February CPD Newsbrief – Investment principles and risk
Unemployment drops to 7.1% as BOE seeks to manage expectations
The Bank of England’s 7% threshold for raising interest rates came close to be being realised on 22 January, when the latest unemployment figures from the Office for National Statistics (ONS) showed a significant fall of 0.5% from September to November last year to hit 7.1%.
In August 2013, Bank of England (BOE) governor Mark Carney initiated forward guidance by pledging to keep interest rates at 0.5% until unemployment falls below 7%. The rapid falls in unemployment since his announcement has seen him try to cool expectations by insisting the 7% level is a “threshold, not a trigger” for rate rises. Minutes from the BOE’s monetary policy committee, published today, went further, saying there is “no immediate need” to raise rates even if the threshold is met:
“It is likely that the headwinds to growth associated with the aftermath of the financial crisis would persist for some time yet and that inflationary pressures would remain contained. Consequently when the time did come to raise Bank Rate, it would be appropriate to do so only gradually.”
The rate has fallen 0.6% compared to the same period in 2012. There were 2.32 million unemployed people aged 16 and over, down 167,000 from June to August and down 172,000 from a year earlier.
The ONS reports the percentage of people aged from 16 to 64 who were in work was 72.1%.
Total pay and regular pay both rose by 0.9% compared with September to November 2012, well below the annual rate of inflation which hit 2% in December.
In November 2013 employees earned, on average, £475 a week including bonuses and £447 a week excluding bonuses before tax and other deductions from pay.
The Islamic sukuk comes to the UK
The UK is to become the first non-Muslim country in the world to issue an Islamic bond, known as a ‘sukuk.’ This is a bond that is structured to generate returns that do not infringe Sharia (Islamic law and moral code).
With conventional bonds, the issuer has a contractual obligation to pay the investor/bondholder interest and principal on certain specified dates. In contrast, under Islamic law, all transactions must be based on real trade or business activities, and the payment or acceptance of interest or fees (known as riba or usury) is prohibited. Gambling is also forbidden.
A sukuk investor has an undivided share in the ownership of the assets linked to the investment, such as property. They are entitled to a share in the revenues that those assets generate, and so the encashment of the sukuk after say three or five years is effectively a sale of a proportionate share in the bond assets. Investors generally regard them as less risky than equities because of the link to the underlying assets of the business.
The first sukuk was issued in Malaysia in 2000 and since then they have become important Islamic financial instruments for long-term funding. Like all other sources of finance, sukuk issuance was affected by the financial crisis but they have been steadily growing in popularity since 2011.
There are various types of sukuk structures depending on the nature of the underlying assets. The most common type is where the sukuk relates to partial ownership of an asset, but some bonds relate to the partial ownership of a debt, a project or a business.
Some commentators believe that Islamic finance provides a valuable opportunity for the UK’s financial services industry. Islamic investments have soared by 150% in the past seven years and are expected to be worth £1.3 trillion this year alone. There are also plans for a new Islamic index on the London Stock Exchange.
Some of the risk factors that investors should consider include: the lack of a liquid secondary market, the absence of standardised deal structures, and the difficulties of enforcing their rights that investors may encounter in many jurisdictions.
Keep calm and taper on
In December 2013 the Federal Reserve (the Fed) finally announced its intention to reduce its asset purchases. Tapering, which was first publically mooted in May last year, is now a reality.
The potential for reduced stimulus was enough to encourage the yield on the ten-year US Treasury to double almost 3%. In the event, however, a reduction of just $10 billion, taking the total monthly amount of quantitative easing (QE) from $85 billion to $75 billion, was barely acknowledged by the bond markets.
The reason that bondholders are sanguine, even as the scale of bond purchases reduces, is that the simultaneous signals from the US central bank are becoming increasingly dovish. In Ben Bernanke’s penultimate monetary policy meeting, his accompanying statement included a significant strengthening in the policy of forward guidance.
The main rate of interest will probably remain at less than 0.25% ‘well past’ the time that the unemployment rate falls below the 6.5% threshold, ‘especially’ if US inflation remains below 2% (at present it is 1.2%). The message is that easy monetary policy will prevail, in spite of what seems likely to be a steady pace of sustained reduction in Fed-sponsored bond purchases.
But while policy rates of interest in the US, UK, EU and Japan are unlikely to rise soon, we have seen a sustained increase in longer-term rates. Mirroring the rise in US government yields, UK gilts are close to 2% at the five-year horizon and 3% at the ten-year mark. Another rise of 2%, perhaps over the next few years, will see gilt yields finally fall back to more normal levels.
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