PIMCO, one of the biggest fund managers in the world with more than $1.7 trillion assets under management in December 2017, have recently published their 2018 Asset Allocation Outlook¹ ² and believe that the US economy is now in the late business cycle (i.e. late in the expansion phase) (see the chart below showing how the business cycle works), which would create a few challenges for investors.
The economic risks that have been highlighted for investors to be aware of in 2018 are:
Monetary policy overkill
3. Decrease in negative correlation between stocks and bonds
Although PIMCO's outlook mainly focuses on the US market, these three risk factors can also apply to the UK.
What is monetary policy overkill? It means that the central bank might be tightening monetary policy by increasing interest rates too quickly and causing the economy to have a shock slowdown. The Bank of England (BoE) raised rates in November last year – the first time since the global financial crisis – meaning the hiking cycle has begun and rates might rise at a faster speed than most people think. The majority of the analysts in the market expect the next rate hike is likely to be in May or June this year, and another one or two by the end of 2019³. Any earlier and sharper interest rate increases from the BoE could do more harm than good to the economy.
On the other hand, although UK inflation went down slightly to 2.7% in February 2018 from 3% in the previous month⁴, it is still higher than the inflation target of 2%, whilst the real wage continues to shrink. It is definitely not good news for ordinary people who pile up cash from their wages, as their purchasing power is diminishing.
More importantly, the equity and bond markets in the developed world are experiencing higher volatility and becoming more correlated over the last couple of weeks due to inflation fear (i.e. stock and bond prices were moving up and down in the same direction). As demonstrated by the research from Calamos Investments (chart as shown below), an empirical study for the period from 1962 to 2018 in the US shows that the correlation of stock and bond prices is positive (prices moving in the same direction) when inflation becomes the concern for market participants, and vice versa when deflation begins to cause a panic⁵. Inflation has already picked up for more than a year in the UK³; therefore, it is more likely for us to see a positive correlation between stocks and bonds in the coming months.
The combination of all the above factors make it more difficult to use purely traditional asset classes (i.e. stocks and bonds) to build a diversified portfolio for investors.
What are the solutions? PIMCO has suggested three main areas that would potentially drive good returns this year:
2. Master Limited Partnerships (MLPs)
3. Private allocations (i.e. private lending sector)
The previous chart shows that commodities typically perform well in the late business cycle based on historical studies. However, the challenge for retail investors is to pick and choose the right vehicles, as many commodity funds use derivatives to mimic commodity price movements rather than holding physical commodities, and these derivatives over time increase risks and erode returns, which would cause significant underperformance relative to their own benchmarks.
MLPs is also a type of investment that is closely related to the energy sector, and although a bounce back in this year is expected due to a massive slump in the market last year, it is only available in the US and probably not as suitable for UK investors.
Lastly but certainly not least, PIMCO thinks that the private lending sector could provide some good opportunities this year, and this is an area that Basset & Gold specialises in. There are more opportunities coming up in the market, especially in the SME or marketplace lending space. The whole market now also has a higher profile as Funding Circle – one of the largest marketplace platforms in the UK – is preparing to go public later this year⁶. At the same time, the sector is getting more and more traction from renowned institutional players such as Goldman Sachs, JP Morgan and other commercial banks⁷. They are involved in various partnerships and deals with marketplace lenders in recent years.
All three types of investments require professional knowledge to make investment decisions. At Basset & Gold, we are specialised in the private lending sector and our products provide diversification of investments as well as asset-backed security, and no volatility as seen in the equity and bond markets.
Disclaimer: The information contained on this article is of a general nature and intended as a guide only. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial, legal or other issue. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult a financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs. Risk Warning: Capital invested in bonds is placed at risk and interest payments are not guaranteed. Investors should note that it could take the time it takes to liquidate an asset held as security in order to get money back at an acceptable price. There is no right to compensation in respect of poor investment performance. B&G Finance Limited is authorised and regulated by the Financial Conduct Authority.