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The following is a transcript of the podcast which has been edited for clarity.
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The challenges of low interest rates and inflation in the UK
Hi and good afternoon to everyone who will be listening. It's a very, very good question. And a big challenge for everyone, both in the investment world and people out there with cash. What people need to consider when they're thinking about cash are interest rates that they will receive on cash, which are obviously at historical lows, and inflation, because it's the differential between the two that creates the real challenges. So when inflation is running at a reasonable rate and interest rates are very low, the real rate that you are receiving is obviously negative. No one wants to see their capital and their buying power eroded.
But as we sit here today the impacts of Covid 19 have driven short term inflation rates down - the Bank of England’s most recent inflation report showed CPI in the UK running at barely 0.2% - so in the very short term holding cash, is not doing as much damage today as maybe two years ago when interest rates were still low, but inflation was running at 2%. The big challenge is more about what happens next. Because if you think about the way in which central banks and governments are responding to the Covid crisis and their attempts to support the global economy, it seems highly probable to us that that the relationship between low interest rates and low inflation will break down. With central banks likely to keep short-term interest rates low, probably as low as they are today, for the next 12 to 18 months, but boosting fiscal spending to try and stimulate growth you're likely to see the inflationary impact on savings becoming significantly more negative over the next couple of years.
So being prepared to think about the way in which you invest cash and the way in which you can obtain an inflation plus return is actually very critical to the way in which you view the next couple of years. And I think that if you look at the instruments that are currently available to people and the way in which you can invest both in terms of bonds, the next safest investment vehicle, interest rates there are also very low. And if inflation rates rise, it's likely you could receive a negative rate of return even in bond markets. So investors are really now being driven into equities as the only way of achieving inflation-plus returns. That helps explain the way in which equity markets have recovered since the lockdowns of March despite the poor economic backdrop.
Global tech businesses seem immune from the short-term impacts of Covid, says Gareth
Thank you, Gareth, very thorough response. And actually, that leads nicely onto a question that we get asked frequently. Taking on board what you said, I think we all agree that interest rates will remain very low or at zero for some time and we accept that we will actually expect to see some inflation here in the UK and in the US. What's the impact we should expect to see on equity markets?
I think the first thing you're likely to see is some mild rotation in the way equity markets are behaving. So if you look at the detail behind the recovery that you've seen in many equity markets since March, it's been driven largely by global technology stocks, and really by a small number of those, the really large global technology businesses, because not only are they seen as being largely immune from the short-term impacts of Covid, but in many cases their big business models have actually thrived.
Corporate earnings from many of these – Amazon, for example – have risen through this period. These companies generate huge amounts of cash flow, their balance sheets are very strong and they have a track record of returning some of that cash flow back to shareholders through dividends. So the logical re-rating of these stocks makes a huge amount of sense in the current environment. But if we go into a broader based economic recovery from the low points we're experiencing at the moment, and probably through to the first quarter of next year, and you get higher inflation, then you will see some equity market rotation, probably into some of the lower-quality companies that will benefit from a more general economic rebound, rather than the quality growth business that benefited through lockdown. While that may create short term opportunities there is a risk that the investors are blindsided in trying to time and capture this, so we would strongly suggest people focus on the quality of the companies they're investing in, the longevity of the business models, the solidity of the balance sheets and their abaility to generate free cash flow when looking at how they may invest their cash to benefit themselves and their family over the next five to ten years, rather than just the next six to 12 months.
A holistic view and a long time horizon are key to investing today, according to Gareth
Coming back to some of the things that our clients are worried about right now: the outcome of Brexit, the US election and Covid. Would you just give us your views on investing surplus cash right now?
Well, yes, I think the challenge about the ‘right now’ is that there is no easy answer to timing markets. I mean, one of the things that 30-odd years of experience has proven to me is that actually trying to time the optimal entry point into any asset class is extremely difficult. Some people may be able to do it, but there's a strong suspicion in my mind that a large element of that is luck. And what you really need to do when you're thinking about committing capital, is actually think about the investment. So you're actually making an investment decision and you need to focus on the quality of what you're buying. Because if you buy good quality assets, even at a difficult time, those good quality assets will provide compounded returns for you over multiple years. So the big decision you've got to make is how much appetite for risk you have got and how long you have got to commit to your capital. Because if you've got a suitable time horizon, which is probably three years plus, and you're prepared to accept some volatility in markets to market pricing of those assets, buying good quality businesses through equity markets will undoubtedly provide a solid basis for inflation plus returns.
Whether you should do it today or tomorrow is actually not as relevant. What you should be thinking about is the composition of a portfolio. A portfolio has got multiple different parts to it, it's not all equity. It consists of other asset classes. And those asset classes are designed to dampen down your equity volatility through time. So if you get the balance between your equity content that provides your CPI plus returns and the everything else that you can use, whether it's bonds, or commercial property, or absolute return funds, or infrastructure funds, all of these things can dampen down your equity volatility to provide a smoother return profile. So it's more about thinking holistically about a portfolio, rather than the short-term decision making on timing and entry points into an equity market.
Gareth’s outlook for investors in the next months: cherry-picking won’t be a solution
Music for the ears as a financial planner, holistic view and a plan for the longer term. So we've got those three big uncertainties at the moment, based on what you've seen historically, what would be your prediction with your crystal ball on what might happen if we get some clarity on the unknowns, I mean, one that jumps to mind is if we got a vaccine for Covid, what would you expect that to do to markets?
Ironically, and it's quite counterintuitive, it's quite possible that after an initial rally in risk assets in response to a vaccine, that actually equity markets have a period of weakness. And to understand that quite odd response, you need to understand that what's driven equity markets over the last six months has been as much to do with central bank, Quantitative Easing, and government fiscal spending as it has been to do with the underlying economics of the situation. So the closer you get to a resolution of the virus situation, the closer you get to perhaps some of that support being withdrawn. And if you start to see people returning back to work in large numbers, that's obviously extremely good news for wider society, but it may mean that some of the fiscal spending plans that investors have started to focus in on actually don't get delivered. And in that environment, you could get some uncertainty. So equity markets might actually experience a period of significant volatility around this, as you get the two different pools, one to do with the positivity around vaccine, the other to deal with the negativity of the withdrawal of some of the fiscal and monetary support the markets have become so fixated on.
So if we have clients that have their holistic plan, they've got the time horizon. There is surplus cash. So what's your view on investing cash?
This has much to do with the psychology of the decision as it has to do with the hard investment realities. I think if you've got an appropriate time horizon and you're focusing in on this correct balance between your equity component and your everything else, and the equity component is very much focused on strong key free cash flow generation and the ability to return that cash flow back to you as an investor through dividends, then whether you do it today, tomorrow or next week probably doesn't matter because your time horizon will smooth that path. Psychologically, however, it's quite a difficult decision to make, particularly against the very uncertain backdrop we face over the next three months with Covid, US presidential election and Brexit. So you know, psychologically, you would feel more comfortable perhaps doing it in two or maybe three tranches. The important thing about that, though, is that if you do phase, you phase as a whole portfolio. What you don't do is pick and choose, or cherry-pick the asset. A portfolio is exactly the same as baking a cake, you have to have all the right ingredients in the right order for the right period of time for it to work, you can't just pick and choose which bits you want. So, you know, by all means invest in two or three tranches for comfort reasons; but if you do, you phase across the whole portfolio, don't pick and choose the asset classes that you want.
A way of protecting yourself from risk is “to focus on the quality of what you own”
Okay, thank you. I like the analogy on the on the cake. So for lots of our clients, they've seen interest rates fall significantly over the last five to ten years and they've probably then moved to portfolios to provide income to support their lifestyle with rates now so low on cash and some of the big stocks reducing their dividends. And just coming back to your point earlier regarding quality and potential negative rates of return, what's your view around investment risk and where we should be investing if clients are looking for income dividend yield?
I think the challenge is people confuse a yield, which is the starting income portfolio generates, and long-term income generation. And you know, you could put together a portfolio that would consist quite significantly of UK large capitalised companies with a seemingly attractive dividend yield. But those dividend yields, which in the current circumstances in many cases have been cut, more fundamentally are unlikely to grow by any material amount. The real way of protecting yourself, both in terms of your capital pool but also your ability to spend the surplus, is to focus on the growth in the yield, not the starting yield. That may mean that you end up with a lower starting level of income. But if that income is growing by more than the reflect rate of inflation year in year out, you're actually protecting yourself against inflation in a way that buying a high yield that doesn't grow does not. And what history demonstrates admirably is that if you invest in companies with lower starting yields but higher growth rates in dividend, that helps to support share prices, it helps to drive the share price up over time. But more importantly, in times of stress, it puts a floor under the share price as well, because people know the cash flow is there to pay the dividend and to grow the dividend. And people will tend to reallocate capital back into these companies when markets are falling. So it's to do with the relationship between the starting yield and the growth in that yield that people need focus on, not just the absolute starting number, because high-yielding companies generally do not grow their dividend. And if they do, it's certainly not at a compounding rate above the rate of inflation over a long period of time.
So thinking about the clients that I've been speaking to recently and some of my colleagues, with National Savings notifying people that their rates are going to be falling I think it's fair to say that clients are really assessing what level of cash reserve they want to have. So where they have identified that they have surplus, I think there's a natural tendency to be apprehensive about where they invest the surplus cash, and to potentially consider just investing either a relatively small amount, or to invest in something that's deemed to be lower risk. For clients that we look after, most of them have time horizons of five to ten years plus. What your views would be for clients who have that typical time horizon?
Yeah, I think if you've got that time horizon and you're comfortable with committing capital, it comes back to the point around what sort of return above the rate of inflation you're looking to achieve, which will dictate the amount of exposure you need to inflation protection assets, which is basically equities. You could buy index-linked bonds or index-linked Treasury issues around the world, but they're so expensive that their ability to protect you against rising inflation is quite low. And you need to get this point about the balance between your equity and your everything else. If you can get that right, then I can see no issue at all with investing the surplus cash. Because even though the current environment seems difficult, and it undoubtedly is, particularly because of Covid, there are many companies out there that continue to do very well, what you've got to do is make sure that you avoid the things that potentially could lose you some or all of your capital. So you need to look very closely at balance sheet strength, you need to look very closely at cash flow generation. And you probably need to avoid some of the asset classes like, for example, high-yield bonds. On paper it sounds great; ‘bond’ makes it sound quite low risk and ‘high-yield’ sounds like the sort of magic formula that everyone wants. But investors need to remember that high-yield bonds or rebranded junk bonds of 15 years ago. And the reason why many of these companies are in this sector, or subclass, it’s because they don't have the free cash flow required to pay the coupons and the debt, let alone a growing dividend. So it's all about focusing on what you're buying. When you commit capital to an investment portfolio, you are making an investment decision. And investments require an element of focus on the quality of what you own. It's not about chasing short-term market returns – that's trading, that's not what we do. This is about investment and about focusing on the long-term longevity of business models and the quality of what companies do.
Will investing cash right now get you to a better place in 10 years?
I think it's really interesting when I'm talking to clients around their surplus cash, we spend lots of time thinking about what's their objective and their time horizon and what are they trying to achieve which feeds right into the investment decision and holistic planning that you've mentioned already. I think we have got lots of nervous clients and they are inclined to sit on their hands with their surplus cash for now. Just thinking about your experience, if we consider a typical market cycle and we try and look forward to the next 10 years, how confident are you that investing cash now with a 10-year time horizon would put clients in a better place?
If you have a 10-year time horizon and you're not tempted to take capital out along the journey, then I'm very comfortable that you will receive a return above the rate of inflation after costs over that period. The journey may not be a smooth one and there may well be periods of drawdown that can be quite unpleasant. Look at what happened in March; the low points in certain global equity markets were down 30 or 40% and it happened within 30 trading days, which is actually the fastest decline into bear market territory in history (source: BofA Global Research). And the speed of the recovery would have taken many people by surprise. But the reason markets recovered at that point was to do with investor confidence in policymaking; particularly, central bank policymaking and their ability to support markets. Now, if you're trying to time an entry point, I would think many people would not have thought the 23 March 2020 was the ideal time to commit capital. But if since then you had bought the right quality companies, your return on invested capital would have been very significant. Now, we may well have further pullbacks along the way through the journey around Covid. So it's more around having the appropriate time horizon and not becoming fixated on short-term market movements. Short-term mark-to-market changes in share prices or even index levels are incredibly difficult to anticipate or predict. They have been for the last 30-plus years: it becomes more difficult. The quicker information travels around the world, anticipating what Donald Trump will tweet or what North Korea will say, is actually a fool's errand when it comes to trying to make investment decisions. So over a 10-year period, without any focusing in on the peaks and troughs along the journey, absolutely comfortable. But investors have to have an appropriate time horizon.
Moving to what we've been seeing in the press recently, namely the reporting on potential future negative interest rates, what's your view on what that might do for our clients holding large cash deposits?
Firstly, I think it's highly unlikely that we will see negative rates in the UK. It's certainly possible, but I think it's unlikely. There are two reasons for that: one, I think there is no hard economic evidence to suggest that taking interest rates into negative territory produces any incremental economic benefits. The second thing that I think will be concerning to policymakers is the impact negative rates will have on asset prices. And one of the backdrop stories to everything that we've been seeing in the last 10 years is that the benefits, economically, of the recovery we've seen – and this goes for not just 10 years, but the last six months – have largely accrued to those people who already own capital. And by which I mean asset prices generally rise as interest rates go lower and equity markets have gone up. But all other asset prices, including house prices, etc. have tended to go up over a long period. And the people who've benefited are the capital owners, not the people who are working and spending all of their income to survive. Then if you go into the future, and you have negative rates, then the people who will really benefit from this, are the people who have already benefited materially from low rates; they will probably drive house prices up yet further, putting most house prices out of the reach of another generation. And I think that's a very socially corrosive situation to be in. So I think, you know, although interest rates may go negative, the negative impact of that is actually going to be felt more widely in society than it will be for those people holding cash deposits. And in fact, if you actually think that is likely to happen, then the first thing you should be doing is committing your surplus cash into real assets. Because you do not want the combination of higher inflation and negative rates, eroding your hard earned capital at quite a material rate over the next few years.
Get in touch
If you have any feedback about the podcast or ideas for future episodes, we would love to hear from you. You can get in touch by emailing email@example.com or calling us on 020 3811 3625. Investing carries risk – you can lose money.
This article was previously published on Tilney prior to the launch of Evelyn Partners.