Asset allocation: when will be the time to buy back into gilts?

Taking account of valuation, economic prospects and political stability, the UK market looks a decent bet, says Ipsofacto's David Liddell.

Is the gilt market finally about to roll over? The current situation is complicated by the shenanigans between Greece and the rest of the eurozone over a further bail-out; fears of the impact of Grexit have held up assets perceived to be low-risk, such as gilts.

Without this, we might have seen long-term interest rates rising (i.e. gilt prices falling) more than they have.

As it is, since a low of 1.3 per cent in late January, 10-year gilt yields at the end of June were 2.14 per cent, implying a capital loss of over 7 per cent.

For the first half of the year as a whole, the total return on five to 10-year gilts has been negative 0.7 per cent compared to a 3 per cent gain for the FTSE All-Share. Over one year, however, medium gilts have still returned 6.1 per cent, in excess of the 2.4 per cent on the All-Share.


In the main, after a weak first quarter, the recent global economic news has been good. The US created a very healthy 280,000 jobs in May; retail sales were up 2.7 per cent from a year earlier.

In the UK unemployment has continued to fall, a potentially tricky election has been navigated and in the three months to April wages grew at the fastest rate since August 2011, up by 2.7 per cent.

There are even signs that productivity is on an improving trend: output per hour was 1.3 per cent higher in first quarter of 2015, the fastest annual growth rate in three years, though still below the pre-crisis norm of 2 per cent.

Despite the problems of Greeks bearing demands for even more money, the eurozone economic news was pretty positive. The OECD now expects growth in the euro area in 2016 to be 2.1 per cent, up from 1.7 per cent previously. A respected survey from Markit indicated eurozone companies created jobs at the fastest pace in four years during May.

It does seem as though the long-looked-for fillip of lower oil prices may be feeding through to consumer spending and more than offsetting the recessionary effect of savage cuts to investment in the oil and gas industry.

Having been subject to quite wild gyrations, the oil price in sterling is actually up over the first half of the year, but the accepted view is that the price is not returning to the more exalted levels seen prior to the middle of 2014.

Of course, as usual, risks abound, with geopolitical concerns in regards to Russia/Ukraine and the Middle East, in particular, not to mention Grexit. But the most obvious scenario would seem to be one in which the global economy is on a gradually recovering path, and indeed potentially one with increasing momentum.

The central question, therefore, becomes: will the Federal Reserve raise US interest rates too early, and thereby choke off the recovery and send equity investors running for cover?

This is of course difficult to call, but Fed chair Janet Yellen has insisted that actions will be 'data dependent' and it seems likely that she will err on the side of caution as regards the timing of a rate rise. The consensus is, just about, for a US rate increase this year, possibly in September.

All of this supports our quantitatively driven asset allocation advice which has a core position of 70 per cent equities, 15 per cent bonds and 15 per cent cash, unchanged from the beginning of the year.


Looking within the equity exposure, we do think UK investors should overweight the UK market. Over five years, the FTSE 100 has underperformed other developed markets by a considerable margin; it is up 40 per cent, but the US (S&P 500) has increased by 106 per cent and Germany (Dax) by 96 per cent, for example.

The effect of currency movements changes this equation slightly, but the UK main market has definitely been trailing (mid and small cap not so much).

This is partly the result of the prominence of financials and resource stocks (mining and oil & gas) in the FTSE 100, sectors that have been very weak. But these are also the sectors that should be beneficiaries of a faster-growing economy, and, in the case of financials, higher interest rates.

Moreover, valuations overall don't appear that stretched; our 30-stock UK equity model portfolio has a weighted average price/earnings ratio of 14.5 and yield of 4 per cent. It may not be that cheap but it is not that expensive either.

With the election out of the way, the main clouds on the horizon are the economic wellbeing of the eurozone, the uncertainty caused by the EU referendum, and the persistent trade deficit. There are of course still issues remaining around the size of the fiscal deficit and how the new government balances austerity with much-needed infrastructure investment.

But all in all, taking account of valuation, economic prospects and political stability, the UK market looks a decent bet at the moment. So coming back to the original question, we do think there is a good chance that the gilt market may see a decent sell-off. The interesting question then becomes the level at which it makes sense to buy back into them.

David Liddell is majority owner and chief executive of IpsoFacto investor, which is authorised and regulated by the Financial Conduct Authority. It is offering a free two-month trial of its investment advisory services:

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