InvestmentsNov 22 2016

Global trusts are the answer to higher inflation

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Global trusts are the answer to higher inflation

This is certainly the end of the post 1945 consensus and an international order supported and policed by America. It is too soon to say that the Trump election will lead to a 1930s world of ‘beggar-my-neighbour’ trade policies, as brought in by America’s 1930 Smoot-Hawley Tariff Act, but tomorrow’s world will be very different from today.

The pound and the economy

Inflation is here again, and will probably rise to some 4-5 per cent next year. It will be higher for the old than the young, since the former spend most of their money on food and fuel. But the young may well be hit by higher mortgage rates. 

A cheaper pound means more expensive imports and, with two thirds of our food imported and nearly all our fuel, increased prices in the shops should be no surprise.

This is good news for the Bank of England (BoE) since it, like all other central banks of the developed world, has been desperate to reignite inflation, and thereby reduce spiraling government debt. 

Inflation helps politicians, as it is a form of increased but hidden taxation. It helps reduce the burden of debt, which otherwise would need to be tamed through austerity. But past history shows that inflation is a very false friend, and it is bad news for investors.

Since the financial crash of 2008, savers have suffered from ridiculously low rates of return on their savings, whether as a bank deposit or invested in government bonds. This has been due to quantitative easing, or the policy that making money cheap will keep assets dear and the rich happy.

And the happy rich, so the theory goes, will invest in new business capacity, so supplying the rest of us with new jobs, and therefore get the world spending again, so justifying all that extra business investment.

This was a necessary theory in 2008, with world banking facing meltdown, but it has failed to produce a robust recovery in economic activity. Now inflation will give a spurious credence to the idea of growth, which is what all politicians, central bankers and business people are desperate to see.

Changes in central bank policy

Brexit and inflation present an awkward dilemma for the BoE. The UK is running a significant deficit on its trade balance – the gap between what we sell to foreigners and what we buy from them. Until the era of floating exchange rates, this trade gap caused serious problems for the management of the economy.

Floating exchange rates partly solved the problem, but the promotion of the UK as the ideal country for direct foreign investment was the real solution. Add English law and language plus unimpeded access to the EU, and the trading gap ceased to be a worry. But it is a concern now, and will continue to be so until the future EU/UK trading relationship is clarified. 

As the governor of the BoE put it, we must rely on the kindness of strangers to cover that large and growing hole. Whatever else, the BoE will have to think about the exchange rate, as no one will hold sterling if they believe it will be devalued, or it is the currency of a declining 1970s style economy, adrift in a world of protectionist blocs.

The era of quantitative easing is probably coming to an end, as it has not worked. Even if central banks deny this, politicians cannot avoid the message of elections. But what happens when central banks return to normal behaviour? That is to say money priced to prioritise business opportunities and to encourage savings. 

This will require interest rates to return to positive levels, which will take time and cause disruption. Fortunately, the hole in our savings needs has been filled by asset managers reinventing the investment company – that Victorian relic which enabled investors to take great gambles, but at low risk.

New lenders replace banks

Monetary policy requires central banks to supply retail banks with money and for these to lend this on to business. But Britain’s high street banks no longer have the skills or desire to undertake risky lending; they just prefer mortgage lending.

So quantitative easing failed because the central bank’s largesse ended up locked away in retail bank vaults. Others then stepped in to undertake these profitable activities.

Investment companies avoid the difficulties of illiquid assets, and changing asset allocation preferences by their closed-end nature; investors cannot panic out of their property or other fashionable investments. They can only sell investment company shares within the stockmarket. This change of investor demand causes the premiums and discounts shown in Table 1.

RDR and investment trusts

Hard times have benefited investment companies with efficient corporate structures compared with unit trusts and exchange-traded funds. 

The number of advisory and wealth management firms using investment companies increased by 33 per cent to 1,638 in the second quarter of 2016. This is a record number of users, and nearly triples the number of firms using investment companies in the last quarter of 2014, just prior to the Retail Distribution Review. 

The two most popular sectors were Global and UK Equity Income, followed by Property Direct – UK, Infrastructure and UK All Companies. This was a good portfolio strategy before Brexit and the US election upended all expectations.

As Annabel Brodie-Smith, communications director of the Association of Investment Companies, says: “Investor appetite for income remains strong in this low interest rate environment, and this is reflected by a number of higher yielding, specialist sectors trading on premiums.

“The problems in the open-ended property sector this summer also highlights that the investment company closed-ended structure works well for illiquid assets, which can offer a higher level of income such as commercial property and infrastructure.

“But investors should be aware that sentiment can change and income from investment companies is not headline yield. There’s a broad spectrum of risk and reward, so it is crucial that investors do their homework, take a long-term view and, if necessary, seek financial advice.”

Markets remain overpriced and if investors are to take the equity route they need to concentrate on managers proven over many years, and without restrictive mandates in terms of income levels or indices. This suggests global and technology investment trusts, rather than domestic UK, US or European yardsticks.

UK economic growth will be uncertain for the next few years while EU negotiations continue, and the problems of EU governance have escalated to a level where its continued existence is in doubt.

The Republicans’ clean sweep of the presidency and congress should mean the Washington gridlock is over, but what that means for domestic policies is anyone’s guess. Global investment trusts are the way to go and Asia is the new America.