, yes, even negative –returns.

No magic in 60/40, just balance and discipline

The broader, more important issue is the effectiveness of a diversified portfolio, balanced across different asset classes, in keeping with an investor’s risk tolerance and time horizon. In that sense, 60/40 is shorthand for an investor’s strategic asset allocation, whatever their actual target mix.

We do not believe in one-size-fits-all solutions in this regard. Investors can dial up or down the risk-return profile of their portfolios depending on their investment goals, investment horizon, risk tolerance and a set of realistic expectations for asset returns (net of costs).

The last thing investors should be doing, however, is to abandon the principles of good asset allocation.”

I do hope the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered FCSI

Managing Partner

The Mini-Budget and some Context!

When I last sent one of these communications on 22nd September, I ended with the following, “Things will improve when inflation appears to be coming under a degree of control and if/when there is some kind of resolution in Ukraine; I do hope to be able to write with more positive news soon.” This was of course, before Kwasi Kwarteng’s so-called ‘Mini-Budget’, which has spooked the currency market, the UK Gilt market and, to some extent the UK equity market. As a result, I do not have any good news to report just yet, but I do want to provide some context which I hope might settle some nerves.

I don’t want to get into the politics of announcing the removal of the 45p tax rate at a time of hardship for many (it’s not now happening of course) but it does seem that this is the aspect of ‘Mini-budget’ that the media and opposition parties have latched on to. The inference in the media has been that it was this announcement that caused the pound to crash and the Gilt market to go into freefall – it wasn’t! Out of a total package of tax cuts announced amounting to some £40 billion, the loss to the exchequer from repealing the 45p rate would have only been about £2 billion (5% of the total) and it could have led to higher tax receipts as the wealthy lose the incentive to find convoluted ways to avoid it. No, the markets (unlike the media) responded to the important bit, the other £38 billion of cuts and how they were to be funded - through borrowing! When Kwarteng publishes the Fiscal Plan, now at the end of October and not 23rd November (thankfully), the markets might settle down a little, until then the markets are staring into the dark, unsure of the impact on the financial stability of the UK, further volatility can therefore be expected.

So, where is the context that might settle clients’ nerves? Well, Clearwater portfolios (constructed and managed by EBI) are not just invested in the UK Gilt and Stock markets; the geographical spread (top 10 countries) of our most popular portfolio Vantage Earth 60, is currently as follows:

1. United States (US) 50.68%

2. United Kingdom (GB) 6.98%

3. Japan (JP) 6.58%

4. Germany (DE) 4.90%

5. France (FR) 3.43%

6. Canada (CA) 3.22%

7. China (CN) 2.37%

8. Switzerland (CH) 2.26%

9. Australia (AU) 2.18%

10. Italy (IT) 1.43%

The gyrations in the UK are certainly having an impact on the performance of our portfolios but it is what is happening in the wider world that is much more important, the global fight against inflation and the war in Ukraine.

If there is a silver lining to the clouds around us, it is actually in the weakness of the pound relative to the dollar because of the weighting we have in the US. The following chart shows how far the S&P 500 has fallen since the beginning of the year in Dollar terms:

As you can see, a fall of 23.76% since the start of the year! This second chart shows the same index but in Sterling terms:

We still see a substantial fall of -6.85% but the pounds weakness has provided a welcome hedge against the worst of the falls. It is important to understand that a significant strengthening of the pound would unwind this position but let’s hope that any such strengthening accompanies a recovery in the US stock market.

In terms of fixed interest exposure, only 11.36% is in the UK and only some of this is invested in UK Gilts which have been hit so hard by recent events. The following chart compares the performance of our Bonds vs the UK Gilt Market as a whole, since the beginning of the year:

What the charts above demonstrate is the benefit of diversification. Investments across multiple countries and multiple sectors ensures that we are never going to be at the bottom of the pile when shockwaves are felt, unfortunately it does not mean our portfolios can buck global trends. The battle against global inflation and the war in Ukraine will continue to cause substantial volatility in markets but this volatility comes hand-in-glove with long-term investing.

One last chart to provide more context – this one shows portfolio Vantage Earth 60 (simulated returns) over the past 20 years.

When we look back over many years we can see plenty of incidences of extreme volatility BUT we got through it in the end! While writing to one of my clients this week, I was reminded of Boris Johnsons’ tribute to the late Queen, he referred to her broadcast to the children of the nation during World War II, age 14, during which she offered these encouraging words; “We know, every one of us, that in the end all will be well.” I think that attitude of optimism is the best way to get through each day whilst markets are gyrating all over the place, we will come through it ……. eventually.   

I do hope the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered FCSI

Managing Partner

Update

Yesterday, the Federal Reserve in the US increased interest rates by the widely expected 0.75%, but the markets still fell sharply following comments by chairman Jerome Powell that central banks still have “some way to go” in their fight against inflation. He indicated that rates have only just reached levels in the States where they are starting to have the necessary effect on prices. This hawkish stance is not helpful to equity or bond markets, meaning there is no hiding place from the pain just now.

I was interested that in the UK equity markets rose yesterday, even though on the Today programme on Radio 4 yesterday morning, I listened to Sergei Markov, a former adviser to Vladimir Putin, all but threaten the West with full scale nuclear war. I fully expected the markets to fall off a cliff at the open but of course they didn’t, as most see these statements as the empty threats they almost certainly are, let’s hope they are right.

It is clear that the equity and bond markets are focussed firmly on inflation and the actions that central banks are taking to tackle this, with even the prospect of nuclear war having very little effect.

Against this febrile backdrop I thought an update on how the Clearwater Portfolios, managed by EBI, have been doing might be welcome.

This first chart shows how EBI Vantage Bond, EBI Vantage 60 (60% equities, 40% bonds) and EBI Vantage 100 have performed since the start of the year. In this chart we can see how the portfolios containing equities rallied during the period June to August, but that the Bond portfolio continued its downward slide, due to the continuing increases in interest rates.   

This next chart focusses on the market rally from 16th June to 19th August. Here we can see that the 100% equity portfolio rose by over 14% in a period of just over 2 months, highlighting why it is so important to stay invested through periods of volatility – we never know when sentiment is likely to change, and markets tend to respond very quickly when it does.  

We must then look at what has happened since 19th August. The following chart shows a renewed slide caused almost exclusively by the hawkish stance being taken by central banks to combat inflation. Interest rate rises had previously been priced in to some degree but as inflation around the globe has proved so persistent, central bankers have turned up the heat even further and consequently, markets have given back most of the progress that was made earlier in the summer.

I am conscious that I quite often provide updates on how our portfolios are performing but what I don’t often go into is, how are our portfolios performing when compared to others? The following couple of charts address this.

These are slightly different charts which look at returns on the vertical access, with volatility (risk) on the horizontal access. If you think about it, the perfect portfolio would appear in the top left corner, because this would mean the portfolio had performed spectacularly well but with very little volatility – sadly, no such portfolio or fund exists.

This first chart looks at the same portfolios above and compares them with the appropriate sector averages over the year 31st August 2021 to 31st August 2022.

If we first look at point E towards the bottom left of the chart, this represents the EBI Vantage Earth Bond portfolio, and compare this with point F, which represents the pension sector average. Here we can see that the sector average has delivered a worse return and with greater volatility, this is a good result (relatively) for the EBI portfolio. The EBI portfolio has still fallen over the course of the year, but it hasn’t fallen as far, and it has been less volatile.
The same is true for the EBI Vantage Earth 60, against its peer group and also EBI Vantage Earth 100, against the global equity sector. In each example we can see better performance from EBI with lower volatility.   

The chart above just looks at the past 12 months, which I think we can all agree, has been unusual. The following chart, however, covers the 20-year period from 31st August 2002 (The EBI portfolios haven’t existed for 20 years, so these are simulated returns). Even over this much longer time period, the results are the same, except for the Bond portfolio. Over this longer period, the sector has marginally outperformed, BUT it has done so with considerably more volatility.  

I hope the above charts have helped provide some reassurance that, although things are not going particularly well at the moment, on average our investment solution is faring as well (if not slightly better) than alternative offerings.

Things will improve when inflation appears to be coming under a degree of control and if/when there is some kind of resolution in Ukraine; I do hope to be able to write with more positive news soon.  

I do hope the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered FCSI

Managing Partner

The Energy Transition

The following is a piece I was reading this morning from LGT Wealth Management. I thought it was interesting and hope you do too.

“The global energy complex is under pressure. Supplies, already constrained due to Russian sanctions, have been further strangled by the impact of the summer heatwave. In France, which frequently relies on up to 70% of its energy from nuclear, the rivers essential to the cooling of the reactors are too warm, reducing current nuclear energy production by half. Germany’s Rhine River is currently too shallow to transport cargo, including traditional energy, and the Sichuan province of China which relies on hydropower for 82% of its power generation, is seeing its worst drought in more than half a century halving hydropower capacity and causing a number of factories to close. Even efficiency of solar energy is impacted by hot weather. For every degree above 25C, the efficiency of a solar panel can drop by as much as 0.5%. When a panel temperature reaches 45C, the solar efficiency could fall by 10%.

You could be mistaken for thinking that the soaring traditional energy prices are a source of distraction from investment in green energy, which ironically is made more inefficient by the summer heatwave. In fact, it is quite the opposite.

The US

Last month, the US passed a historic Inflation Reduction Act. Whilst many countries have recently approved climate packages and enforced regulation, the size and scope of this Act should not be underestimated. It represents more than $370billion of investment and subsidies to be spent over 10 years dedicated to climate and energy measures. These include tax credits for EVs, $20bn spent on clean vehicle manufacturing facilities, 10 years of consumer residential energy tax credits and $20billion to support climate-smart agricultural practices.

The EU

In response to the outbreak of war in Ukraine, the European Union published their plan to reduce reliance on Russian oil and gas. This represents spending of circa €300bn by 2030[1] and includes investing in solar and wind power, energy storage investment, green hydrogen innovation and promotes awarding of permits to renewable energy projects.

China

Whilst these significant commitments by some of the developed world’s largest economic powers seem encouraging, they pale into comparison to the levels of deployed climate investment since already this year by China. Last year, China accounted for 46% of the world’s new construction of renewable energy infrastructure, investing $380bn, more than any other country during 2021. China’s solar energy spending for the first six months of this year has totalled $42 billion (173% higher than last year). The country’s spending on new wind projects totalled $58 billion (107% above 2021 levels). According to China Renewable Energy Engineering Institute, the country is set to install a record 156 gigawatts of wind turbines and solar panels this year. By comparison under the Inflation Reduction Act, additions to US wind capacity could increase from 15 to 39 gigawatts per year in 2025-2026, according to researchers at Princeton University.

China leads global energy transition spending
Public and private investments, 2012-2021

Source: BloombergNEP, Note: The UK is included in EU calculations until 2020

The energy transition represents one of the most environmentally, but also economically, important shifts of recent times.”

Inevitably this transition will throw up exciting investment opportunities around the globe which our highly diversified portfolios (managed by EBI) are well positioned to take full advantage of.

I do hope the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered FCSI

Managing Partner

1 G. Lengauer, F. Esser, R. Berganza, Negativity in political news: A review of concepts, operationalizations and key findings. Journalism 13, 179–202 (2012)

Do you want the Bad News or the Good News?

Some of what follows has been taken from a communication I received from 7IM Investment Management last week, I thought it was interesting and worth sharing.

Do you want the good news or the bad news? As it happens, you don’t really have a choice. Your brain is only interested in the bad news.

And unfortunately, the world is a scary place day-by-day. We are bombarded by negative news – studies estimate that just 10% of daily news stories are ‘good’1. And those studies don’t include what people are reading on Twitter and Facebook!

There’s a lot of messy psychological stuff at work here. Our brains are designed to engage more with negative news than positive news, so media outlets keep it coming, swamping our optimism with every click and swipe we make.

2022 has been dreadful for this. If you’re not reading about the war in Ukraine, it’s only because you’re watching the UK Conservative party have a full-scale public identity crisis, or the price of petrol slowly creeping towards £2 per litre, or are queueing at an airport, or worrying about another wave of COVID. Our investment approach in the face of such hysteria is to stay informed and engaged, while not getting overexcited about any single outcome. Arguably that has been even more difficult than usual in the first part of 2022.

I’ve got a few techniques which help me to take the long-term view – going for a long walk without my phone is top of the list or getting lost in a history book or science-fiction novel or watching the Test match. Living in the short-term is just too stressful, and genuinely reduces our ability to make the sensible long-term choices we need to make.

True long-term trends

It’s easy to miss the true long-term trends if we just focus on the short-term. A research company, GaveKal, had a great example of this a few years ago. They asked their readers what the most important event of 2007 was for financial markets.

Most of their readers are investors of some kind, so in one form or another, the answer was “the Global Financial Crisis”. That seems fair enough, that would have been my answer. We’re arguably still dealing with some of the fallout from this. Surely historians of the future will look back and pick that out as the key event of the year?

Perhaps not. Although it was 15 years ago, that is still a short-term way of thinking. Financial crises come around quite often (almost annually if you’re from Argentina or Venezuela). They leave their scars but tend not to change the world. No, the truly important event of 2007 was when Steve Jobs and Apple launched the iPhone, completely changing the way that we interact with the world around us.

Staying diversified and staying the course

Of course, in 2007, no one realised that the iPhone was as important as it has proved to be. Apple shares fell along with everything else, down 50% by 2009, along with the US market.

Since then however, the world has moved on from the financial crisis – the global equity market has quadrupled since its 2009 lows2. But Apple shares are up 56 times. Long-term trends always trump short-term crises.

The investment process of our chosen provider, EBI, is designed to capture these kinds of long-term trends via their strategic asset allocation.

Strategic Asset Allocation

EBI’s strategic asset allocation has two key benefits. First, it keeps our clients invested at all times. Over time, financial markets reflect long-term trends in the world; Apple moved from being less than 1% of the US equity market in 2009 to nearly 7% today. That’s why, more than anything else, staying invested in times of crisis is important, as it lets you capture these global trends. Having a plan for staying invested is essential.

Secondly, their strategic asset allocation keeps our clients diversified. It’s difficult to identify where and what the genuine long-term trends in the world are going to be. In 1989, the world was obsessed with the fall of the Berlin Wall, and the end of the Cold War. But in the mountains of Switzerland, Tim Berners-Lee had just created the World Wide Web. Which mattered more?

Sometimes even a century later, it’s tough to know what’s important: 1928 saw the discovery of penicillin and the launch of world’s first television station. I’m not sure I know which has been more important to the development of society. So, we need to make sure we’re invested in a little bit of everything, regardless of what seems most important at the time. A broadly diversified asset allocation keeps lots of fingers in lots of pies.

What will be the defining event of 2022 for financial markets?

It feels tempting to say Russia and Ukraine. But the truth is that may just be a geopolitical blip. What if it’s the shift to working from home of the way workers are paid, reducing inequality? Could it be the downfall of Facebook and Twitter? We just don’t know and may not know for years.

So, we rely on EBI’s robust investment process. Remaining invested, across lots of different sectors and regions, all of the time; it worked in 2008, and through Brexit, and COVID-19, and so far in 2022. We think it will keep on working for the next few decades too.

I do hope the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered FCSI

Managing Partner

1 G. Lengauer, F. Esser, R. Berganza, Negativity in political news: A review of concepts, operationalizations and key findings. Journalism 13, 179–202 (2012)

2 Data from 01/03/2009 to 30/06/2022

Inflation, Interest Rates and Recession

This is my first ‘Round Robin’ e-mail since the end of June but that doesn’t mean I have not been paying attention to what has been going over the past couple of months – and it has been a lot!

The war in Ukraine continues unabated with seemingly no peaceful resolution in sight and this has exacerbated the inflationary pressures already being felt around the world. We knew of course that inflation was likely to rise as we emerged blinking into the sunlight at the end of the pandemic, people had money to burn and supply chains remained gummed up, with some countries, notably China, still enforcing lockdowns even now – the war in Ukraine has just made things worse.

The impact of the war in Ukraine cannot be overstated, the dramatic increase in wholesale gas prices is largely down to restricted supplies coming out of Russia and it’s difficult to see this changing much in the short-term, particularly while sanctions persist, and Putin needs a way to fight back.   

The outlook for the UK has worsened considerably over the past few months as the Bank of England (BOE) constantly revises its inflation forecasts upwards, heralding a tough winter ahead with energy bills likely become difficult for some and unaffordable for many. Whether or how the government can help those most in need remains to be seen.

The following chart shows how dramatically the BOE forecasts have changed since 2021:     

There are 2 particularly striking aspects to this chart,

1. How did those in charge of forecasting inflation, the so called ‘experts’, get it so wrong?

2. The expectation remains that inflation will revert to somewhere near the BOE’s target of 2.0% per annum by the end of 2024. Given my question in 1. above, how much confidence can we have that inflation will not prove more stubborn and difficult to shift?

In May 2021, the BOE was predicting inflation would peak at around 3.0%, by Feb 2022 this forecast had increased to 7.0%, only to be revised upwards again in May to 10.0% and then last week to 13.0%! As I say, how could they have got it so wrong?

It doesn’t help to apportion blame for this incompetence ….. but I’m going to. It’s Andrew Bailey’s fault, along with his fellow Monetary Policy Committee (MPC) members! Bailey was head of the Financial Conduct Authority from 2016 to the time of his appointment as Governor of The Bank of England, and he was pretty useless there too, presiding over a number of financial scandals in which many innocent victims lost their savings and dreams of a comfortable retirement. His reward for these failings was to be appointed to even higher office, a perfect example of someone being promoted beyond their capabilities, I do remember shaking my head at the time.

By way of providing a little balance, it must be said that being Governor of the BOE at the moment is something of a poison chalice, but we really should be able to expect more from our central bankers, steering us through this kind of maelstrom is pretty much their one and only job.

The markets take on this has been clear, the BOE should have raised rates sooner and more sharply as a signal that taming inflation was an urgent priority; it does now at least seem to have got the message. Last week’s Interest rate increase of 0.5% was the highest in 27 years, taking us to 1.75%.

The following chart shows how the Base Rate has changed since 2006.

The purpose of interest rate increases when attempting to combat inflation, is to reduce the amount of money in the economy, the idea is that if people and businesses have less money to spend (because their borrowing costs have gone up), demand will fall, followed soon after by prices. Whether this tactic will work, given that current inflation has not been caused by an overheating economy but (partly at least), by a foreign war, remains to be seen.

What interests me about the above chart is that there must be an entire generation of borrowers who have grown up on super cheap money and who might now face significant increases in their monthly mortgage and/or credit card payments at a time of rising energy bills and other non-discretionary items like food.

The last time interest rates went up by 0.5% rates were already higher, so the impact was arguably less. Going from 1.0% mortgage payments to 2.0% say, means your payments will double; if you are a young couple on a tight budget facing a winter of higher bills, this must be very concerning indeed.

At the BOE press conference, Andrew Bailey mentioned the dreaded ‘R’ word, recession and this prompted my eldest daughter to ask me, ‘What’s the difference between a recession and a depression?’ I think the following definition just about it sums it up:

I have already learned the difference between a Recession, a Depression and a Panic.

A Recession is where you tighten your belt; a Depression is when you haven’t any belt to tighten, and a Panic is when you have lost your pants.

— The Ephraim Enterprise (Ephraim, UT), 21 Jan. 1949

A depression is no laughing matter of course, just spend a few minutes reading about the early 1930s and you’ll see what I mean. By the way, I don’t think anyone is actually predicting a full-blown depression.

What did the financial markets make of all this talk of catastrophe? As usual, all the bad news, the increase in rates, the threat of recession etc. had already been priced in, and markets hardly moved at all. In fact, in recent days, US jobs data has surprised on the upside, putting a question mark over whether the US might actually escape a recession and markets have moved further forward. As I type this on 8th August, the FTSE is up 0.83% and the S&P 500 is up 0.74%, following quite a decent recovery which began on 16th June, see below:  

This chart shows the performance of a selection of the EBI portfolios since 16th June (yes, I did select the date carefully).

The portfolios are still down Year to Date, but things are looking a little better, for now.

This positive past few weeks does not necessarily mean the Bear Market is over and it’s entirely possible that markets might lurch downwards again at any moment BUT this shouldn’t alarm long-term investors.

Conclusion

In conclusion, the markets maybe don’t seem as pessimistic about prospects as Andrew Bailey did during his press conference but as always, we’ll have to wait and see.

I do hope the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered MCSI

Managing Partner

“Why have my low-risk investments gone down?”

It is a good question and one I have been hearing a lot lately.

Traditionally it has been accepted that one of the best ways to protect oneself from steep equity market falls is to include high quality bonds in a diversified portfolio. Usually, we would expect to see higher concentrations of bonds lead to lower volatility when stock markets around the world encounter turbulence, so why isn’t that happening now?

In a typical market cycle, the economic conditions that might lead to an equity market correction, are often the same conditions that favour bonds. As an economy contracts for example, interest rates tend to fall to help businesses and consumers with the cost of borrowing, this reduction in interest rates makes the fixed income yield of a bond more attractive and, as result, prices of bonds go up while equity prices are falling.

In a 50/50 portfolio of equities and bonds, if the equity market falls by 10% and the bond market rises by say, 4, then the net loss is 6% and not the full 10% experienced by equities. In these circumstances the bond holding has done its job in mitigating the worst of the falls.

What we are seeing now however, is something of a perfect storm, even for the most highly diversified portfolios; currently there really is nowhere to hide.

The following is taken from some interim commentary by Evidence Based Investments (EBI) whose expertise we employ in constructing and managing our portfolios.

“Current Situation

The current situation is rare in that both equities and fixed income have been falling. High inflation and fears of a slowing growth rate have been headwinds to both asset classes and headaches to central banks.

Inflation concerns have rapidly increased in the first half of the year. While central banks thought inflation would partly normalise and take care of itself in 2022, they were blindsided by the sudden Russian invasion of Ukraine. Russia is also a major energy and commodity producer providing roughly 10% of the global supply of oil and supplying Europe with around a quarter of its crude oil imports and 40% of its natural gas imports. The sanctions put in place have therefore affected energy and commodity prices, pushing them exponentially to extreme levels. This has intensified the surge in inflation, supply chain disruption, and the risk to global growth. The biggest issue we are seeing is when certain industries can pass off inflationary pressures to the consumers: prime examples are the energy, automotive and retail industries.

Why are bond prices falling?

The main narrative is the shift in gears by the central banks on hawkish stances which has led to further downward pressure on bond prices. The market environment is rare in that bonds and equities are falling in the same direction due to inflationary pressures. The unfortunate events taking place in Ukraine have exacerbated inflationary pressures due to the unexpected inflation created.

For a bond, one of the risks incorporated into a bond’s price comes from interest rates. Since we are currently in a high inflationary environment or heading towards a period of higher inflation, the increased inflation will tend to be countered by an increase in interest rates to steer the economic growth rate to a sustainable level and soothe inflationary pressure. Bond prices have an inverse relationship to interest rates, therefore when the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa. The Bank of England has recently increased the base rate multiple times within a short period, with the market pricing in further increases expected throughout the year. EBI portfolios are well-positioned to weather this type of environment due to the effective duration of our bonds. Our average effective bond duration is short-dated (4.3 years compared to 7 years of the Bloomberg Global-Aggregate) and duration can be interpreted as the measure of the sensitivity of a bond’s price to changes in interest rates. Therefore, the bond portion of our portfolio has reduced risk stemming from interest rate rises compared to longer-duration bonds. Short-duration bonds are closer to maturity and have fewer coupon payments remaining, nevertheless, we are not immune to market events.

Conclusion

With the current economic climate, it’s easy to be sucked into flashfire reporting using a short-term lens. It’s important to remember the primary role of bonds in a well-diversified portfolio, the bond portion of the portfolio is there to offer stability against the increased volatility of equity markets over the long-term, and shorter-duration bonds inherently have less inflation and interest rate risk and provide better protection and a smoother path.”  

The following chart shows how EBI’s higher concentration of shorter-dated bonds has led to lower falls than the bond market as a whole, scant comfort though that may be during this difficult period.

As I have been explaining to several clients, at some point the economic weather will change and with it, investor sentiment. In the Sunday Times this week and in a couple of blogs I have been reading, there is already talk of the falls in both bonds and equities possibly being overdone and that the gloomy outlook has been more than priced into current valuations. As usual we will just have to wait and see.  

I do hope all of the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered MCSI

Managing Partner

“Here’s why you should learn to take more risk!”

You will notice the heading is in quotation marks and this is because it was the title of an article I saw in the Money Section of The Sunday Times yesterday (12th June 2022), written by Ian Cowie.

Markets had another terrible few days last week as fears of a global recession persist and the war in Ukraine rumbles on, with no end seemingly in sight. Despite this and the extended decline in almost all asset classes since the beginning of the year, Ian Cowie is telling us to take more risk…….and I agree with him. We must never confuse short-term volatility with the possibility of no long-term growth.

Ian’s article follows:  

“Why do so many savers and investors misunderstand the relationship between short-term risks and long-term rewards? If that sounds a tad theoretical, then be aware that it might make the practical difference between living where you like and doing what you want, instead of having to settle for something much less enjoyable on both fronts.

The reason I ask is that new savings statistics from HM Revenue & Customs suggest that most people are still making the same old mistake with their annual Isa allowance.

To be specific, two thirds of holders of these valuable tax shelters are wasting time and money in bank and building society cash deposits, despite their meagre returns remaining barely visible to the naked eye.

It is a historical fact that shares reflecting the changing composition of the London Stock Exchange delivered higher returns than cash deposits in three quarters of the five-year periods since records began in 1899.

You don’t need to take my word for it, Barclays Bank publishes an annual analysis of returns from shares (also known as equities), plus cash deposits and bonds (gilt-edged stock issued by the British government) over the past 123 years.

The Barclays Equity Gilt Study shows that if you could afford to set aside money for five years in a row, you had a 76 per cent probability of doing better in shares than deposits. Put another way, the odds of doing better with equities for medium-term investors are slightly better than three to one.

People who could afford to remain invested for ten consecutive years enjoyed a 91 per cent probability of equity outperformance, despite the period of analysis including the Great Depression, both World Wars, Brexit, the Covid crisis and many stock market crashes. If I had to point to a single fact that made me a long-term investor in shares, that would be it.

Of course, there is the short-term danger of loss. If you could only remain invested for two consecutive years there was a 69 per cent probability of shares doing best. In other words, there was nearly a one-in-three chance that deposits would beat shares. What it all boils down to is the difference between the danger of short-term speculation and the rewards of long-term investment.

Against all that, another important fact in favour of deposits is that the Financial Services Compensation Scheme (FSCS) provides a statutory safety net to ensure that you will always be able to get back £1,000 for every £1,000 you deposit with a registered bank or building society, up to £85,000 per institution, per person.

Unfortunately, that guarantee only relates to the nominal value of your money, rather than its purchasing power.

The real value of money you set aside to spend in the future is falling by 9 per cent a year, according to the Consumer Prices Index (CPI) measure of inflation, or 11.1 per cent according to the Retail Prices Index (RPI). If inflation remains at those rates, CPI would halve the purchasing power of money in eight years, while RPI would take less than six-and-a-half years to do the same.

Bear in mind that Barclays has no reason to diss cash deposits because there are fat profits in banks paying individual savers a pittance, while these institutions invest your money to work for their own shareholders’ benefit elsewhere. By contrast, this DIY investor prefers to put my money to work for me.

Better still, in addition to the probability of bigger long-term returns, investors can immediately enjoy more income than savers because many shares pay dividends that beat bank deposit interest rates.

For example, McDonald’s (stock market ticker: MCD), the biggest fast-food chain in the world, which is due to distribute dividends on Tuesday, was yielding 2.3 per cent on Friday.

That’s the value of the income paid to shareholders, expressed as a percentage of the current share price. Interestingly, the independent statisticians Refinitiv calculate that MCD’s dividends have increased by an average of 7.8 per cent a year over the past five years. So, if that rate is sustained, shareholders’ income will double in less than ten years.

None of that is guaranteed but MCD has raised its dividends every year since 1976. Here and now, 30 per cent net profits give a return on investment of 15 per cent, so the burger-flipper should continue to supersize payouts for a while yet.

This DIY investor paid $95 per MCD share in July, 2014, as reported here at that time, and they trade at $238 each now. That has made this business my third-most valuable holding, worth a low six-figure sum.

I could report similar returns from other top ten holdings, including the tractor-maker Deere (DE); the technology giant Apple (AAPL) and the agricultural commodities group Archer Daniels Midland (ADM).

None of these businesses could be described as low-profile or high-risk. But they all beat the banks when rewarding long-term investors for putting our money at risk. I’m lovin’ it.”

Summary

No matter how counter-intuitive it may seem, now is the time to be investing cash (maybe transferring Cash ISAs to Stocks and Shares), for two reasons:

1. Inflation is going to erode the spending power of your cash savings increasingly quickly if it persists at current levels, or even if it falls back to say, 4% per annum. Unless your cash is delivering at this level (spoiler alert – it’s not) after tax, then you are destined to become poorer, even though the nominal value of your money stays the same.

2. The markets are at levels last seen more than a year ago, this means, from a long-term perspective, they are at a discount!

I do hope all of the above makes sense but, as always, if you have any concerns about your own financial arrangements or would like to discuss whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered MCSI

Managing Partner

Update – 26th May 2022

As the war in Ukraine shows no sign of ending, conditions for investors across the world remain challenging; inflation is rising, supply chains continue to be stretched and consumer confidence is low. Against this backdrop which has existed since the start of the year, both equity (shares) and bond (fixed income) markets have fallen; equities have fallen because of worsening outlook for consumers and the prospect of a recession and bonds have fallen because rising interest rates (to combat inflation) reduce the value of the fixed returns that bonds provide.

The impact of these headwinds has been felt within the Clearwater Investment Portfolios constructed by EBI but also by every other fund manager across the globe. No manager of highly diversified portfolios is immune from market corrections and the following charts provide confirmation of this.  

The first chart shows how our Vantage Earth 60 has performed since the start of the year, when compared with the following benchmarks:

UT Mixed Investment 0%-35%

UT Mixed Investment 20%-60%

UT Mixed Investment 40%-85%

As a reminder, Vantage Earth 60 has 60% exposure to global equities and 40% exposure to global bonds, it is the most popular portfolio with clients of Clearwater, as it provides an opportunity for real growth with manageable downside risk.

The numbers next to each of the benchmarks represents the percentage exposure to equities of the funds contained within the benchmark. So, UT Mixed Investment 20%-60% represents all funds in the UK that have exposure to equities of between 20% and 60% - The very lowest would have 20% equity exposure and the very highest 60%, whereas Vantage Earth 60 has exactly 60% exposure to equities.

In a rising market we would expect Vantage Earth 60 to outperform the 20%-60% benchmark because it has higher equity exposure than many of the funds contained within the benchmark. Similarly, we would expect Vantage Earth 60 to underperform the 40%-60% benchmark because many of the funds represented will have higher equity exposure.  We would, of course, expect the reverse to be true in a falling market, as the funds with the highest equity content will usually fall furthest.

Let’s take a look at a chart showing how things have gone since the beginning of 2022:

I would say, this is pretty much what we would expect to see, given market conditions that have prevailed since January.

I have included the above chart so that our clients might take comfort from the fact that, although their investments have been falling, as happens from time to time, they are not alone.

This might lead you to question, ‘If I am only matching the benchmarks, where are Clearwater and EBI adding value in the investment process?’ Over the short-term this is not always obvious but if we extend the time period covered by the chart, things do look a little different.

This next chart replicates the first but over the last 5 years:

In the above chart EBI Earth 60 has clearly outperformed the comparable benchmarks.  

What about the outlook?

The following is taken from some commentary I received this morning from 7IM Investment Management:

“There is a saying in finance – ‘markets can only look around one corner at a time’. Headlines tend to jump from one narrative to the next. Suffice to say, investing on this basis is not a great strategy. Worrying about the next corner often results in poor decision making – usually demonstrated by selling after the fear has already been priced in. Instead, we try to build portfolios for the longer term, looking around 3 or 4 corners.

When we look around the first corner, there are some near-term concerns. Goods producers thought we’d be at home for longer than we were, and as a result, have made too much stuff – there is almost certainly a manufacturing slowdown coming. The surge in rates is taking the steam out of the housing boom. And higher inflation is eating into strong wage gains.

But looking beyond this first corner, it looks to us that any growth slowdown is likely to be short-lived. The manufacturing slowdown is just a reversion to normal production – we overspent on goods while locked down, and now we’ll underspend for a bit. The imbalance between housing supply and demand means that the rates impact will be short-lived – people need to live somewhere! And those pent-up savings are still there, ready to supplement spending where required.

Putting it together, we believe any near-term growth slowdown will be moderate, short-lived, and eventually give way to stronger growth.”

I thought it was good to end on a note of optimism!

As always, if you have any concerns about your own financial arrangements and whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered MCSI

Managing Partner

Time in the Markets and not Market Timing!

"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." – Peter Lynch, Mutual Fund Manager

During periods of heightened financial market volatility, and increased levels of uncertainty, it can be tempting to try and time the market by selling assets and then buying back at a later stage. However, timing the market is virtually impossible, even for the most experienced investors. This is why it's often said that, time in the market is more important than timing the market.

As investors, we are often too emotional about the decisions we make. When markets dive, too many investors panic and sell; when stocks have had a good spell, too many investors go on a buying spree. Many investors try to time the market, however, having such a short-term horizon can harm performance and jeopardise your long-term financial objectives.

People tend to ‘panic sell’ based on their past experiences. There have been six major crashes in the past 30 years, so psychology plays its part.

-              1987 Black Monday

-              1997 Asian economic crash

-              1998 Russian economic crisis

-              2001 Tech stock crash

-              2008 global financial crisis

-              2020 COVID-19 selloff

It is never an easy ride on the way up in a bull market. Investors seem perpetually concerned, worried about the valuation levels, forever peering around the next corner and ever watching for the canaries in the coal mine that might signal the onset of the next market downturn. Prospect theory from behavioural finance suggests that investors are more likely to focus on gains rather than the perceived risk of loss when the outcome of an investment is uncertain. This ties into regret aversion where the fear of a loss outweighs the joy of winning – hence many investors panic sell when the going gets tough. This is a large reason why investors are always encouraged not to look at their investments every day.

The pace at which markets react to news means stock prices have already absorbed the impact of new developments and when markets turn, they turn quickly. Those trying to time their entry and exit may actually miss the market bounce. Timing the market is trying to predict the future and you could end up being out of the market when it unexpectedly surges upward, potentially missing some of the best performing days.

No one can consistently pick the best or worst days of the year, so this is why it can be so dangerous for investors to miss time in the market by trying to time the market. If you miss one or two big days, compounded over time, this can greatly impact your portfolio.

The graph below illustrates how a hypothetical $100,000 investment in the S&P 500 Index would have been affected by missing the market’s top performing days over the 20-year period from 1 January 2002 to 31 December 2021. For example, an individual who remained invested for the entire time-period would have accumulated $616,317, while an investor who missed just five of the top performing days during that period would have accumulated only $389,263.

Source: BlackRock, Bloomberg

Adding to the difficulty of trying to time the markets, most of the best days happen around the worst days. Over the last 20 years, 70% of the best 10 days happened within two weeks of the worst 10 days (Source: Factset). Incessantly going in, and out, of the market erodes returns and can also have tax implications and transaction costs.

It is true that a broken clock is right twice a day and hindsight is wonderful, but we are not soothsayers. If it was easy to time the market, lots of investors would be doing it and retiring early in the Bahamas, but this is not the case. We must remember that short-term volatility is the price you must pay for the chance of higher long-term returns and let the power of compounding take effect rather than potentially crystallising losses.

Diversification

Avoiding all risk is impossible but we must look at what we can control in the investing world – having a well-diversified portfolio that can weather the stormy financial markets is one of the few things we can do.

Each of the coloured boxes in the chart below represents a different asset class, don’t worry if you can’t clearly see which is which, it isn’t a very clear picture. The point is that there is no clear pattern that emerges over time, as to which is the best asset class to invest in, thus the only way to be sure of capturing the ‘free’ rate of return that capitalism provides is to invest in the most diversified way possible, which of course, is what we do.   

In summary, holding a highly diversified portfolio and not responding in a knee jerk fashion to short-term market volatility is the best way to guarantee long-term returns in excess of inflation. BUT, in pursuit of these returns we must accept that, from time to time, markets will fall and losses can appear on paper, however, these losses are temporary, they only become permanent if you sell.

Having spent most of this piece arguing that timing the market is a very difficult game to play, it does stand to reason that when markets have fallen, opportunities to invest at better prices do arise. As I always say, markets could still go down from here, but one thing is certain, they are cheaper than they were 4 or 5 months ago, so now could be a good time for the long-term investor (all of our clients) to add to their holdings.   

As always, if you have any concerns about your own financial arrangements and whether you are truly making the most of your money, please do not hesitate to call me.

With kind regards,

Yours sincerely

Graham Ponting CFP Chartered MCSI

Managing Partner