Oh the British weather! Excitingly unpredictable and a sure fire way to strike up a conversation with the natives, it now stands officially accused of causing havoc with the economy. Whether it was unusually cold, as in the fourth quarter of 2010, or unusually warm, as in the second quarter of 2011, it seems as though the U.K. economy can only thrive at the right air temperature. What that right temperature is the statisticians have been unable to tell, which, when you think about it, might be not too bad a thing, as it leads to all kinds of interesting bets. My money is on 16 Celsius.
Weather-impacted or not, the fact is that the recovery in the U.K. is proceeding at a much slower pace than most had anticipated. What the data have shown is a mix of persisting recession in consumer spending, a manufacturing sector propped up by a weak sterling but not increasing in size relative to the overall economy, and a services sector--particularly the much maligned financial segment--kind of saving the day. And all this against a backdrop of persistently high inflation, as measured by the Bank of England’s price stability target of 2.0%. Even the most optimistic of economic analysts must be concerned about the off-chance that the U.K. economy could be drifting into something of a stagflation phase; not 1970s-style stagflation but one befitting today’s globalised economic conditions.
Concerns about a stagnant economy have fuelled the debate about whether the coalition government’s deficit-fixing plan needs complementing with a growth plan. Chancellor Osborne is proud of his “not a u-turn-kind-of-guy” credentials, and despite some Lib-Dem noise about the need for some kind of stimulus (e.g. more quantitative easing), the government as a whole is sticking to the “austerity is the way to growth” policy line. The end-goal of this policy is to overhaul the economy’s growth pattern from debt-funded consumerism to export-oriented manufacturing. High inflation, a by-product of the manufacturing-supportive weaker currency, becomes a price worth paying in so far as it keeps consumers focused on deleveraging.
Bar a policy u-turn, the likely macro outlook shaping investment decisions over the medium term is thus one of retrenching private consumption and higher-than-average inflation pressures on imported prices. The obvious investment response to this macro scenario would be one of overweighting inflation-fighters and non-cyclical equity holdings. All this can be done via the exchange-traded product (ETP) route.
Catering For Inflation Fighters...
Inflation fighters come in all forms of assets, although if asked, most investors would cite inflation-linked government bonds and commodities as the most popular. As we write, the offering of U.K. government inflation-linked bond ETPs remains a small one with only three exchange-traded funds (ETFs) available, the iShares BarCap GBP Index-Linked Gilts (INXG), the db x-trackers iBoxx UK Gilt Inflation Linked (XBUI) and the Lyxor iBoxx UK Gilt Inflation-Linked (GILI). The iShares ETF is physically replicated, while the db x-trackers and Lyxor ETFs are swap-based. Despite the apparent competition, this particular market is almost monopolistically dominated by the iShares ETF (TER 0.25%), with close to 98% of overall assets under management.
Meanwhile, the offering of GBP-denominated or GBP-hedged commodity ETPs is more varied, with 62 ETCs (exchange-traded commodities) and 13 commodity ETNs (exchange-traded notes) listed on the London Stock Exchange as of end-July 2011 covering the broad spectrum of commodity classes (e.g. metals, agriculture, energy).
Any inflation-beating strategy would need to be fine tuned to monetary policy expectations, as the efficacy of different asset classes against inflation will be determined by moves in interest rates. One of the current drawbacks of government inflation-linked ETFs is their long duration, particularly in the case of the U.K., which would make them proportionally more exposed to capital losses than short-duration vehicles when interest rates rise.
...Then On To the Sector Equities
Building the equity side of our chosen investment strategy with ETPs would call for a flexible approach both in terms of geographical and currency exposure. Gaining exposure to the broad U.K. stock market via ETPs is a fairly straightforward task. At the last count, the Morningstar Direct database showed 30 ETFs tracking the main U.K. stock market indices (e.g. FTSE 100, 250, All-Share) plus a handful following the MSCI UK indices. These will help you set up investment strategies based on size (e.g. large cap, small cap, etc), but they are not suitable vehicles to roll out sector-based bets.
In order to overweight non-cyclicals (i.e. if you need to eat it, drink it, clean and medicate with it, you’re on the right path), U.K. investors would need to go for European (e.g. STOXX 600, MSCI Europe) or Worldwide (e.g. MSCI World) equity sector ETPs, where U.K. companies for each sector will be represented alongside their continental or world peers. The choice of these ETPs is ever-growing, with a fair number listed on the London Stock Exchange and traded in GBP. Amongst these we could cite the likes of the Lyxor MSCI World Consumer Staples ETF (STAG) and the db x-trackers STOXX 600 Healthcare ETF (XSDR). However, the possibility to trade in GBP should not be taken as a sure sign that these are GBP-denominated products. The indices tracked by these ETFs are typically either EUR- or USD-denominated. Hence U.K. investors will need to account for foreign exchange fluctuations.
Visit Morningstar's ETF Education Centre to watch slideshows on how to use these investment vehicles.
