What now for charity investment?
As charities perhaps pause for the summer, it gives time to reflect on the year to date and make preparations for the remaining months. Also, it is interesting to take stock of current thinking and aspirations or worries for the future as these are so wide ranging.
While a number of previously simmering anxieties have come to the fore, be it tension in bond markets over interest rate increases, economic uncertainties in China or Greece and the EU, the main concern charities currently have is not necessarily financial. The increasing scrutiny of charitable activity in the UK is causing some alarm as the Charity Commission and the media take a greater interest in the workings of charities.
This doesn’t mean financial and economic issues are being ignored and it is possible that a number of factors will cause charities to take action. The outcome of the scrutiny within the ongoing investment debate is a significant factor in relation to investing with an ethical or social responsibility, in order to support the charitable objects of the organisation in line with donors’ wishes and the interests of beneficiaries.
Considering investments in general, attention to interest rates is increasing with growing confidence in the global economy amid signs of reflation and a significant oil price bounce in April. While oil and other commodities have seen recent price weakness, the overall confidence has translated into higher mid and longer-dated bond yields as interest rate expectations have been reset. These developments have most prominently played out in Europe, where the usually sedate German bond market has been an unlikely source of volatility.
Almost perfect environment
Bonds have enjoyed what could be termed the "almost perfect environment" for the last thirty years which is declining inflation and therefore declining interest rates. The next thirty years are likely to be less perfect.
Charities should not subscribe a high probability to the notion that we are entering a profound and prolonged bear market in bonds. Global debt in aggregate is at an all-time high and this will mean that the growth we experience globally in the next few years is likely to be less pronounced than more recent economic cycles. This is important as one consequence is that the long term interest rate for the global economy will be lower than been perceived in the past as "normal" and therefore will keep a lid on how far bond yields will move over the foreseeable future.
Confusingly and to demonstrate signs of higher volatility, last quarter’s "mini-tantrum" in bonds tells us that we are entering a period of greater circumspection. This was an additional warning signal to those flagged in October 2014 and January 2015. Somewhat ironically, despite more signs of global economic healing, central bankers are warning investors to prepare for more turbulent times ahead.
Most would agree that as the bull market since the credit crisis matures and valuations creep higher across asset classes, there is more opportunity for disappointment and risk. Thinning market liquidity, Greek headline risks and how the Federal Reserve in the US manages its exit from zero interest rates create the conditions for volatility. Global central bank quantitative easing policies also have potentially unknown consequences. The foreign exchange markets have taken most of the pressure, but other asset classes are also vulnerable, such as emerging markets.
Global economic activity
Reassuringly and after a slow start to the year, global economic activity is picking up. Investors’ concerns about the depth of the US downturn have largely eased, and the data is increasingly supporting the view that the first quarter stall was related to temporary factors. Across developed economies, we are seeing broad indications that economic growth is on track, with manufacturing output starting to recover, service activity remains robust and stronger jobs growth is leading to modest wage gains.
For those charities invested in fixed income markets, holding shorter dated bonds and with a reasonable percentage in sovereign issuers should help to avoid capital losses in longer duration bonds. Having a preference for less duration-sensitive sectors such as floating rate notes and high yield bonds should benefit charities as fixed income markets become more volatile.
Turning to another significant uncertainty, despite achieving a very strong return in the second quarter, China’s domestic "A" share (onshore) market has seen significant volatility, falling nearly 16% from an eight-year high in early June. The Chinese "A" share market started to look interesting to when the Shanghai-Hong-Kong-Connect programme opened last November to provide more access to foreign investors. It was a deliberate strategy of expressing a positive view on China with the understanding that the "A" share market was not as developed and mature as the offshore Hong Kong market. Despite the significant market fall since early June, the onshore market is more than 50% higher from the announcement of that programme and 100% higher from the cycle low of March 2014.
Many investors are justifiably questioning the tactics of the Chinese government’s intervention into the onshore equity market. It should be acknowledged that some policy actions are concerning; specifically, the ban on major shareholders to liquidate stocks and the pressure on private investment banks and fund managers to buy the market. Other steps to curb margin trading and to inject liquidity were probably necessary. Arguably, the purchasing of the stock market on the part of the central bank, sovereign wealth funds and state pension funds is not so dissimilar to programmes that have been followed in other major developed economies.
Clearly, there are lessons to be learned. The government’s tactics have been counter-productive and have undermined confidence among foreign investors. Due to the significant volume of leverage in the market and the largely retail investor base, the sell-off has become self-reinforcing, which has prompted aggressive policy actions. While the authorities are facing new challenges as the market infrastructure matures, they have strong tools to manage the real economy; for example, there is plenty of room to cut interest rates.
Fixed asset investment
The area of the economy which has seen significant contraction is fixed asset investment growth, mainly due to overcapacity issues in property and certain areas of manufacturing. However, this is a necessary adjustment as China transitions to a more sustainable growth model. It is arguable that China is not in the ‘hard landing’ camp, but rather a structural slowdown story.
Despite nervousness in bonds and China, charities should continue to participate in rising equity markets and remain committed to several market themes depending on two main outcomes. If investor sentiment remains positive, Europe remains a favoured area on the expectation of a further recovery in valuations and broader economic improvements.
Notwithstanding increased Greek-related volatility recently. Likewise, retaining a reasonable exposure in Japan, where corporates’ increasing focus on shareholder-friendly activities is underpinning the strength of its domestic equity market. Notwithstanding higher volatility, select country exposures in China and India are expected to benefit from long term fundamental economic and market reforms.
If the mood turns negative and uncertainty in asset classes increases, charities should remain invested in developed equity markets such as the US, which generally is seen as a safer haven with stronger growth prospects. The UK market is vulnerable to weakness in commodities, given the higher exposure to energy and mining companies in the larger capitalised stocks that represent over 15% of the FTSE 100.
In property, charities should remain focused on UK commercial property in London and other key UK cities, where supply constraints should drive capital and income growth.
Although at times unexciting and potentially more volatile, taking a prudent approach will continue to deliver rewards as charities are generally long term investors. Holding slightly higher levels of cash in the short term will create opportunities to invest as we see more periods of market dislocation.
Managing downside risks
All of these considerations reinforce the belief in actively managing downside risks as well as creating opportunities. Most pleasingly, taking the Asset Risk Consultants ARC Charity Indices as a proxy of charity returns, all risk strategies have delivered positive absolute returns over the first half of 2015. Careful planning for the remainder of the year, with an eye on the big risks and potential drawdowns in markets should be the key for charities when they consider their investments.
