Taking a defensive approach to charity investing
A year ago, it was fair to predict that the US and UK economies would make further progress on a self-sustained basis. Europe would struggle, while Chinese economic growth would continue to slow, with natural impacts on developing nations reliant on trade with China.
Against this backdrop, many charity investors assumed that six years after the financial crisis the US Federal Reserve and other central banks would continue to promote growth, while ending their programme of quantitative easing (QE) and easy monetary policy – in the case of the US and UK. This would result in higher bond yields and a possible de-rating of expensive share prices.
Against this backdrop, many charity investors assumed that six years after the financial crisis the US Federal Reserve and other central banks would continue to promote growth, while ending their programme of quantitative easing (QE) and easy monetary policy – in the case of the US and UK. This would result in higher bond yields and a possible de-rating of expensive share prices.
As January is typically the month that the investment community issues their forecasts for the year ahead, an activity akin to catching a falling knife, we have already witnessed a few notable events, some unpredicted. The European Central Bank bowed to pressure in being the latest to launch QE. Greece voted in a political party, whose main policy was to remove the European austerity measures, possibly leading to their exit from the European Monitory Union. Switzerland abandoned its currency peg with the euro and the resulting sharp appreciation in the Swiss franc. A year ago, few would have predicted the collapse in the oil price within a six-month period beginning in July 2014.
Growing steadily
There are a few things that are more predictable. The UK and US economies are growing steadily. While the euro-area fell into deflation in December, the real economy continues to observe stabilisation despite the weak inflation picture, which will no doubt be assisted by the accommodative monetary policy. China’s adjustment to a slower growth path continues and, partly as a result, emerging markets remain in a weaker state than the developed world.
With these factors in mind, market volatility has been picking up more recently, including visible spikes in October, December and January. The nervous tone has been driven by the significant move in the oil price. Looking ahead, the overwhelming question centres on whether financial markets will start to ignore the dramatic move in oil, and related to that the strengthening US dollar. In the short term, it would be sensible to expect a period of adjustment as the ramifications of energy price declines continue to be absorbed by the markets. However, longer term, there is conviction that the positive effects of energy price declines will act like a large tax cut or wage increase, benefitting global growth and non-energy related companies and sectors.
Of course, cheaper energy will also keep inflation at bay, giving central banks further time and less need to raise interest rates in the near future. It will certainly assist Asian economies which are significant importers of oil, offsetting the effects of a slowing economy in China. Meanwhile, investors are still very hungry for income and forever chasing assets that display a modest yield. This outcome may keep the Roman farmers happier for longer, with low bond yields, higher equity and property prices. We are seven years into the recovery from the financial crisis and the standard economic cycle may be extended for years to come until the normal cyclical pattern resumes.
Valuation levels
There are certainly big risks to consider. While the US economy is undoubtedly growing, the US stock market has risen for six consecutive years and valuation levels are relatively high. Furthermore, the strength of the US dollar could provide headwinds to earnings growth of US companies. . The position in Greece is far from clear, given it has voted for an end to austerity but not to abandon the euro. The religious tensions in the Middle East, tragically played out on the streets of Paris recently, together with a new ruler in Saudi Arabia will not help settle investor mood.
If charity investors wished to take defensive measures in these uncertain times, there are a number of traditional options to hedge against short term volatility. It is worth considering a number of alternative asset classes:
BONDS. As previously discussed, the hunt for income and yield, together with the natural hedge against volatility, has pushed conventional bonds to ever higher levels. Despite this, there is merit in having an increased duration exposure in portfolios. Global fixed income markets are pricing in a benign inflation outlook and charities should expect longer dated maturities to benefit in the near term. The US treasury market offers better relative value versus other developed bond markets, due to the higher yield which should continue to attract a strong technical bid from overseas.
PROPERTY. Investors’ conviction in the UK property market remains strong, given the low interest rate environment which should help to compress yields further and improve capital growth. A key support to the UK property market in 2015 will be rental growth, especially in London, where there remain significant supply constraints. Indeed, outside Mayfair, rents in London as a proportion of company costs remain well below peak levels. Capital growth should improve incrementally as yields compress.
Relatively unattractive
COMMODITIES. The oil price shock and the general negative sentiment across most commodities underline the relative unattractiveness of that investment in portfolios. The energy sector will continue to grapple with excess supply issues and there is little evidence yet to suggest that the oil price is stabilising. The attraction of gold and precious metals is not evident in a low inflation world and where there is mute demand. Nonetheless, most commodities are trading at the bottom of their 5-year ranges, which at some point will present tactical buying opportunities. Currently, though, the futures curve, which is the most accessible way of investing in the commodities market, is not favourably priced across most commodities.
HEDGE FUNDS. The sector continues to adjust to a world of lower credit and investor demand for transparency with low fees. Despite this, and some notable hedge fund closures, there are some interesting areas, particularly as market volatility has increased. A focus on equity long/short strategies in both equity and credit, as well as macro strategies, could provide a useful defensive measure. There is less scope to take advantage of interest rate movements in the current environment, but over time as central bank policy divergence widens, one expects more opportunities will be created.
CASH. Low interest rates will keep returns on cash at low levels for some time to come. Given the current environment, it can be argued that holding higher levels of cash in portfolios gives charities a good measure of liquidity should another crisis emerge and a ready source of funds to invest as opportunities arise.
For those charity investors looking to make quick and cost effective changes to asset allocation, they might consider using exchange traded funds (ETFs) as a means to gain exposure to markets. These funds are constructed to closely track the performance of a particular market or asset class. They are generally London Stock Exchange listed funds, with high liquidity, offering cheap, transparent and liquid exposure to the underlying assets. Management fees are typically low too, but care must be taken when investing into ETFs which follow a synthetic replication method, especially funds which track commodities, as they will invest in derivative contracts that can perform differently from the underlying asset, not to mention any counterparty risk.
Modest risk
In practice, most charities have a long term investment horizon and with sufficient liquidity elsewhere in the charity, so can take relatively modest risk in their portfolios. Despite the increase in volatility, cheap energy will reduce inflation, so the Fed is likely to be relaxed as growth strengthens. It is more likely that the US will tighten policy this year in a measured way, in order not to damage the economic recovery. This should be accompanied by job and wage growth. It is difficult to call the economic outcome of the UK election, which may lead to more uncertainty for financial markets.
While charities should expect further gains in most core asset classes, it is likely to be modest. Bonds are likely to remain expensive and equity prices volatile to headline news events. Charities have fewer defensive measures in their portfolios, but regular reviews of the investment policy are encouraged to maintain an appropriate mix of assets in uncertain times.
