WISE SEMINAR - YOUR QUESTIONS ANSWERED, YOUR ANSWERS CONSIDERED
Blog - May 29th 2013
A summary of your feedback from our seminar earlier this month, and a narrative that tries to answer most of the questions you asked us.
Our seminar was held on a day of hot sunshine at Eynsham Hall on May 7th. Around a hundred and fifty of you came - the largest attendance we have had. It was a good party. Many thanks to everyone who came, and special thanks to those of you who completed the feedback forms, which are a great help to us in planning future events.
You all loved the hall, which was seen at its best in the spring sunshine, though some of you found the directions to the hall unclear. The room in which we did the presentations was not an ideal shape - a long, narrow rectangle, so people sitting at the sides couldn’t see very well. Some people felt rather squashed together, and some of you commented that the room was too hot. For the first time ever, we had more people wanting to come than we had seats available in the room, partly as a result of having just one ‘business’ session, rather than two, as on previous occasions. On the day, the Eynsham Hall management agreed to put more chairs in the hall than their previously-stated maximum, which they had said was limited by health-and-safety requirements. Around twenty-five guests were unable to attend, which left us at the last minute with more chairs in the room than were needed. If we had known all this in advance, you could have been a bit less squashed!
Like us, some of you were rather underwhelmed by the food. It looked a lot better in the brochure!
We’re not sure if we’ll use that venue again. It is impressive, but the room would still be the same narrow rectangle on a future occasion, and the weather might not be as good. If we do go back, we will use an outside caterer - we know several excellent ones locally.
You liked the presentations, which you thought were clear, relevant, and about the right length (though several people said they would have liked them longer!). Those of you who completed the feedback forms all liked the question-and-answer session, and we liked it, too. Issues of audibility and visibility were mainly due to the shape of the room, though the equipment we used wasn’t perfect. The laser pointer produced a tiny purple point which was invisible to anyone beyond the third row. And we’ll make sure that the speaker echo and howl don’t happen again.
You were more or less equally divided on the question of whether we should hold our seminars every year or every other year, which more or less reflects our own thoughts on the subject. We may compromise and hold our seminars every eighteen months or so, alternating between October and May. We may also experiment with other smaller formats. Our aim in all this is to keep you as informed as possible, in an enjoyable way.
You like meeting members of the Wise team, and they like meeting you.
Most of your questions concerned the larger issues of government policy, austerity, inflation and interest rates, the potential for stock markets to become overvalued, and what we might do if that happens. These questions are all highly relevant to Wise’s raison d’etre, the investment of your money, and they are all linked together. So, I thought it might be useful to put together a narrative which strings all your ‘macro’ questions together and tries to answer them. This narrative contains my personal view of the ‘macro’ environment, and may not be shared by my colleagues, or anyone else.
There were also some specific questions, which I will answer individually below.
In the Western world, the investment environment continues to be dominated by the aftermath of the financial crisis of 2007-08, characterised by low levels of economic activity, low consumer and business confidence, highly indebted governments, and ultra-low interest rates.
For the best part of three decades up to 2008, there was a slowly-building asset bubble, focussed mainly on property. There was also a stock market boom in the 1990s, which culminated in the TMT (technology, media and telecoms) bubble of 1998-2000. In the U.K., the stock market still hasn’t recovered to the level it reached at the end of 1999.
Activity and prices in the property market tend to move roughly in line with the economic cycle, but during the recession of 2000-3, prices in both the commercial and residential property markets continued to rise. This kind of cycle-defying price action is indicative of bubbles. As property prices rose, particularly in Spain, Australia, the U.S. and the U.K., the level of indebtedness rose, with increasing signs of excess, such as lenders offering mortgages of more than the value of the collateral properties, and loan-to-income multiples rising to ever more extreme levels. The sub-prime mess in the U.S. was the catalyst which brought to an end an unsustainable process which would have collapsed under its own weight soon enough. Unfortunately, financial regulators round the world failed to see how perilously over-extended the banking system had become.
The 1990s were good ones for the Chinese economy. During this period, China cemented its position as the workshop of the world. Between 1990 and 2010, around 400 million Chinese people migrated from the countryside to the cities, where they were prepared to work long hours in factories for a tiny fraction of what anyone in the West could survive on. Chinese government policy helped the entrepreneurs by keeping interest rates, and the currency, low. The result was that China ‘exported deflation’ to the West, by supplying western markets with an expanding range of goods at ever cheaper prices. Some western governments, including our own, mistakenly assumed that our persistent low inflation was a result of their policies, rather than being caused by an external input which was out of their control.
A third element of today’s situation in the U.K. was the need to rebuild infrastructure. Labour governments tend to spend money, while Conservative ones prefer not to. So, in 1997, at the end of an eighteen-year period of Conservative administration, there was an undoubted need for investment, particularly in schools and hospitals. This the incoming Labour administration provided, though some would say that the money was not prudently spent, and that much of it was wasted. Together with the wars in Afghanistan and Iraq, infrastructure and social welfare spending were the main reasons why the U.K. government budget was in deficit every year after 2001. Thus, the U.K. entered the period of crisis with its public finances in a far weaker position than one might have expected after a long period of economic expansion and rising tax revenue.
During the crisis, strategic decisions were made which continue to affect the environment in which we live and work. These include:-
Ultra-low interest rates
If the crisis was caused by too much of the wrong sort of borrowing and lending, then it would be reasonable to assume that the solution would be to a pursue a policy of higher interest rates, which encourage saving and discourage borrowing. Exactly the opposite was done. This was because the authorities realised that higher interest rates would cause a tidal wave of corporate and personal bankruptcies and a savage recession, exactly what happened when interest rates were raised following the Wall Street Crash of 1929. U.S. Federal Reserve Board Chairman Ben Bernanke, an expert on the U.S. depression era, is a powerful exponent of ultra-low-interest rates, which have been adopted by central banks worldwide.
The adoption of the new policy marked a major change of direction for the world’s central banks, whose aim now is twofold – to prevent the crisis from derailing the world’s economy and banking system, and to promote a new era of growth. Containing inflation is no longer the priority.
There are unwelcome consequences. For savers, interest rates below the rate of inflation mean that even if you roll up all your interest and don’t spend it, the purchasing power of your money is less at the end of the year than at the start. A policy of ultra-low interest rates pushes savers towards higher yielding, normally riskier investment vehicles, such as the ‘retail bonds’ which companies have been issuing in the last couple of years. Low interest rates allow ‘zombie’ companies to survive –ones which would collapse if they had to pay normal rates of interest on their often excessive borrowings. The continued existence of the zombies slows down the rate at which more efficient companies can grow, and distorts the progress of economic recovery.
After more than four years, we are coming to think of a bank base rate of 0.5% as normal. Three hundred years of history remind us that it is not.
The Bank of England has bought £375bn of U.K. government stock (gilts) -around a third of the outstanding issuance - with money which it has magically created. The result - much higher gilt prices and much lower yields - a massive exercise in price-fixing. As I write, the price of one such gilt, Treasury 5.0% 2025, is £1.296. If you buy £100’s worth of this stock today, costing £129.60, the government will pay you £5.00 each year until the issue matures in March 2025, when it will return you the face value of the stock, £100.00. Eleven-and-a-half years’ worth of income, at £5.00 per year, after tax, comes to £46.00. After a capital loss of £29.60, your net return is £16.40, or £1.426 a year - an annual return of 1.1% on your investment, which is likely to be further diminished by inflation. Gilts share with cash the characteristic of giving you an overall return well below the current rate of inflation, and bearing in mind that the central banks are no longer mainly interested in controlling inflation, it seems hopeful to expect inflation to fall significantly from its current level of around 2.5%.
You may be wondering why governments should pursue such a daft policy as to force the price of their paper up to a point where no one in their right mind would want to own it. Q.E. has two purposes. One is to lower the rate at which governments borrow new money and, despite austerity, our government is still borrowing new money at the rate of £120 billion a year. The other is to entice investors who have a choice in the matter to switch to riskier assets, such as corporate bonds and shares, with the aim of increasing the prices of those assets, and stimulating confidence among investors which could spill over into higher economic activity. Many investors in gilts actually don’t have a choice in the matter, and it is these investors who own the other two-thirds of the gilt market not owned by the Bank of England.
Q.E., like low interest rates, also carries unintended consequences. The ‘discount rate’, which is used to calculate whether final-salary pension schemes have sufficient assets to cover their future liabilities, is based on the gilt yield, and a low yield on gilts lowers the assumed growth rate on assets, and creates deficits in almost all company pension schemes, the vast majority of which would have been in surplus otherwise. This means that companies are obliged to make large annual payments to reduce their deficits, which means that less of their surplus cash-flow is available for investment and job creation. Closely linked to the discount rate is the annuity rate, the number used to convert a personal pension fund into an annual income when its owner retires. Annuity rates are now at such low levels that unless your pension fund is small, it makes sense to leave the pension invested and take income drawdown, rather than buying an annuity, and drawdown is now what the vast majority of people choose to do.
In 2010, when the Coalition came to power and announced the policy of austerity, I was wholly in favour of it. Now, I am not so sure.
It seems obvious - if your spending exceeds your income, then it makes sense to reduce your spending, if you can’t increase your income. That’s what you or I would do, but if you’re a government, it’s more complicated, because many of the things you save money on, such as making people redundant, reduce activity in the economy, end up reducing your tax income, and increasing your spending on benefits, creating a vicious circle which forces you to cut spending further.
The classic Keynesian response to recession is for the government to spend money on infrastructure - roads, railways, schools and hospitals. This spending creates employment, and the whole economy benefits from better communications and facilities. However, our government has argued that it cannot afford to do this, because its finances have been so weakened by the excessive spending of its predecessors that it just doesn’t have the cash, and risks losing the confidence of the financial markets. Lower confidence would result in higher borrowing costs for the government, as we saw with some of the weaker European countries last year, which could create another nasty vicious circle. I agree - the state’s finances were weakened under the previous administration, we need to run balanced budgets for the long term, and it is important to retain the confidence of the financial markets. But Q.E. alters the picture radically. Most commentators, including the influential International Monetary Fund (I.M.F.), believe that the U.K. should invest in infrastructure, and the markets are therefore unlikely to react negatively if infrastructure spending happens. But, in the event of a negative reaction, the Bank of England could stabilise things with a little more Q.E.
Your questions answered
Thank you for your patience so far - it has taken me a little over two thousand words to bring the story up to the present day. Now we can look ahead and make predictions for the future.
Roger Backhaus askedfor a prediction of future inflation in the U.K. I expect that inflation will not fall significantly below its current level, and could rise substantially from here. That’s partly because central banks no longer see inflation as their main concern, and are pursuing expansionist policies which tend to create inflation eventually. Also, the deflationary effect of China is much less than it was, because costs, particularly wage costs, are rising rapidly in China. One might ask why the creation of money on the recent epic scale has not caused higher inflation before now. The answer may be that inflation is caused partly by a combination of the supply of money, and its velocity - the rate that money moves around the economy, which continues to be low.
Jeff Peters comments ‘At the start of the recession when the base rate fell to 0.5%, I said that we would not be out of the woods until the rate started rising again’ and asked what circumstances would lead to interest rates rising, and whether it would be a sign of strength in the U.K. economy.
For me, there are two possible answers to this question. Banks may raise interest rates when they feel the time is right, or they may be forced to raise interest rates by circumstances beyond their control.
Interest rates will rise when central banks once again become more concerned about inflation than by a lack of economic growth. We can assume that this change of policy will not happen until the bankers are assured that their economies have returned to a sustainable level of growth, as it seems the U.S. has begun to do. One central bank might act alone in raising rates, or they might all act together. A central bank which acted alone would have to be sure that its region’s exporting industries were strong enough to withstand the effects of a sharp rise in the currency, caused by a sudden inflow of savings, attracted by the higher interest rate. Banks acting together would need to be sure that their economies were capable of absorbing the inevitable wave of bankruptcies, mortgage repossessions and lower property prices which would result from any significant rise in interest rates.
There is another, less benign possibility. There may come a point when inflation has gradually taken hold unchecked, and then starts to rise in an uncontrollable way. Then, interest rates would have to be increased, and quickly, in order to head off further inflation. Higher interest rates could attract a lot of money back from ‘risk’ assets into deposit accounts, causing big falls in asset prices. It is important to be sure that we hold assets which could survive such a period of volatility intact.
After the seminar, we had a question from Anna Franks, who said ‘I always thought low inflation was bad for savers, not high’. I would draw a distinction between savers, people who have money on deposit, and investors, who put their money into things like shares and property. You could make a further distinction between two kinds of savers, re-investing ones who roll up the interest on their accounts, and spending ones who withdraw their interest as it arises. For the re-investors, what matters is the real return on their money, which is the interest rate they receive minus the rate of inflation. If you are getting 5% interest, and inflation is 3%, then the spending power of your savings pot will be greater at the end of the year than at the beginning. If the figures are the other way round, then you have a ‘negative real rate of interest’ which means that the spending power of your pot is getting lower all the time, even though you aren’t taking a penny of interest. That is the situation of financial repression, in which we have found ourselves since the crisis.
For the spenders, any amount of inflation, however low, is a bad thing, because it reduces the spending power of your deposit.
Geoff Stephens asks ‘Has the economy undergone structural changes during the current recession or will we revert to the normal cycle?’ Yes, there have been structural changes, such as the requirement for banks to hold much higher levels of capital to support their lending, which many of them have already achieved. However, I believe that cycles are endemic in all economic activity, and will always recur in economic life.
Ian Mackay asks ‘It used to be said that as you approached expected/planned retirement age you should move your pension pot into assets with lower risk/greater certainty. Does this still hold true in today’s world of lower interest rates, and poor annuity rates?’ Others asked the same question, in a slightly different form.
The reason for holding lower-risk assets in the period before retirement was to avoid losses, which would be crystallised when you came to exchange your pension fund for an annuity. Nowadays, people don’t buy annuities as the annuity rates are so poor, so there is not the same cut-off point as there once was. After retirement, some people’s pension funds will look very much as they did before, while others will tend to move towards more income-producing assets, where the investment income covers the drawdown income - but the risk profile will be similar. So, that ‘guillotine moment’ when the fund disappears to be replaced by annuity no longer exists for most people, and that changes the need to protect your asset values in anticipation of that time.
A further complication is that the prices of lower-risk assets, such as gilts - the sort of thing into which you might move your pension fund with a view to protecting its value - have been forced up to levels where they are actually quite risky.
Steve Webb askedabout the size of Wise Investment in terms of the numberof our clients, and the amount of money we have under management. Our assets under management come to around £230 million at the moment, an amount which would allow you to take every man, woman, and child in the U.K. out to a coffee bar, and buy them a latte and an almond croissant. It is a huge sum of money, and yet we are very small compared to the large investment houses. Standard Life, for example, manage around £200 billion, which means that they look after nearly £1,000 for each £1 Wise looks after. We have 1,406 clients, a little over a tenth of whom came to our seminar and birthday party. We have 1,094 clients with assets of more than £10,000 held through us, and the average portfolio size of these clients is £188,000. We would like to think we are ‘big enough to serve you well, and small enough to know you well’.
I hope that the above has answered your questions to your satisfaction. There were also some individual questions, which have been answered individually by our advisers. If you have any further questions, then please let me know, and I will be happy to try and answer them.
This has become rather a long blog, so I will end here. I will write again soon with a long, hard look at markets and an update on my funds. I had reduced Japan in T.B. Wise Investment to 2.6%, and had started to feel rather uncomfortable after doing so, but I felt better again last Thursday, when the Japanese stock market fell 7.3%.
With best wishes,
PLEASE NOTE - THIS BLOG CONTAINS THE PERSONAL OPINIONS OF TONY YARROW AS AT MAY 29TH 2013, AND DOES NOT CONTAIN FINANCIAL OR INVESTMENT ADVICE.