Market Outlook Report – October 2016

Brexit Update

The rollercoaster performance of the UK stock market in the wake of the referendum has been rather entertaining for market pundits. Its sharp fall in the immediate aftermath of the vote to leave was taken by some as a proof of the economic folly of Brexit. Yet the hawks had nothing to say when the indices later made a full recovery. And they were still quieter when it powered ahead of their previous levels.

It should have been obvious to them that short-term stock market movements say nothing useful about broader trends and true fundamentals.

It should have been obvious to market pundits that short term movements tell us nothing about the true funamentals of our economy.

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Yet doubts have been creeping back over the past five weeks. The FTSE 100 and the Dow have both fallen back and this has not been driven by Brexit alone. There is a growing fear that world economic growth is slowing and that policymakers have run out of tools to do anything about it. Commercial banks have found it hard to cope with negative interest rates. Something which has been demonstrated by the struggles of recent quantitative easing programmes.

The Key Risk in Today's Market

A key risk is how the future relationship between the UK and Europe will affect the real economy. Brexit will undoubtedly have an impact on political decision-making processes in the rest of Europe. But whatever the final deal looks like, the UK will still part of an region that is heavily interdependent. This relationship between the UK and its European neighbours will not cease to exist after Brexit. It will merely change. We therefore believe that the impact of Brexit on the European economy, albeit negative, will not be disastrous.

married couple arguing

The UK and EU are breaking up but it's not clear yet what the divorce settlement will look like.

We are not therefore prepared to downgrade the whole European economy because of Brexit.

In terms of asset allocation, we remain convinced that European equity has a potential. In fact, we believe that European equity is currently a less risky alternative to other developed equity markets which we think it holds for both the UK and the rest of Europe.

Europe

On the face of it, the European macro-economic picture is a bit of a basket case. There’s its broadly declining working population, slow productivity growth, high structural unemployment, high debt levels and - to top it all - a risk of EU dissolution. This isn't exactly a recipe for success.

queue of people looking for a job

The European economy is beset with difficulties - high unemployment being one of them.

However, these downside factors are already priced into market valuations so there may not be and further significant falls.

But that’s not to say that the only way is up. The slowdown of the eurozone's largest economy, Germany, has hit market sentiment. France is now expanding at a faster rate than its neighbour; the first time in more than four years.

Europe is still more attractive than the United States on a 10-year view under the most plausible scenarios. And for us there appears to be two standout opportunities from a valuation perspective: European energy and the European emerging market.

I like the European energy and emerging markets - Nigel Reeves

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UK Inflation

Inflation remained unchanged in August due to cuts in alcohol prices, cheaper hotel rooms and clothing discounts. This was counter to forecasts that the weak pound would lead to higher prices for everyday goods and services.

The Consumer Price Index (CPI) that is used to measure the headline rate of inflation in the UK rose by 0.6 per cent in the year to August. This was the same as in July, according to the Office for National Statistics. Economists had been expecting inflation to rise to 0.7 per cent. However, the ONS stated that there were signs of price pressures on manufacturers and businesses.

Inflation hovered around the zero mark for all of 2015. However, the sharp fall in sterling’s value since the Brexit vote will make imports more expensive. It’s likely that supermarkets, manufacturers and businesses will eventually pass on their higher costs to consumers.

graph of uk inflation rate over time

There was no change in UK inflation rates during August 2016

Monthly inflation rates in the United Kingdom are reported by the Office for National Statistics.

Sell in May and go away. Come back on St Leger day.

"Sell in May and go away. Come back on St Leger day", is probably one of the best known of all stock market adages. Unfortunately it is also woefully out of date.

The saying dates from a time when the market was dominated by a small number of wealthy investors. They would leave London in May to enjoy sporting events out in the country for the summer. With fewer players in the market, liquidity would be thin and anyone trying to sell would be met by an absence of buyers. Hence it was considered better to wait until the world’s oldest classic flat race, the St Leger, had taken place at Doncaster Racecourse before returning to business.

the st leger takes at doncaster

Today's markets operate all year round and trading is no longer thin from May to the day of the St Leger Stakes in September.

The Markets No Longer Break For Summer

The London Stock Exchange is open for business all year round these days. This summer gone was far from uneventful on the markets. The EU referendum initially knocked more than 8% off the FTSE 100 and 13% off the FTSE 250. Yet both indices finished August flirting with their all-time highs.

Investors who sold on 1 May this year only to buy back on 7 September would have missed out on a 10% increase in the FTSE All-Share. However, this year at least, St Leger Day might still have represented a good time for investors to get back in the saddle. The 2016 St Leger ran on 10 September, 80 days after the referendum was held.

The Summer of 2016 Has Been A Rollercoaster Ride

Initial fears about what the referendum meant for UK-focused businesses were quickly offset by the fall in sterling. This boosted the values of companies with overseas earnings. However, the initial rally was quickly followed by a batch of negative survey data. The closely-watched UK Service Sector Purchasing Manager’s Index fell to a seven year low in July. More positive survey results suggesting that confidence has recovered from the immediate post-referendum blues have followed.

The Bank of England added to the uncertaintly when it took the surprise decision to hold interest rates steady at its July meeting. It did however hint strongly that it would take action in August. The interest rate was duly cut and an expanded quantitative easing (QE) programme launched in August. The bank suggested it could go further if necessary, a comment which provided a further boost to asset values.

Looking Forward

There are a few things that do look relatively certain, although the nature of the UK’s relationship with Europe will remain the subject of political wrangling for years to come:

Firstly, the continued weakness of sterling will likely result in inflation picking up in the near future as imported goods become more expensive to sterling buyers. Secondly interest rates are likely to remain lower for longer.

Big business will benefit from the weak pound and low interest rates. It's going to be the small businesses up and down the country who suffer.

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This combination would be good for some businesses with large international earnings and the ability to use cheap debt to invest for future growth. But it will be bad for others, especially mature businesses who sell imported goods to a largely UK customer base.

Cash Savers Are Bearing the Brunt

However, there is one group for whom it is an undeniably toxic mix: cash savers.

Pile of cash

Cash savers may be hit by a double whammy of high inflation and low interest rates.

Record low interest rates and increased living costs will erode the purchasing power of those with savings if the rate of inflation outstrips the interest paid on savers’ cash. For those investors who have been sitting out the recent market volatility, this year’s St Leger Day could mark the point where they consider re-entering the market.

What’s better for retirement — property or pension?

Recent research by the Nationwide Building Society and Fidelity International has provided an interesting insight into the comparative performance of property and shares over the past 30 years.

Investment Peformance of Property

It was no great surprise to see typical house prices have quintupled over this period, from £38,250 in 1986 to £204,240. Prices paid by first-time buyers soared sixfold over the same time, from £29,450 to £175,450.

Research shows that equities have outperformed property investments over a 30 year period.

However, the journey hasn’t been smooth. Average house prices fell by nearly a fifth over a six year period between 1989 and 1995. Around 1,500 properties a week were being repossessed by lenders at the worst point in 1991. Yet despite spells of turbulence, property prices rose by 434% overall through the 30 year period.

Historical Share Price Performance

So what about the performance of shares over the same period? It may surprise some people that the stock market has done even better. The FTSE 100 index of Britain’s biggest public companies has delivered total 12-fold return from 1986 to 2016 — turning £10,000 then into £126,870 now, assuming all dividends were reinvested. Meanwhile, investments in mid-sized companies in the FTSE 250 soared at over twice the rate, turning £10,000 into £265,000 over the same period. That’s 26 times the initial outlay.

Property vs Shares? The evidence says that shares have performed better over the last 30 years.

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It hasn’t been plain sailing for stock market investors either: There have been some real scares including ‘Black Monday’ (19 October 1987, when stock markets around the world crashed rapidly) ‘Black Wednesday’ (16 September 1992, when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism), the collapse of the 1995–2001 ’dot-com bubble’ and the global credit crisis (triggered by Lehman Brothers going bust on 15 September 2008).

Shares Have the Edge

There is risk inherent in any investment, whether shares or property, and there are no guarantees attached to either. Evidently, the performance of shares has had the edge over property during the past 30 years. There's no reason why you shouldn’t experience positive returns in the future with the support and professional, proactive investment management of a trusted advisor like Reeves.

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) were introduced in the UK in 2007. Since then, most of the UK’s largest property companies have converted to REIT status. This includes big names such as British Land and Land Securities.

Here we take a look at what REIT status means and why REITs could be of particular interest to income investors. We then take a closer look at one REIT that we particularly like.

What is a REIT?

A REIT is essentially a company devoted to property investment. This means that, unlike many other property investments, it can be easily traded on the stock exchange – exactly the same as any other share. This can make it an attractive way for retail investors to access property investments at reasonable prices.

The government wants to encourage investment in UK real estate and offers some attractive tax breaks as an incentive. REITs, for example, do not pay any corporation or capital gains tax on their property investments. However, there are some pretty strict parameters that must be met in order to qualify for REIT status. At least 75% of a company’s profits must come from property rental and 75% of the company’s assets must be involved in the property rental business. REITs must also distribute 90% of their property rental income to investors.

Specialist vs. General REITs

REITs are not all alike. Some larger companies, such as British Land, operate in a variety of different real estate types. But there are a number of specialist REITs that focus on particular segments of the market – including healthcare, logistics and retail.

What are the advantages for income investors?

Having to pay out 90% of rental income as dividends can make REITs an attractive option for investors looking for income. The special tax arrangements also mean that the dividends are only assessed for tax once, rather than twice as would otherwise be the case.

Many REITs have long-term lease agreements with their tenants which helps to make rental income relatively reliable. Althoughthere are no guarantees of course. Those who are able to impose regular rent reviews on occupiers should also enjoy steady, if usually unexceptional, income growth.

These traits led us to include Tritax Big Box, a logistics-focused REIT discussed in detail below.

Tritax Big Box REIT plc

Tritax Big Box REIT plc was identified and selected as a core holding in our Balanced Investment Portfolio some time ago.

Business Overview

The company owns a £1bn+ portfolio of Big Box buildings. Those are the vast, looming distribution centres that line major trunk roads. Online retailers in particular are a strong source of demand for these buildings. They fill them with automated goods handling equipment that are essential for driving costs down. Tenants tend to stag once they are fully installed because the capital they invest inside the building tends to be many times the building’s value itself.

Tritax tenants  are so keen to have the best-located and most flexible buildings that they commit to long leases with upward-only rental renewal arrangements. That keeps revenue visibility high and means tenants like M&S, Rolls-Royce motor cars and Sainsbury are unlikely to miss their rent payments. Borrowings are targeted to be 40% of the property’s value or less and the average lease has 16 years left to run. The shares offer a prospective yield of around 5.1% (variable, not guaranteed and not an indicator of future performance).

Tritax Big Box REIT plc Share Price

Graph of Tritax share price

It is important to remember that REITs are high yielding stocks.

Recent Liquidity Issues Have Benefited Tritax

A number of unit trusts and OEICS have been forced to sell assets in order to meet redemption requirements following the recent liquidity issues that affected a number of open-ended retail property funds. These distressed sales presented REITS like Tritax with opportunities to pick up some attractive buys. Like all investment trust companies, REITS don’t suffer from the inherent liquidity risk which affects unit trusts and OEICS when faced with overwhelming redemption requests.

I like the "get rich, slowly" benefit of the Tritax REIT. It won't shoot the lights out, but instead focuses on a steadily increasing dividend - Nigel Reeves

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Tritax should be viewed as a "get rich, slowly" scheme. It is not trying to shoot the lights out, simply to deliver a steadily increasing dividend. The prospective 5% yield on the stock is very attractive, compared to gilts or bank deposits. Tritax Big Box is therefore a strategic ‘hold’ within our pension investment portfolios for these reasons.

Investment Performance of Reeves Managed Pension Balanced Portfolio

Name Total Ret
1 Day
(Daily)
Total Ret
1 Wk
(Daily)
Total Ret
1 Mo
(Daily)
Total Ret
3 Mo
(Daily)
Total Ret
6 Mo
(Daily)
Total Ret
1 Yr
(Daily)
Baillie Gifford Shin Nippon Ord -0.08 6.23 9.18 12.15 17.30 54.65
AXA Framlington Biotech GBP Z Acc -0.78 2.64 6.71 22.12 25.45 1.30
iShares US Property Yield 0.15 4.29 3.05 11.05 21.06 42.53
Jupiter Financial Opportunities Inc -0.34 1.79 2.91 13.43 15.88 15.69
Empiric Student Property PLC 0.87 1.98 2.62 4.62 9.55 12.33
JPMorgan European Smaller Comp Ord -0.65 1.45 2.50 14.12 19.01 32.33
Marlborough Special Situations P Acc -0.40 -0.77 2.20 17.83 9.66 12.45
Schroder US Mid Cap Acc -0.81 0.82 1.92 9.38 19.53 29.66
Schroder Global Cities Real Estt Z Acc 0.10 2.67 1.86 9.27 16.59 29.93
Jupiter North American Income Acc -0.14 1.95 1.34 12.53 18.26 36.25
Threadneedle Eurp Sm Cos Ret Z GBP Inc -0.98 0.04 1.20 13.56 15.82 30.59
Schroder European Sm Cos Z Acc -1.40 -0.62 1.17 16.22 14.45 24.90
Legg Mason IF CB US Eq A Acc -0.53 0.00 0.91 10.34 17.92 29.47
iShares Core S&P 500 -0.95 1.02 0.84 11.14 15.97 32.38
AXA Framlington Financial Rl Acc -1.23 -0.10 0.81 15.90 14.71 12.69
Lazard European Smlr Coms Retl C Acc -0.82 -0.10 0.64 14.27 11.33 22.64
Fidelity American Special Situations -0.63 0.14 0.57 8.08 16.52 28.56
Liontrust Special Situations I Inc -0.36 -1.20 0.41 15.19 15.15 21.92
GCP Student Living Ord 0.00 0.00 0.00 4.80 5.60 13.88
Target Healthcare REIT 0.00 0.00 0.00 -0.20 2.90 9.32
Tritax Big Box 0.00 0.00 0.00 5.94 5.94 13.32
Investec Cautious Managed I Acc Net -0.56 0.04 -0.02 6.20 8.88 12.98
MedicX Ord -0.02 0.01 -0.06 2.50 4.36 10.57
TR Property Ord -0.41 2.22 -0.11 12.45 13.99 19.23
Benchmark:FTSE AllSh TR GBP -1.26 -0.07 -0.28 11.94 12.95 14.65
JPMorgan Mid Cap Ord -1.15 -1.36 -1.00 9.91 0.56 1.11

Funds ranked in descending order, based on 3 monthly performance figures.

Source: Morningstar as at 27 September 2016

The above table illustrates the commendable performance of our core Balanced pension portfolio over the past month. All but one fund beat the performance of the FTSE All-Share Index during the same period. We continue to monitor the performance of our portfolio investments and adjust the composition as appropriate. We are pleased with the performance to date and we constantly strive to achieve the best outcomes for our clients in the future.

Sources:

We gain our information from a range of sources including seminars, webinars, industry publications and general media comments.