UK: At a Crossroads? - Be Wary of Biasing Investments Strongly in one Direction

Last Updated: 28 October 2010
Article by Adrian Taylor

Adrian Taylor looks at volatility in the investments arena.

We all like the idea of having 20/20 vision to allow us to look to the medium and long-term to invest with confidence. However, when even the short-term horizon is difficult to define, we can experience periods of increased volatility – making charity trustees understandably more nervous.

Throughout 2010 we have argued that investors will soon reach an economic crossroads, but it was hoped that, by that time, the best direction to take would be adequately signposted. The following factors suggest we face a choice of two roads.

The high road

  • Investors have grown confident that the co-ordinated global quantitative easing programme, brought in as a result of the financial crisis, has succeeded. We may have entered a mild recession in the later part of 2009, but a repeat of the 1930s style depression has been avoided.
  • The new Coalition Government's Emergency Budget was well received, as it sought to calm global investors by reassuring them that austere deficit reduction measures were balanced and manageable and would lead us into a healthier and more productive future.
  • The likelihood of a double dip recession has diminished, and although the UK economy is not expected to sparkle in 2011, investors have become more confident and risk tolerance has increased marginally. This has led to a rally in the bond markets, and more recently in equities, as company profits have met expectations and analysts have upgraded growth targets for 2011.
  • This has led to an improvement in the dividend outlook. At the same time, income yields on much of the UK FTSE Index are at historically high levels and exceed those available for government bonds.
  • If the economic recovery can be sustained, company profitability will rise, suggesting higher capital values. Capital growth and attractive income seems an easy option.
  • Inflation may not be a major threat at the moment but if all these factors are played out then these pressures will rise in the future and the current low interest rate policy may have to be tightened sooner than many expected.

The low road

  • Recent data suggests the economic recovery is anaemic and may not provide sufficient momentum to become self fulfilling in 2011. While this potential problem could be alleviated with further government stimulus (the so called QE2) there is concern that the authorities are running out of ammunition.
  • The Government's upcoming autumn Spending Review was always going to be carefully monitored, but cracks may already be appearing with resistance to spending cuts mounting and forecasts of tax receipts lowering as economic growth expectations are trimmed.
  • Given that the impact of the initial public sector cuts have yet to be felt, many observers believe that the outlook for the consumer sector is still too optimistic and that unemployment is set to rise, affecting both the discretionary spending market and the property sector. The Government is hoping that cuts in the public sector will be cushioned by new investment in the private sector. There is no real evidence that this is being seen and there is talk of imposing greater public sector cutbacks in coming months.
  • If the evidence from the USA is a guide, then we need to be concerned. In the first few months of 2010 the US economy emerged strongly from the 2009 recession offering hope of sufficient momentum to allow the authorities to ease back on its fiscal stimulation. Recent data however all but confirms that the recovery has fizzled out and suggests the threat of a double dip recession is a real possibility.

Where to from here?

We are now at the crossroads, but regrettably the signposts are not that helpful. Trustees should be aware of the risks associated with biasing their investments strongly one way or the other. Volatility has increased during the year which reflects investors switching between the two sets of factors described above. In the very near term we see this continuing to be a feature of investment markets.

There is no merit in taking a big gamble in a game where the factors determining the outcome are so unclear. There are many good economists and strategists whose opinions we value strongly, but when their views are polarised into two opposing but well argued camps this sends a strong message. It may be better to take the prudent approach and look to reduce the increasing pressure of volatility (risk) rather than chasing gains. Perhaps we should consider travelling in two cars and try to pick the best options from both routes away from the crossroads

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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