17 December 2015
2016 Investment Outlook – Sell Everything?
by Frank O’Nomics
At the risk of being called “the Grinch”, or sounding like Private Fraser (“we’re all doomed!”), it is very hard to identify any asset class that is going to generate an attractive return over the next 12 months. The widespread adoption of quantitative easing by the world’s largest central banks has pumped a huge amount of cash into markets driving valuation levels to unprecedented extremes. These levels were further justified by the benefits coming from consistently high growth in China, but now that China is seeing a more moderate, and arguably declining, growth level there is less to justify them. One could argue that this is precisely what was intended, so that we are now left with no alternative but to spend rather than save, thereby stimulating the economy and accelerating inflation. This is fine up to a point, but with ageing populations in most developed nations, there remains a need to save and invest for retirement (or unemployment). So where do we put our money? It is worth briefly considering the various opportunities in cash, equities, bonds, and property, as well as looking at other alternatives.
Cash can very easily be discounted. Many banks have been recently pilloried for the almost zero rates that they have been offering savers, cutting levels to barely more than 0.1% in many cases. Some lesser names offer more attractive rates for longer periods, but tieing up your cash at a relatively low rate in an institution with a dubious credit rating leaves the danger of taking risk in the supposedly riskless element of your portfolio.
Many would argue that equities still offer very good value, with the FTSE all share dividend yield looking very attractive a 4.1% and the absolute level of the FTSE 100 hitting its lowest close since 2012 this week. However, while the yield may look attractive, the valuations are much more questionable. PE ratios are at very high historic levels and the ability of stocks to continue to pay attractive diviends can be questioned. Take for example, Glaxo SmithKline, where the PE of 27 suggests that the stock is over 50% richer than it was at the end of 2013, with a dividend yield (4.5%) that is fragile given that they are paying almost all of their net income in dividend, ie any fall in profitability and the dividend will be difficult to sustain. Looking outside the larger stocks there are some compelling arguments for smaller companies that have a much greater growth potential, but this area should really be left to the experts and the performance of smaller companies investment trusts this year demonstrates just how hard it is to pick winners. There are some absolute return vehicles that have the scope to go short of stocks (ie make money when equity markets fall) but this approach carries greater risk given that (in theory) the potential for loss is unlimited.
Perhaps the most compelling funds are those where the investment managers take a very long-term view and focus entirely on stocks that deliver consistent returns. There are some fund management superstars in this area (Neil Wooford and Terry Smith to name but two), but this approach may just mean that you outperform in a bear market, rather generate a positive return next year.
There is clearly a disconnect between equity markets and corporate bond markets. The former look very rich and point to an ongoing improvement in the economic outlook, whereas the latter have seen a significant increase in yield spreads, suggesting that bond investors are seriously questioning the ability of firms to service their debt. This may point to an opportunity to buy corporate bonds, but the problem here is that their absolute levels are to some extent a function of where government bonds are seen to be trading, and here we see the most significant over-valuations. 30% of the European Government bonds trade with a negative yield, ie, if you hold the bonds to maturity, you are paying for the priviledge of lending these governments your savings. This clearly makes no sense and is a clear reflection of the effects of a combination of central bank purchases (quantitative easing) and regulatory constraints that force banks to hold these bonds. The UK is something of an exeception, given that we still have a positive base rate, and you can get almost 1.5% on a 5 year gilt – but this is hardly any protection if inflation starts to pickup.
It is worth briefly looking at commodities – but only briefly. Gold is a non-yielding asset with a price that was inflated considerably by the extreme uncertainty of the post-Lehman crisis. Now that some trust in governments to repay their debts has returned, the need to hold a portable real asset has faded, and so should the gold price. As for other commodities, those nursing losses in stocks like Glencore will need some persuading to return and many have called a turn in the oil price, only for it to continually hit new lows.
Does this push us, yet again towards the property market? Again I would argue that we face extreme valuation levels, with the average house price over 5 times the level of average earning in the UK as a whole, and some 9 times earnings in London. For the UK this ratio is back to its pre-crisis high and for London some 30% above its 2007 high. Only in the north is the ratio close to its long-term average (around 3.5X). Some of the drivers of house price growth are clearly starting to turn. The increase in stamp duty on more expensive homes has decimated turnover in the last few months, while the combination of setting in train a gradual reduction in tax relief for buy-to-let loans, along with the impostion of an additional 3% stamp duty next year, will hit the lower to middle end of the housing market. Clearly, if you want to increase the size of your family house this backdrop may not be a factor in stopping you doing so, but there is perhaps a stronger incentive for some to take advantage of current levels to downsize.
We are still left with the question of what to do with any spare cash going into next year. Topping up your pension would be an obvious choice, but the tax benefits for doing so are being eroded yet again next year and, once the money is in your pension you are still left with the same asset class selection conundrum. Investing in art or postage stamps might be a possibility, but only to those with a genuine interest. Most such assets will appreciate in line with real wages over time, and so if you can find some that are historically out of line you may be making a shrewd purchase, but the transaction costs are very highly and liquidity cannot be guaranteed should you wish to sell. Perhaps the most compelling move is to pay off any mortgages or other debt. If we do move into a period of deflation, then the real value of your debts will rise, and not paying a 3.5% rate of interest is equivalent to getting around a 5% yield for a higher rate tax payer – a very tough return to match on the assets listed above.
Coming full circle there is a final solution, and that is to do exactly what the authorities have been encouraging us to do. Just spend it. 2016 may become the year of the SKINs (spending kids inheritance now).
