Investing for Change
Danger and Opportunity
Investing for change means looking out for dangers, but also embracing the opportunities.
"The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognise the opportunity."
|Sterling||Short-dated Bonds||Financial Debt||European Equities||Global Healthcare||Technology||Alternative Investment Strategies|
Since the UK voted in June to leave the European Union, dark clouds have formed over sterling which was trading recently at its lowest level since a long and steep decline in the first half of the 1980s. For sterling-based investors, the silver lining in this cloud has been higher returns from overseas assets. But we see a different path for sterling in 2017 – and a different set of opportunities for UK investors.
Elevated returns from overseas assets this past year imply lower sterling-based returns in 2017 if, as we suspect, we see the sterling exchange rate moving back towards its longer-term average. A recovery in sterling could turn many of 2016’s winners into losers in 2017. These include almost all investments in overseas equities. So how can we mitigate this risk?
Hedging against currency risk
First, we can look to take profit on some of our overseas investments and re-invest the proceeds in sterling-denominated assets, while still maintaining a diversified portfolio. Where possible, we might also hedge against moves in exchange rates.
This can be done by using hedged share classes of funds investing in overseas equities, thus maintaining exposure to non-UK markets while hedging out the currency risk. In some instances, hedging out currency risk via the use of derivatives, such as currency futures, will allow investors to lock in future exchange rates at particular levels.
This would mean, of course, that in times when sterling was weakening, as it has post Brexit, these investments would miss out on currency-related gains. Conversely, they would be protected from losses if sterling were to revert back to its longer-term trading range, a view we will outline in a subsequent feature in our Investment Outlook 2017 series: ‘Sterling’s dependence on the kindness of strangers.’
Looking for the opportunities
Since the EU referendum in the UK, we have also been looking at asset classes that suffered most from the vote to leave, and may offer value today. Apart from sterling, the main asset classes that suffered were small to mid-size domestically-focused UK shares, like those in the FTSE 250 and commercial property.
While the FTSE 250 plunged post the referendum result, it has surged since, as the chart below shows. This mid-cap index has produced stronger and more stable earnings growth than the FTSE 100 since the global financial crisis, reflecting the solid performance of the UK economy relative to most of the developed world.
We believe, though, that the FTSE 250’s sharp recovery from post-referendum lows has discounted a better outcome for the UK economy outside the EU than feared. Given ongoing uncertainties about what form Brexit ultimately will take – ‘hard’ or ‘soft’? – we prefer to wait for better buying opportunities.
Commercial property is a favoured income diversifier given the ultra-low yields from government bonds and should remain solid if the UK economy remains strong. But UK commercial property funds have already surged since August, with some only slightly down for the year at the time of writing, after being down about -15% at one stage. Transaction costs are high for these funds (i.e. they are expensive to buy), and though we regard existing holdings as attractive, we are inclined to wait for better buying opportunities in this area as well.
The other side of the coin
On the other side of the coin, safe-haven UK government bonds (gilts) enjoyed a strong rally post-referendum (see graph). But these gains have now evaporated, with 10-year gilts, for example, down 6% from their highs in just two months. With an annual income of only 1.4% at the time of writing, this ‘safe’ asset looks decidedly unattractive.
We still see gilts having a role in providing liquidity (they can be easily sold if cash is needed) and helpful diversification away from equities (they tend to rise in value when equities are falling). However, we see better solutions for providing income and diversification, which we will address in a later instalment of Investment Outlook 2017: ‘When safe-haven gilts look ghastly.’