This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Matthew Toms, Investment Manager at Heartwood Investment Management, discusses domestic assets.
Offering insight into UK investment markets feels like an impossible task, given the fluidity of the Brexit situation and ongoing political volatility. Instead then, invsetors should focus on a couple of the longer-term issues in UK markets facing investors today.
Accessng the Domestic Economy
When it comes to the UK equity market, we are already ‘Global Britain’. A simple glance at the UK’s largest companies bears this out. When aggregated, only 24% of revenue from these companies is earned in the UK; the remaining 76% is spread across the rest of the world. Effectively then, investors buying large-cap UK equities are not really buying exposure to the UK economy.
There are pros and cons to this reality. On the plus side, it means that a UK equity approach can equate to a globally diversified product. On the downside, if an investor wants to gain explicit exposure to the UK economy, domestic equities can struggle to provide it.
Buying individual stocks which offer specific UK exposure could solve this, but would hinder portfolio diversification. UK property is another option, though access to the sector can be somewhat limited in public markets. Buying investment vehicles focused on smaller and mid-sized UK-listed companies (which are generally more domestically orientated) is one attractive option, and we have a sizeable exposure here within our UK equity allocation.
Can Gilts Still Serve a Purpose?
Traditionally, there have been three reasons to invest in government bonds. First, income; second, capital gains when interest rates fall; and third, to create diversification within a multi asset portfolio. UK government bonds have traditionally rallied when the stock market has faltered.
Do these reasons hold up today? The first, income, has diminished significantly, as the yield on UK government bonds has fallen from 3.2% to 1.2% over the past decade – an income reduction of 61%. The second, related to falling interest rates, has also lost some strength – the Bank of England recently began raising interest rates and has indicated further gradual rate rises ahead.
This leaves only the third reason: diversification versus equities. In our view, this one probably does hold true. In a meaningful ‘risk off’ scenario, where the economy or investment markets deteriorate sharply, we would expect bonds to rally and to protect investment portfolios, though not to the same extent as in the past given current low yields.
What are the Options for Investors?
In seeking income, one option is to take a more creative approach, investing in niche markets where reasonable yields still exist, such as infrastructure debt, European asset-backed securities and insurance-linked bonds.
In combatting near-term price vulnerability amid - slowly - rising interest rates, a shorter timeframe can help – i.e. moving to shorter-dated bonds and holding them to maturity, when the principal amount of the bond is repaid.
For diversification, investors could look instead to other defensive assets, from hedge funds and gold to insurance policies and the Japanese yen. None of these assets are perfect, and none are guaranteed to work, but as part of a diverse blend, they could offer a robust chance of protection.
Morningstar Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar.
