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Peter Toogood: Why investors have less choice than ever before

13 June 2017

The Adviser Centre’s Peter Toogood and Gill Hutchison outline the macroeconomic factors impacting returns for the foreseeable future.

By Jonathan Jones,

Reporter, FE Trustnet

High debt, a lack of returns in the fixed income space and extremely high equity valuations mean investors have fewer investment choices than ever, according to The Adviser Centre chief investment officer Peter Toogood.

June’s general election and ongoing uncertainty over Brexit talks have stopped people looking at the wider picture, with the large debt-to-GDP ratio in the UK among the chief risks to investors, he said.

“It’s all missing the point that we are 480 per cent in hock in terms of total debt,” Toogood said.

UK total debt since 1987

 

Source: Andrew Hunt Economics

With the UK at near full-employment, a savings rate of 3.5 per cent and productivity remaining low compared to other countries, Toogood said it is a worrying time for the economy.

However, he said that investors shouldn’t expect to see a dramatic shift in interest rates or the quantitative easing (QE) program any time soon.

“It doesn’t just play out, it will keep going. Central banks will keep doing QE and everything else can continue,” Toogood said.

And the effect this will have on markets means investors will have fewer asset classes to choose from than ever before.

He said: “What is the current 10-year bond yield in this country – under one per cent – and investment grade is 150 basis points over that so its 2.5 per cent.

“If you have got some bonds you are going to earn somewhere between that on 40 per cent of your portfolio. It’s not very exciting is it?

“Think of it this way round: the economic challenge is obvious – it’s just mathematic – but the opportunity set of the assets that you own, regardless if there is stability or not, is diminishing.”


He said in Europe there has arguably been the most drastic forms of monetary policy taken by the European Central Bank (ECB).

“The ECB now owns 13.4 per cent of the entire €650bn corporate bonds market so for the first in history we have governments – the buyers and lenders of last resort – in capital markets,” he said.

“Just for the sake of clarity that isn’t exactly normal. So if you’re a European credit manager you’ve got someone backstopping you every day.

“All those debt dynamics that are a problem – who cares – because every day it goes on and the ECB buys more bonds.”

He added: “Do you think anyone has ever invested in that environment before? When has a central bank ever owned 14 per cent of the corporate bond market?”

However, he noted that this is not an exclusive problem to Europe, with around $4trn being pumped into US treasury bonds by the Federal Reserve and Japan owning almost 48 per cent of its sovereign debt market.

“Do you think any of this is normal? Of course not yet that is the world that our fund managers have to operate in,” he said.

Similar to the UK, he said European fixed income yields are at record low levels, having fallen back from highs during the financial crisis.

Gill Hutchison, research director at The Adviser Centre, added: “In 2008 yields went sky high but basically they’ve been on their way all the way down because of the effect of the surplus flow of funds and you’ve got the ECB buying which has had a halo effect on bonds.

“Plus they’ve also been buying some of the junk bonds which wasn’t in the plan but they have been doing that.”

European high yield index effective yield since 2004

 

Source: BofA Merrill Lynch

Toogood said that if the ECB continues on the same path with its QE program and monetary policy then rates will continue to stay low.


With a portfolio split evenly into three – government bonds, investment grade and high yield – in Europe this would offer a return of just 1.8 per cent. 

He said: “It’s a third at 0.6 per cent sovereign overall in Europe, investment grade is 150 basis points on another third and let’s give high yield 3 per cent on the other third. So 40 per cent of your portfolio is going to make you 1.8 per cent.”

However, the bigger fear is if ECB president Mario Draghi removes this support from the market as it would create a ‘normal cycle’.

He said: “Money is piling in and if you’re a European credit manager you go – ‘oh it’s alright, Mario will bail me out’ but what happens when Mario is not there anymore?

“If Mario is not there backstopping you, what happens then? You have a normal cycle because you have got to believe we’ve suspended the economic cycle.”

However, if Draghi continues to support the economy then it is possible that he has suspended the economic cycle, he said.

"If that is the case how did that go for the Nikkei in Japan? It was 40,000 in 1990 what is it now 24,000,” Toogood added.

He said the way to remove the debt without this continued intervention is to either inflate it away or write it off, but for now it looks as though the story will remain the same.

Toogood explained: “What happens if they somehow keep the party going and the ECB doesn’t own 14 per cent it owns maybe 40 or 50 or 60 per cent.”

Yet, Hutchison said central banks are likely to continue this is because they remain unwilling to aggressively raise interest rates.

“They want to get rates up but the risk is that they do that and everyone squeals because of the debt they’ve got hanging around,” she said.

“And maybe you can argue that 25 basis points isn’t going to make much difference to you as a consumer but that doesn’t mean that markets won’t take fright from that.”

Meanwhile, she claimed equities look overvalued, particularly in the US, where valuations are at historic highs.

Hutchison said: “The trouble with equities is that fund managers are all reluctant participants in equity markets and they have been reducing the number of positions in their portfolios for ages now.

“There are pockets of excitement so if you talk to someone like Richard Watts – a mid-cap manager – he is still terribly excited about his companies like boohoo.com or internet-type stocks that we know are genuinely different.


“But apart from that they’re finding it very difficult to have a comprehensive view of being excited about the market because it is so expensive; acknowledging that the US is the most expensive and then everything else is relatively a bit less than that.

She added: “It’s a very unexciting format and I think people are sort of holding out for something to happen but the longer it goes on the more hopeless they feel.

“There’s momentum behind the market, there is a lot of cash around and that’s forcing markets to get more and more expensive yet the trend just carries on.”

Several fund managers and analysts have highlighted the value on offer in Europe currently, indeed as the chart below shows, the index has lagged the wider MSCI All Companies index over the last three years by 18.43 percentage points.

Performance of indices over 3yrs

 

Source: FE Analytics

However, Toogood said while it may be considered cheap by others, there are reasons why valuations might not have that far to climb.

“Everyone says that Europe is cheap but it’s full of financials, utilities and all sorts of other things that actually no one really believes in,” he said.

“I’ll give it the grace of saying it’s a bit expensive. I’ll be generous, so it could go from 19 times to 21 times (P/E), maybe, and the dividend chucks off about 3.5 per cent.

“Let’s call it 6 per cent and I’m being generous, by the way. That combined with the 1.8 per cent on 40 per cent fixed interest and 6 per cent at 60 per cent gives you a total return of 4.5 per cent.”

He added: “If they (the ECB) hold the line and manage to continue the party, the dividends will be paid out, debt will have to exponentially grow to make that happen.

“They will try and form stability as they have done for years which means that your return profile is very diminished.”

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