Economic backdrop 2016/17

16 January 2017

Patrick Norwood, Insight Analyst (Funds and DFM)

Learning objective: to view the current economic backdrop and what it could mean for (1) various asset classes, including multi-asset and (2) investment charges.

The two main events for markets in 2016 were the UK’s vote to leave the European Union and Trump’s victory in the US Presidential election.

After falling in the immediate days following the EU referendum result, equity markets across the world increased strongly over the Summer and early Autumn, with these increases resuming after the US elections. However, many commentators now see developed market equities as overvalued. In addition, with lower gross domestic product (GDP) and productivity growth plus profits as a share of GDP at very high levels, equity returns are likely to be lower over the next few years than historical averages.

Bonds, the traditional diversifier from equities, saw yields, which were low anyway, fall further after the ‘Brexit’ vote and ultra-low or even negative government bond yields have become the norm in many developed markets. Yields, particularly in the US, have recently been on the rise again as markets appear to believe Trump’s policies, such as greater spending on infrastructure and scrapping some trade agreements, will be more inflationary. Bond yields, though, are still low by historical standards therefore sovereign bond returns are likely to be lower over the coming years, with investors in negative yielding bonds virtually guaranteed a negative nominal return on securities held to maturity!

Interest rates on cash, meanwhile, have fallen to almost zero following the cut in the Bank Rate by the Bank of England from 0.5% to 0.25% in August.

With likely lower returns across most of the traditional asset classes, people will need to consider a combination of saving more, working longer and/or investing in riskier assets. Multi-asset products and solutions that combine risks intelligently and consider loss mitigation should continue to increase in popularity. Defaqto provide Risk Ratings, on a scale of 1 to 10, for multi-asset funds, enabling advisers to match funds with a Defaqto Risk Rating corresponding to the client’s risk profile.

Costs will also become more important - when equity markets were rising 15-20% a year, fund managers could get away with charging 1.5% or even 2% ongoing charges (OCFs). In this new era of low single figure returns, however, with charges forming a higher proportion of returns, funds with OCFs of less than 1% will probably be much more appealing to investors.

In November the Financial Conduct Authority (FCA) published the interim findings of its asset management market study, which suggest that there is weak price competition in a number of areas of the asset management industry. Most people believe that investors should be able to see the costs that relate to the management of their assets and that these should be comprehensively disclosed (all of Defaqto’s Diamond Ratings for funds include OCFs as one of the criteria in calculating the overall rating). There is also the question of trading costs - whether to show an estimate of them ex-ante or the actual figure ex-poste - and who should bear these costs. The Financial Conduct Authority (FCA) are currently consulting on a range of different remedies, most of which place the incentive for the management of trading costs with the manager.

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