Recently, there has been quite a bit of volatility in the markets. US government bonds sold off after Ben Bernanke indicated that their quantitative easing program may now be slowed down. This is the equivalent, in our current world of “no downside left to go with rates”, to monetary tightening or a hike in interest rates and, in a tightening scenario, fixed income markets pretty much always suffer. The powers that be are signalling that some growth is coming through as the reason for this tightening, however, by selling off too, the equity markets clearly think this is all a bit premature. Also, in the real asset arena, with a major crisis not having taken place for a while, the need for the safe haven of gold has been reduced, so the gold price has been falling too.
We have been going through a period of low growth and/or recession around Europe and the States for so long now that it is hard to come to terms with the possibility of growth. The mind-set has been that the UK, US and the rest of the Eurozone are on their knees and we have looked to the high growth from the emerging markets and asian economies to keep us going. However, declines in growth in countries like China and recent severe spikes in their money market rates have given rise to concerns in these sectors too.
What’s behind this?
Compared to the volatile periods in the markets in recent years, this time it has not been caused by a bank or other form of financial or political crisis. This is the market demonstrating confusion as to how to asset-allocate and, as such, it is more of a traditional type of investment challenge. The dilemma is that, whilst monetary tightening means that we should allocate away from bonds, the tightening is not expected to happen quickly. Equally, while growth is likely to drive the equity markets forward, this is likely to appear slowly and the monetary tightening is being perceived as potentially strangling off any nascent growth. Meanwhile, sudden shocks are only too fresh in the mind and there is still that nagging doubt that there may still be some scare out there – some skeleton in someone’s cupboard set to emerge – and then we are back to flight to quality, which means that money will go into bonds and gold despite fundamentals to the contrary.
So, we have lots of volatility and, the end result, a lot of market sectors ultimately going nowhere. In fact, if you have funds invested in UK equities and you haven’t looked at them since January, it would simply look like nothing has happened. So, what’s all the fuss about? Certainly, your equity investments should have been made with a medium to long term time horizon and it is good not to be concerned about short term volatility, however, this time the volatility signals a possible change in the order of things and, it is in this respect, that you should re-appraise your financial plans now and keep closer tabs on developments. It is clearly difficult after such a period of adversity to be absolutely sure, but it does look like our world may be about to change positively.
Are things about to change for the better?
If growth is starting to come through, we are likely to see rates go higher, albeit slowly to start with. If rates go higher, fixed interest bonds will sell off and the longer dated the bonds the more the price fall will be. Equally, if we see growth coming through, equities will benefit. So, if your portfolio is set up defensively, as it should have been for the last few years, you will most likely need to review this now relative to your own attitude to risk.
The current scenario also makes tailoring a portfolio a bit tricky as most financial planning theory would suggest that government securities represent a low risk asset because there is very little credit risk and good liquidity to be found. At present, they have very little upside, barring a new crisis, and have plenty of downside. Surely this makes them high risk and, accordingly they should be used sparingly in a cautious portfolio. The muttering in the markets is that there is a bond bubble. The reservation when it comes to moving client portfolios is that you are going against the “theory” and the bubble isn’t bursting, but isn’t that always the way of things? The markets were talking about the lack of tangible value in tech stocks for months before the stocks actually crashed. We were well aware of the sub-prime issues in the US and that these could have a serious knock-on effect to the wider financial markets way ahead of the crisis.
Although very much at the embryonic stage, we have to come to terms with the fact that there is increasing evidence of growth in the US and even in the Eurozone, with incomes rising in Germany and competitiveness increasing elsewhere in the Eurozone. This is the change in profile the markets are grappling with at the moment and they are trying to figure out what is going to pop first.
How to make it work for you
If we accept that we are moving into a new economic phase, what are the options? Corporate bond spreads are considered to represent good value and are relatively more secure than equity for a given company, but investments in corporate bonds typically come with associated fixed interest rate risk and, in practice, considerable liquidity risk in a bear market. Floating rate corporate bond funds should, however, do the trick very nicely just now. Otherwise, it makes sense to review your fixed income allocation, perhaps retaining some for diversification purposes, but keeping it in shorter maturities where price falls will be more limited. On the equity side, it may make sense to stick to the larger caps in the most promising countries.
Don’t forget up and coming economies
As far as Asia and emerging markets are concerned, their growth levels are still good by our standards and as, for example, China becomes more consumer-driven and less reliant on manufacturing, there will be new opportunities. Also, although it may be a little late in the game, Abenomics may well help to get Japan back on its feet again. So, we have to be selective, however there is growth to find outside of the Eurozone and the States.
Looking at mortgages? You may get lucky
Investments aside, one of the anomalies being thrown up that may help you with your financial planning is that all the while the wholesale markets are worrying about the likelihood of tightening of monetary policy, the retail market is offering some record low fixed rate mortgages. Although longer dated fixed rate mortgages rarely offer the best actual rate around, at present they are not at all bad and, if you think that rates are likely to go higher for the majority of the fixed rate term, then they are worth a look. Not only is there the opportunity to save money if you are correct, but you also have the surety of knowing what your mortgage payments will be for the term, which makes budgeting easier and protects you from shocks. Conversely, be aware of the costs involved in the re-mortgage and any penalties if you redeem your mortgage early or if you want to pre-pay part of the new one. As I was writing this, Ray Boulger pipped me to the post and put out this article which you may also find of interest.
To give you an idea of how your mortgage payments may change as rates move, here are some examples of what you could be looking at for a £100,000 mortgage over 25 years should rates start to rise:
A final silver lining
This change could be very good news for savers who have struggled for so long to get any kind of decent rate on their money. They may finally find that they can get some better rates on their cash accounts. However, contrary to their rhetoric, the central bankers may well let inflation get a little more of a hold than they would usually in order to help the Government balance sheet along by inflating out some of the debt. This may mean that, although the headline savings number gets higher, the real rate of return on your savings does not improve that much.
It could also be positive for those approaching retirement or for those who have gone into income drawdown because they are waiting for annuity rates to improve. We may need to be a little patient, but if gilt yields rise, so will annuity rates.
So, what does it mean? This is a heads up. It means that we should watch this space and review our finances carefully so we know we have taken into account this possible change in the economic outlook.