The disparity between UK mid- and large-caps, the impact of interest rates on the valuation of gold and the strong performance of European equities are among some of the key themes Rathbones’ Strategic Asset Allocation Committee will focus on throughout Q4 this year.
The committee is also turning its attention to the increasing levels of consumer debt in the US and the UK, as well as the dwindling attractiveness of infrastructure investment trusts.
In the below article, we take a closer look at these five themes and what they could mean for investors throughout the rest of the year.
UK mid- and large-cap valuations
Following the post-EU referendum plummet in sterling, global-facing FTSE 100 stocks thrived relative to their smaller counterparts during the second half of last year.
Performance of indices in 2016
Source: FE Analytics
As the likelihood of an interest rate hike has increased and sterling has strengthened, however, Rathbones’ Strategic Asset Allocation Committee said this trend has started to reverse.
“The FTSE 250 has outperformed the FTSE 100 in terms of share price since 2009, but the earnings of large-cap UK companies have not lagged those of small- and mid-caps nearly as much,” it said.
“As a result, a valuation gap has appeared between the indices.”
While the UK mid-cap index tends to outperform the FTSE 100 over the longer term, the committee believes the latter will generate stronger returns during the rest of the financial quarter.
“Despite an uneven market, we view the mid-cap area as a source of interesting opportunities compared with FTSE 100 companies,” it continued.
“This combination suggests active management rather than passive investing may be particularly productive in the UK market.”
Interest rates and their impact on gold
While gold tends to be used as a hedge against inflation eating into the valuation of cash, the committee’s research shows that real interest rates – the difference between interest rates and inflation – has a greater impact on the yellow metal.
It said: “An allocation to gold can provide a hedge against a weak dollar and other currencies in general. It can also be a useful hedge against rising geopolitical tensions, such as the recent sabre-rattling between the US and North Korea.”
As such, the committee explained that gold should fare well during inflationary environments. That said, it doesn’t believe the commodity should only be held during times of waning confidence as it can act as a useful diversifier.
“We invest in exchange-traded funds that own physical gold bullion in secure vaults on either a hedged (protected against fluctuations between the dollar and sterling) or unhedged basis,” it explained.
The strong performance of European equities
It is common knowledge that European equities have thrived year-to-date, following reduced geopolitical tensions and attractive valuations relative to other regions.
Performance of indices in 2017
Source: FE Analytics
In fact, an article published earlier this year, BlackRock’s Richard Turnill and Natixis’s David Lafferty said that Europe still offered good value for money despite some believing it became a consensus trade.
Rathbones’ Strategic Asset Allocation Committee pointed out that more than €20bn poured into European equities from the start of 2017 to the end of June, a significant portion of which came following the election of Emmanuel Macron as French president in May.
“Short-term leading indicators suggest growth peaked in the second quarter,” it said. “Our preferred indicator, the Belgium business confidence survey, shows growth is slowing, while monetary dynamics have also become less supportive.”
The committee is also concerned about the large number of non-performing loans in the region, as well as the strengthening euro and the dampening impact this could have on inflation.
“There are signs that strong returns on European equities could be coming to a halt,” it warned.
“Political risk is not as high as some may think, and fund managers see value in the financial and consumer discretionary sectors.
“However, we are cautious on the outlook for further gains in European equities given growth appears to be peaking.”
US and UK consumer squeeze
Another theme to have been a common topic of conversation over recent months is the mounting levels of consumer debt in the UK and the US.
In fact, the Rathbones committee pointed out that UK household debt is back to levels last seen during the financial crisis of 2008, with car finance deals alone accounting for 75 per cent of the growth in debt.
Given the fact inflation has outpaced wage growth, it also said savings rates have plummeted as consumers have maintained their levels of spending.
“However, Bank of England stress testing of exposure to car loans suggests UK banks would suffer only modest losses to their core capital even if car prices fell more sharply than during the financial crisis,” the committee reasoned.
“In the US, low interest rates, low unemployment and looser lending standards have boosted new car sales.”
It explained: “Auto loans comprise just 9 per cent of US household debt, while mortgages accounted for around 70 per cent at the peak of the global financial crisis.
“Though we do see rising household indebtedness in the US and UK as a growing headwind to growth, we see little risk of another financial crisis.”
Headwinds for infrastructure
Infrastructure investment trusts have been popular over recent years due to ultra-loose monetary policy exacerbating the hunt for income. In fact, the average trust in the IT Infrastructure sector is currently trading on a 10.8 per cent premium to NAV, despite the average trust delivering a choppy, sideways performance year-to-date.
Rathbones’ Strategic Asset Allocation Committee warned that a significant amount of the UK infrastructure market compromises of PFI schemes, which fund public infrastructure projects with private capital.
“The government issues an operating lease to a consortium for 25 to 30 years, which removes the debt from its balance sheet,” it explained.
“Risks for long-term investors include uncertainty about what will happen to the leases when they expire.
“Also, the cash flows used to value UK PFI vehicles are discounted by interest rates and inflation, which have an uncertain outlook at the moment.”
As more and more investors have piled into the asset class in a bid for yield, the committee said the competition for a limited number of products has increased, which has driven down potential returns.
“PFI vehicles are cautious about buying assets where the risks do not match the rewards, so are starting to buy shares of infrastructure companies,” it continued.
“The recent performance of infrastructure investment trusts has become positively correlated with the share prices of utility companies in the FTSE 100.
Performance of sector vs index over 10yrs
Source: FE Analytics
“It remains to be seen whether this shift will last, but for now we are watching these developments closely.”