September CPD Newsbrief — Investment principles and risk
At a (real) loss
The Treasury is now borrowing for more than 40 years at an inflation adjusted cost of less than zero.
The Debt Management Office (DMO), the arm of the Treasury responsible for selling gilts, has the job of raising £127.2bn from gilt sales in 2014-15. Fortunately, there is still plenty of home-grown demand for gilts: witness July’s £5.4bn syndicated sale of a new gilt, the 0.25 per cent Index-linked Treasury Gilt 2058. The offer was nearly three times over-subscribed, with 96 per cent of the allocation going to the UK domestic market.
The gilt sold on a real yield of -0.053 per cent, which the DMO described as being “at the tight end of the published price guidance”. Looked at another way, the gilt’s purchasers were prepared to buy a 44-year bond that, if held to maturity, is guaranteed to lose them money in real terms. It appears a strange investment decision, but there is plenty of unsatisfied demand from final salary pension schemes, which are seemingly less sensitive to gilts’ rates of return than their liability-matching qualities. From the schemes’ viewpoint, a small negative real yield represents only a limited insurance cost for matching very long-term (RPI) inflation-linked liabilities.
Negative real yields on index-linked gilts have now been with us for around three years, so they are by no means the norm. Whether the promised gradual increase in base rates will eventually drag longer-term index-linked yields into positive territory is uncertain because of that demand/supply balance. According to the NAPF, “in order to fully hedge scheme liabilities, pension schemes would need access to an inflation-linked market of approximately £1tn”. The current index-linked gilt market is worth about £340bn, so there is a long way to go.
The pension funds’ appetite for negative real yields is good news for the Treasury, if nobody else.
Sterling performance comes at a price
Sterling has been performing strongly over the last year. From about $1.51 to the pound at the beginning of August 2013, it has now risen to $1.69, having spent the first half of July above $1.71.
There is a similar story with the euro: what was €1.145 to the pound in August 2013 is now €1.260. The massive depreciation that the Bank of England quietly allowed in the wake of the financial crisis means sterling remains significantly lower than it was seven years ago, when it bought over $2.00 (and nearly €1.50). Nevertheless the recent rally is starting to cause concern.
Many large UK-listed companies (BP, Shell, HSBC, Astra Zeneca, BG Group, Rio Tinto and others) quote their results (including dividends) in US dollars. The result is that for sterling-based investors, dividend growth has slowed to a crawl. According to Capita UK’s dividend monitor, in Q2 2014 dividends were only 1.2 per cent up year on year. The top 15 dividend payers, which accounted for 61 per cent of all Q2 dividends, saw an overall drop of 0.8 per cent, with eight companies cutting their sterling payments. The FTSE 100 constituents, where the dollar-denominated multinationals are to be found, managed a dividend rise of only 0.5 per cent, while the more UK-oriented FTSE 250 recorded 2.6 per cent growth.
The strong pound bodes ill for future profits, too, as overseas earnings (whether from exports or foreign subsidiaries) are translated into about 10 per cent fewer pounds than a year ago. Even purely UK-focused companies are not immune, because competing imports are cheaper in sterling terms.
Helped by the Neil Woodford effect, June was the best sales month ever for the UK Equity Income sector, according to the Investment Management Association. For the fund managers, finding a source of rising dividends to keep all those investors happy is becoming increasingly difficult.
Treasury venture capital review
The Treasury has launched a consultation paper looking at the effectiveness of recent enterprise investment scheme (EIS) and venture capital trust (VCT) reforms, and compliance with new EU state aid guidance.
In the past few years, the government has made a variety of changes to VCTs and EISs, including raising the maximum size of qualifying companies, improving EIS tax relief and introducing the SEIS. It has also closed down some of the more ‘creative’ ideas, such as VCT-enhanced buyback arrangements and schemes taking advantage of government-funded green energy incentives.
The Treasury has now been forced to revisit tax-incentivised SME investment in the light of updated European Commission guidelines on state aid, which took effect from 1 July 2014. These include two main criteria that differ from the EIS and VCT requirements:
The EU guidelines say that overall government support to a company should total no more than €15m, whereas EIS and VCT rules allow companies to benefit from up to £5m of tax-incentivised investment a year, combined with a £15m gross assets test.
The EU wants to limit relief to companies less than seven years old (dated from their first commercial sale): no such age restrictions apply to EIS and VCT.
For the UK to remain in line with the updated guidelines, the Treasury needs to show that the overall effect of current VCT/EIS legislation matches the type of support that the EU Commission is targeting. Failure to do so would mean amendments to the existing UK legislation.
The Treasury’s consultation paper asks for views on the impact of the EU guidance and the consequences of moving to the €15m/seven-year criteria. At the same time, the government has taken advantage of the consultation process to ask nearly 30 questions about other aspects of EIS/VCT investment, including the operation of tax relief, the qualifying company rules and the use of convertible loans.
The consultation runs until 19 September 2014, so any changes might appear in one of next year’s finance bills.
US economy grows stronger
The advance estimate from the US Bureau of Economic Analysis sees growth in the second quarter of this year shoot toward four per cent on an annualised basis.
That is a rate of growth far in advance of the consensus estimate of 3.1 per cent. At the same time, output in Q1 2014 was revised upwards, from -2.9 per cent to -2.1 per cent. Similarly, output in Q4 2013 was changed from 3.5% to 4.5%.
The next estimate for Q2 2014 — which will be based on fuller data — will almost certainly contain a revision. Notwithstanding that, it does seem likely that the sharp decline in the first quarter was little more than a blip.
The advance estimate for Q2 can also be thought of as a blip. After all, the surging inventories that make up 1.7 per cent of the four per cent figure cannot be sustained for long. But the data contain a fair amount of good news; consumption was strong, business investment was solid, residential investment bounced back and state and local government spending more than offset the sustained decrease in federal government spending.
Couple all of that with the recent run of strong jobs reports — unemployment is down 1.1 per cent to 6.2 per cent over the last 12 months — and you might well ask when the US Federal Reserve is likely to bring about the first interest rate rise.
However, the US central bank is still expanding its balance sheet. Its programme of bond purchases will not end until, perhaps, October and a pause is the next most likely move following that. That probably rules out the rest of this year.
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