Investing in an abnormal world

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Neil Woodford 24 June 2015 Est. reading: 4 min read

With equity markets revisiting historic peaks in recent months, investors could easily be lulled into a false sense of security about the state of the global economy. At face value, equity markets appear to be suggesting that all is well in the world and the problems that caused the financial crisis are now well behind us.

I have a few words of caution against drawing such a conclusion, however. I believe it would be wrong and, from an investment perspective, risky to believe that we live in a normal world. In case anyone ever needs a reminder of how abnormal current conditions are, I would recommend the chart below. In the first 300 years of the Bank of England’s history, interest rates averaged nearly 5% and never fell below 2%. In the financial crisis of 2008/09, however, they retreated below 2% for the first time in history and have remained at 0.5% since March 2009. In my view, they look set to remain at these very low levels for some time to come.

Graph showing how in its first 300 years, the Bank of England base rate averaged 4.8% and never went below 2%. Interest rates have now been at 0.5% for over 6 years!

Not only do we have ultra-low interest rates, though, we have also had quantitative easing (QE) in the UK and US and this form of extraordinary monetary policy continues in Europe and Japan. QE is a controversial policy for a number of reasons but, in my view, one of its biggest drawbacks is that it can be held primarily responsible for creating a dangerous mirage of normality, because it has driven a wedge between financial asset prices and the anaemic economy underneath them.

From the outset, the objective of QE was to inflate financial asset prices in the hope and expectation that the rise in value of those financial assets would ultimately precipitate a trickle-down effect in the real economy. That was the theory – in reality, we’ve had the first piece in the form of higher asset prices but we haven’t seen the follow-through. Some economists have argued that without QE, deflationary forces would have been more intense and growth outcomes may have been even worse. It’s difficult to argue against this suggestion but, in my opinion, QE has not delivered what the architects of the policy hoped it would deliver, namely, a real economic transformation.

It has inflated asset prices, though, and therein lies my concern. Without an improvement in underlying economic fundamentals, if you keep driving asset prices up, in the end you create a financial asset price bubble. We know from relatively recent history that asset bubbles burst in an unpredictable and unpleasant way with real economic effects that can be very damaging and long-lasting. This is why I worry about QE – the ultimate consequences of the policy could be the complete opposite of what it was originally designed to deliver.

Such an outcome could still be years away, however, and in the meantime, QE is likely to continue as a policy. Investors, therefore, need to remain vigilant and acutely conscious of inflated valuations.

Equity markets remain one of the few areas where undervalued assets can still be found. There are large areas of over-valuation as well, so it’s very important to be selective but there are enough attractive opportunities out there to build a diversified portfolio. Amongst smaller companies, we continue to find early-stage businesses which have tremendous long-term capital appreciation potential. And, within the large cap investment universe, some dependable sources of dividend yield and dividend growth are also undervalued, sometimes profoundly so.

This undervaluation is most evident when high quality, dependable growth equities are compared to yields on fixed interest securities. Within the CF Woodford Equity Income Fund portfolio, we have notable positions in BAE Systems, Imperial Tobacco and Legal & General (to name but a few!), all of which have forecast yields at the time of writing in excess of 4.5%. To find an equivalent yield among 10yr sovereign bonds, you would have to look towards the likes of Brazil, Turkey and Russia – I know which I consider to be the safer sources of income!1

Furthermore, the yield on these equities tends to be higher than the yield on the same company’s corporate bonds! When you consider that equities are real assets, capable of delivering long-term income growth and that bonds are nominal assets offering no growth, this situation looks anomalous. In my view, it is indicative of both the over-valuation of bond markets currently and the under-valuation of select high-quality, dependable growth stocks.

This is why, in spite of my concerns about QE and future bubbles, I am confident that I can find attractive investment ideas. As those ideas play out I am, in turn, confident that I can continue to deliver attractive returns to investors over the long term.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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