Investment Newsletter September 2014

By Mike DeverellInvestment Manager

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

The Last Queen of Scotland?This week sees Scotland go to the polls to vote on whether to remain part of the UK.

The pros and cons of independence have been discussed in great detail elsewhere and this newsletter is not long enough to cover them all! However, a “yes” vote could have an impact on markets and financial services in general, which could therefore have an impact on clients.

The upcoming referendum has already had an effect on several markets, particularly after the recent YouGov poll put the “yes” voters in the lead for the first time.

Since the poll, the pound has dropped quite sharply, after a period where it had already been weakening. From an investment point of view the major short term impact of this is that it pushes up the value of overseas holdings.

We don’t typically hedge currency when we invest in overseas equity markets as this comes with associated

costs. This means that your American investments, for example, are exposed to the movement of the dollar. As the dollar has strengthened against Sterling of late, our US holdings have therefore increased in value.

Part of the weakening pound is simply a reversal of a very strong run for our currency over the previous year or so. This was partly driven by expectations that the UK would be first to increase interest rates, with the US not doing so for some time. This has now changed and the market expects the UK and the US to increase rates early next year. The recent polls on Scottish independence have therefore exacerbated an existing trend.

Longer term, a fall in Sterling could push up inflation through more expensive imports. On the flip side, it would also help British exports by making them cheaper.

The other short term effect we are already seeing is in the UK stockmarket, with the FTSE 100 down 0.6%

However, a longer term issue could come in the gilt market. Until now, gilts have remained unscathed, in fact they have rallied recently. In particular, long dated gilts have gone up sharply as the market now believes interest rates will only rise very gradually. When capital values go up, their yields go down.

However, gilts are simply loans to the British government. How much of this debt (if any) will be taken on by the new independent Scotland remains to be seen. The current view appears to be “if you won’t let us have the pound we’re not taking our share of the debt”!

This has potential issues for Scotland’s ability to borrow in the future, and a recent study showed Scottish “Kilts” would be likely to have much higher rates than current UK gilts! In other words, Scotland would have to pay a much higher level of interest than the UK does at present.

From an investment point of view, we think that any issues will be relatively contained. However, another factor to be aware of is the potential effect on Scottish financial services companies.

Currently, Scottish banks and insurance companies are regulated by the Financial Conduct Authority (FCA). They are also members of the Financial Services Compensation Scheme which insures bank deposits and insurance company investments up to certain limits.

After independence, there would have to be a new Scottish regulator and compensation scheme. Many investors are concerned that this would not be as strong as the UK regime, and therefore there is a potential for “capital flight” out of Scottish banks and insurance companies.

Many large institutions are therefore likely to relocate their head offices to the remaining UK. The likes of

as I write this (Monday 8 September PM). However, it remains around the 6,800 level and so has not yet seen a major hit.

Should Scotland vote “yes”, we would expect further volatility in the stockmarket. However, this should only be a temporary effect in our view, and a big drop would be a buying opportunity.

Selected stocks might see longer term uncertainty, notably those companies based in Scotland or those with big “cross-border” operations. This is especially true for financial services companies (more of which later).

The split would also have an impact on the remaining UK debt. If the stock of debt remains the same but our economy (or GDP) shrinks when Scotland leaves, then our debt to GDP ratio goes up overnight. The ratio of size of debt to size of the economy has historically been closely watched by bond investors.

However, it is worth noting that our debt to GDP ratio is well below the likes of Spain or Italy, who currently borrow money at a similar level to the UK, so perhaps this is not too much of a concern to markets at present!

All this uncertainty may therefore cause at least a short term wobble in the gilt market. Currently, our investors have very low exposure to gilts as we have preferred corporate bonds and property of late. Incidentally, our property portfolio has circa 10% of its assets in Scotland and this does not cause us too much concern.

Standard Life have openly admitted to looking into this, whilst other Scottish companies keep their cards close to their chests for fear of upsetting either side.

Banks may take the same route. Royal Bank of Scotland is still majority owned by the British taxpayer and it seems unlikely this will be transferred to the new Scottish government. It may certainly be more difficult for a future Scottish state to help a bank the size of RBS in future.

Investment Newsletter September 2014

The Last Queen of Scotland? cont’d

Gilts or Kilts?

Financial Services

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

For Equilibrium clients, the potential impact should be relatively small. Many of you have investments via the Nucleus platform. Although they are based in Edinburgh they are in fact registered in London, and so would remain under the FCA regime.

We also invest in some funds run by Scottish companies. Again, it remains to be seen where these would be denominated should independence by approved. However, if they remain under the Europe wide “UCITS” regulatory regime, then there’s no reason we couldn’t continue to invest in them. We already invest in a couple of Irish denominated funds and have considered funds domiciled in Luxembourg and Norway where they have sterling share classes.

Funds are ringfenced entities, legally held separately from the companies that run them. We would imagine that a new Scottish regulator would adopt similar rules to those in the rest of Europe, particularly as Scotland wishes to become part of the EU.

There is one more issue that is of wider concern. We are due a general election in May next year. Based on current opinion polls, Labour are likely to have the most

seats and may well have enough to form a government, partly because they may win a lot of seats in Scotland.

If Scotland then leaves and Labour loses its Scottish MPs, then it could lose its majority. Will there need to be another election after “independence day”? An alternative being mooted is that next year’s election could be postponed until after the split. However, to do so the recent legislation on fixed term parliaments would need to be repealed. This has the potential to cause uncertainty in markets for some time.

As always, markets hate uncertainty most of all. Only once we have clarity over issues can we address them and move on.

Investment Newsletter September 2014

Financial Services cont’d

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

General Economic OverviewThe global economy continues to do well, led by the US and the UK. Emerging markets have strengthened after a period of weaker growth.

Interest rates are unlikely to be increased until 2015, with inflation remaining very low and wage growth currently subdued. Market movements continue to be dominated by speculation over monetary policy, as well as other macro events like the Scottish referendum and turmoil in Ukraine and the Middle East.

Equity Markets

After a rebound in markets we have downgraded our score to -1 from neutral, meaning we expect perhaps 9%pa rather than 10% over the next 18 months or so. We are less positive about European and American markets, but emerging markets and Japan look good value. Emerging markets in particular are currently performing very well.

Fixed Interest

No change from last month. Interest rates are likely to increase in the near future which is normally bad news for bonds, however much of this is already in the price. We prefer shorter duration bonds. We think fixed interest will underperform our neutral 6% pa expectation but not by a huge amount.

Commercial Property

Property continues to do well and our property portfolio has seen a return of over 12% over the past year. We firmly expect returns to exceed our long term 7% pa assumption over the next 18 months boosted by the stronger UK economy. This may lead to a reduction in vacant properties and more rental growth.

Cash

With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future. Rates may increase by 0.25% perhaps early next year.

Balanced Asset Allocation

For a typical balanced portfolio we are underweight fixed interest and overweight property, we have a roughly neutral position towards equity and alternative equity. A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5 means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.

These represent Equilibrium’s collective views. There are no guarantees. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.

-1

-2

+2

-5

Asset class key+ positive - negative = neutral (normal behaviour)

+5 strongly positive-5 strongly negative

Score

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

Asset Class

Market Views September 2014