A matter of TRUST

Most of us work hard at building up assets / wealth during our lifetime.

But how well do we protect them?

Generational wealth / assets / estate that get handed down attract attention, especially from the government/ tax authorities.

Inheritance tax is one such penalty/ charge placed on the ‘estate’ that we leave behind for posterity. Choosing to use a trust to pass on our assets can offer us significant peace of mind, protect our assets as well as reduce the Inheritance Tax bill. 

If we gave away/ gifted all of the estate in our lifetime there would be no residual estate, and hence no IHT liability on death.

However that may not be ideal as:

• We do not know how long we will live or how much estate we would need to get to the very end.

• We may still need to be use these assets and also may not have enough decided the beneficiaries upfront or who gets what.

• The receiving parties / family members may as they may not even be mature enough to look after sudden wealth and may end up squandering it. 

TRUSTS are a valuable tool in for protecting and passing wealth to future generations in a tax efficient way. Let’s take a closer look.   

A trust as an arrangement that allocates assets into an account for the benefit of another person at a future date. For instance, we may want to leave a property to our child. However, we want them to have it when they are old enough to fly the nest and live on their own.

How to make use of TRUSTS for Inheritance tax purposes

Simply put, a trust is a legal method of protecting and managing our assets for the beneficiaries. A trust avoids handing over valuable property, cash or investment while the beneficiaries are relatively young, immature or vulnerable.

The cash / investments / property / other assets put into trust, they no longer belong to us. They now belong to the trust and sit outside our estate and that when we die their value normally won’t be counted towards the Inheritance Tax bill.

There are lots of reasons why individuals do not want to pass on their wealth directly to their beneficiaries.

• Having a Trust bypasses the time-consuming process of probate and allows the assets to be managed without waiting for a Grant from the Courts.

• A Trust can protect our share of assets for the children in the event that our partner should marry or co-habit after we are gone.

• We can place our assets in a Trust to make sure the beneficiaries receive assets in way and at a time that’s right for us and for them. Or maybe we would like the gift to be enjoyed by a group of people, such as grandchildren, whenever born.

• We have complete control and can decide on the trustees and what they can and cannot do.  This may also be beneficial if we are unable to manage our financial and legal affairs due to incapacity.

• We may have concerns about irresponsible habits / behaviour patterns, level of maturity of adult children which makes them prone to poor decisions.

• Or, we may be concerned over our kids divorce and we want to protect our hard earned cash being counted as an asset.

Types of Trust

Different types of trust structures are available in the UK. A Trust allows us to retain various degrees of control over the amount and timing of extending the benefits; as well as help us extend/ restrict the list of beneficiaries.

Absolute Trust or Bare Trust

This is an arrangement whereby a settlor gives trustees cash or other assets to look after for a named beneficiary (or beneficiaries). The beneficiaries cannot be changed. Settlors must therefore be certain of who they wish to benefit from the outset. 

Absolute trusts are normally used for minor children due to the fact that on reaching age 18 (16 if written under Scot’s law) the beneficiary is entitled to the trust fund.

Gifts into absolute trusts are treated as potentially exempt transfers (PET). This does not result in an  immediate IHT charge, and will not be liable to IHT at all if the settlor (or donor) survives the gift by seven years. In case the settlor does die within seven years, the gift becomes a chargeable transfer which may result in an IHT liability.

Discretionary Trust

Under a Discretionary trust there are normally no named beneficiaries but instead a class of prospective beneficiaries. This class normally includes children, grandchildren and so on. Discretionary trusts offer flexibility for the trustees and can provide for several generations.

Interest in Possession Trusts

Also known as life interest trusts, these tools allow the income of the trust, after expenses, to be paid out to a nominated beneficiary or beneficiaries. They’re often used to provide for a spouse for the rest of their lifetime, with assets then passing to children after the spouse’s death.

Packaged Trust Solutions

Many trust solutions come as packaged solutions. These include gift trusts, loan trusts and discounted gift trusts which may use investment bonds as the underlying investment.

A Discounted Gift Trust is an estate planning vehicle designed for people who have excess capital that they are prepared to give away but would still like to take payments from their capital to supplement their income. The gift into trust will provide an immediate IHT saving if a discount is agreed. The whole value of the gift will be free from IHT if the settlor survives it by 7 years. Unless an absolute trust is being used, any gifts above their available nil rate result in an immediate charge to IHT.

In case of a Loan trust, the settlor lends money to the trust. The trustees then invest this money, typically into an investment bond, for the benefit of the trust beneficiaries.

The settlor can demand repayment of the outstanding loan at any time. If regular loan repayments are needed, the trustees can repay the loan by using the 5% tax deferred withdrawal facility from the bond. Any growth in the fund must be used for the benefit of the trust beneficiaries.

© Anu Maakan April 2024

Is DIVERSIFICATION the answer?

TESLA lost more than 10% of its stock price on 25^th January 2025, a day after it declared its quarterly results for Q4 2023. Poor financials driven by higher costs, competition and sluggish sales in international markets resulted in a thumbs down. 

This may have meant a 10% loss in portfolio value for someone who only held TESLA stock. For others, it could have been the loss of as little as a few hundred dollars depending on how much they had invested.

‘Do not put all your eggs in one basket’, as the cliched saying goes.

At best, diversification is a risk reduction mechanism. It allows us to spread our investments to minimize the impact of poor performance from one or more of the investments. 

On that theme, let’s say we invest into a family of hens and chickens to provide us with breakfast eggs. They do provide us the much needed, high quality breakfast……until one fine day when they catch a flu. If the flu virus then spread to the hen family, our investment would amount to 0. Might as well, have invested in a bank deposit alongside? Yes?

What kind of RISK? 

Risk can mean different things to different people. A drop of 2% value could be high risk for those with a low risk tolerance. Volatility can be extremely stressful to some investors, while others thrive on finding opportunities in volatile markets. 

Broadly, RISK refers to the possibility of losing money…….the risk of volatility and sudden losses; and the risk of compromising on returns or not being able to achieve our investment objectives.

A highly skewed, equity heavy portfolio may not give us the income we need and may lose value just at the wrong time. Similarly, a portfolio heavy on fixed income assets is prone to interest rate and inflation risks.

RISK is everywhere

Today, we are living with war, regional conflict, political instability, rising national debt and slowing economies, high inflation and several other risks. All of this impacts business, economies and performance of assets. 

RISK affects performance of different assets in different ways and understanding this is crucial to achieving a diversified portfolio.  

We could choose to spread our investments across stocks, bonds, bank deposits, real estate, commodities, cryptocurrency, art etc. Further, within asset classes we would need to look at diversification across large companies, small companies, geographic diversification, emerging markets etc. We could also diversify across different sectors/ industries, such as healthcare, technology, energy. 

ASSET ALLOCATION is imperative

With the help of a financial planner / adviser we could come up with an asset allocation based on our financial goals, risk tolerance, our current wealth/ savings, investment experience etc.

As the SEC explains, “Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.”

Each asset class comes with its peculiarities. For instance, commodities march to the beat of their own drum, which can help diversification. Supply movements can often be independent of the economic cycle. And while stocks and bonds may reward us with dividends or interest payouts, commodities do not offer this feature. Also, commodity ETFs may not come cheap, we may pay 0.8% a year in expense ratios for some of the more popular commodity ETFs.

How To Diversify Your Portfolio

While diversification can bring smoother returns, more predictability and reduced volatility in our portfolio it is important to remember that excessive diversification can be a losing game, it can mean lost returns/ potential for gain.

Yet, some risk may be necessary to meet our goals. For instance, if we are saving for retirement, it is likely that we will need to include some equity in the portfolio.

Determining our personal risk tolerance and investment goals is the first step. For example, we may be more inclined to invest in bonds or other fixed-income assets if we have a low-risk tolerance; if we have a higher risk tolerance, we may invest more in growth companies or early-stage start-ups.

Conclusion

Managing investments involves some science; we would benefit from using tools such as risk profiling, goal setting, diversification, asset allocation and periodic reviews with a financial planner.

As our portfolio grows and certain investments outperform others, it will be necessary to rebalance the portfolio to ensure that it does not become over or under exposed to the original plan. 

A properly diversified portfolio can help us reach our investment goals and give us peace of mind.

© Anu Maakan Feb 2024

Trends in global markets

We are witnessing extremely challenging times where cries of help, death and destruction are interspersed with financial troubles, inflation and yet progress, lives empowered by new technology, AI, new drugs and healthcare solutions.

The need for dominance (technological or otherwise), power play, regional conflicts and historical conflagrations are making for death, destruction, unstable geo politics, mistrust amongst trading partners, high inflation, energy shocks, human cost and displacement. Will this not impact your investments?

Here is a closer look at some key trends shaping our future.

Conflicts, Geopolitics and Volatility

‘This may be the most dangerous time the world has seen in decades and ongoing war in Ukraine and conflicts in the Middle East may have far reaching impacts on energy and food markets, global trade and geopolitical relationships’, said Jamie Dimon in a recent statement.

Central banks responded to the high inflation with the most aggressive global rate-hike cycle in decades; resulting in tighter credit, higher costs of doing business and forecasts of an impending recession.

Global debt has already hit a record $307 trillion in 2023. Experts predict more volatile business cycles, constraints on supply, shortfalls of demand and labour market shifts leading to economic fluctuations.

A bumpy economic landing seems inevitable as the economy sputters along; 6 out of 10 chief economists expect the global economy to weaken/ slowdown this year, as per the WEF.

As per this PIMCO report, ‘……..with the era of volatility-suppressing policies possibly over, markets are likely in for a period of heightened volatility, with an unusually large array of potential aftershocks.’

We would certainly do well to BUILD IN VOLATILITY into our investments decisions.

There are also reports of a drop in card spending in the US. Credit card spending was seen to be soft in September, across all sectors. ‘I think we are starting to see growing financial strain at the lower end of income levels’, said Citigroup economist Robert Sockin.

US – CHINA relations

The ever evolving US – China dynamic amidst the race for tech dominance continues to be at the cornerstone of geopolitics. This continues impacting the future of many corporations, such as NVIDIA due to the tighter restrictions on exports of hi tech items such as AI powered chips.

China is a larger story in itself. The slowdown and competition in China is beginning to impact the fortune of companies such as LVMH, Starbucks, Nike, Apple, Tesla, Rolex amongst others.

Barrons and The Wall Street Journal have reported these as impacted companies.

‘CASH is far from TRASH’

Last year was painful for fixed income investors in 2022 as they suffered losses on the back of rising interest rates. Higher interest rates have made holding cash more attractive, with many popular fixed-rate accounts paying over 5%.

Some banking stocks such as Bank of America and Goldman Sachs have benefitted from higher NII (net interest income) during this cycle of high interest rates.

Technology, Innovation, new DRUGS

In his recently published 7 page letter, “The Age of AI has Begun”, Bill Gates said that ‘The development of AI is as fundamental as the creation of the microprocessor, the personal computer, the Internet, and the mobile phone. It will change the way people work, learn, travel, get health care, and communicate with each other.’

Of particular interest are breakthroughs in AI, ML, Metaverse and VR (virtual reality), unlocking huge value across the business spectrum…. especially in healthcare, cybersecurity and semiconductors. There is a quiet convergence taking place – providing the grounds for a hyper connected, data driven world.

Recent drug discoveries and treatments in the areas of obesity, diabetes management, cervical cancer are heartening as they cater to huge markets.

Conclusion

‘Markets seem to be pricing the best of all worlds – inflation moderating, policy rates falling, and recessions evaded……. while attractive, the yield provided in ultra-short fixed income may be fickle, and kicking the can down the road on strategic allocations could prove costly for investors’, according to Goldman Sachs.

The key risk factors point to slower growth on the back of higher interest rates, ageing constraints for the workforce, geopolitical fragmentation of supply chains, technology led opportunities and disruptions. Mega forces are creating opportunities and risks across sectors and regions.

Yet, most agree that risks to growth are skewed to the downside and returns across asset classes are likely to be more differentiated.

© Anu Maakan October 2023

A closer look at Consumer Discretionary spend

Investing in Consumer discretionary stocks helps us profit from increases in our own non-essential spending as consumers.

Since consumer spending is something we possibly understand better than corporate spending, it makes this a very attractive sector to have a closer look at.

Demand for discretionary goods is cyclical and tends to rise and fall with the health of the economy. It is usually the first to suffer when we cut back spending on electronics, travel, durables etc. This makes these stocks more volatile compared to essential service providers.

Be it luxury, durable goods, home electronics, luxury, automotive, travel, leisure, entertainment – some of these companies command strong brand loyalty and premium pricing, with an ability to adopt dominant positions in their space.

Current economic scenario

The current economic landscape looks like this:

• Upward trends in wages and wage linked inflation in most of the US, Asia and parts of Europe.

• An environment of high interest rates and inflation leading to rising cost of products and services, thereby making a bigger dent in our savings.

(This is not ideal for the sector, as they make their money from consumer spending, and low interest rates usually stimulates spending. Between Dec ‘08 and December ‘15 — the Consumer Discretionary Select Sector SPDR Fund (XLY), rose more than 280% and outperformed the S&P 500 index, due to the near 0 interest rates).

• Most industry pundits are not predicting a recessionary environment, rather keeping a tight leash on super high growth via interest rate hikes.

Does this support growth of the consumer discretionary sector?

S&P500 Consumer Discretionary constituents and performance

The consumer Discretionary sector is approx. 10% weighting of the S&P500. It is the fourth largest segment after Information Technology, Healthcare and Financials.

Its performance has been leading the overall S&P500 performance and has provided 31% returns YTD, -37.58% in calendar year 2022, 24.2% in 2021, 32.07% in 2020, 26.2% in 2019 respectively.

Due to economic concerns linked to rampant inflation, lower purchasing power, and higher interest rates, the consumer discretionary sector displayed weak performance in 2022, as investors avoided cyclical sectors. However, the outlook improved in 2023.

Key Risks

• Consumer discretionary stocks can be significantly affected by the performance of the overall economy, interest rates, competition.

• This sector is also exposed to changes in consumer demand, consumer confidence and spending, changes in demographics and buying patterns.

• Rising input costs, including higher wages, can cut into margins or force companies to raise prices, which could reduce sales.

• Retailers and manufacturers of consumer discretionary goods are susceptible to supply chain disruptions, especially those with sprawling networks of suppliers.

Key factors to consider

Inflation has been high for a few quarters now and there is no sign of interest rate cuts just yet. This is not an ideal environment for the sector and some stocks have lost value together with the overall market.

Top holdings within S&P500 Consumer Discretionary by index weight are: Amazon, TESLA, Home Depot, McDonald’s, Lowe’s, NIKE, Booking Holdings, Starbucks, TJX Cos Inc, O’Reilly Automotive.

BofA Securities has recently upgraded consumer discretionary stocks from “underweight,” to “overweight”. Some of this optimism is based on expectations of a soft landing for the U.S. economy, improved revenue and earnings beats (relative to consensus analyst expectations) than the staples sector and credit/ debit card data showing that demand for goods is recovering, particularly for big-ticket items like homes and cars.

Some companies in the sector have shown strong growth and growth of new segments.

For instance, Lululemon Athletica, McDonalds and LVMH reported strong Q2 2023 results.

The sports apparel company had total revenues of $2.2 billion, up 18%, surpassing Wall Street estimates. McDonald’s reported second-quarter net income of $2.31 billion, up from $1.19 billion, an year earlier. Others such as Home Depot did not impress wall street and provided a negative guidance for 2023-24.

Until the economy shows strong growth and inflation starts to taper, stocks in the sector will carry some risk. The key will be to perform stock level analysis and pick stocks with a strong value proposition and growth, strong guidance and with reasonable current valuations.

Therefore, stock level analysis and risk assessment will be critical before making a purchase decision.  

The most popular ways to invest in the consumer discretionary sector are individual stocks, ETFs or Mutual funds.

© Anu Maakan September 2023

Investing in Aa+

The decision by Fitch to lower the US sovereign credit rating from AAA to AA+ came on August 1st, 2023.

The AA+ rating is one level below AAA, meaning that the US no longer has the highest credit quality. This is a response to the expected ‘fiscal deterioration over the next three years and repeated down-the-wire debt ceiling negotiations that threaten the government’s ability to pay its bills’, as per Reuters.

‘This basically tells you the U.S. government’s spending is a problem,’ said Steven Ricchiuto, U.S. chief economist at Mizuho Securities USA.

The US government debt now stands at over $31 trillion and is likely to reach 118% of gross domestic product by 2025.

The sovereign state is a profligate borrower and spends way above its means. To top it, the government bickers and regularly lands in stand offs. This has eroded public confidence in government fiscal management.

Is the downgrade simply a commentary on the viability of US debt? Or does it have wider ramifications? What does it mean for the investors in US assets? What does it mean for the future of the US dollar and that of Corporate America more broadly?

Investing in Corporate America

Corporate America is big, bold, innovative and largely profitable. It is defined by trillion dollar market cap, high end technology and turbo charged brands that are recognized globally. Yet can corporate America and its shareholders avoid being hit by the complications and cross-winds in the economy?

Stock Markets were hit after the Fitch downgrade. The Nasdaq Composite suffered its worst day since February, shedding 2.17%. The S&P 500 surrendered 1.38%, and the Dow Jones Industrial average slid 0.98%. Thereafter, news of a China slowdown and Moody’s downgrade of 10 banks has resulted in further fall in US indices.

Corporate America is under pressure, from its debt stockpile, from the slowdown in China, high interest rates, inflation, Moody’s downgrade of 10 US banks.

Can the superstar prodigy, i.e. Corporate America prosper in a dysfunctional family?

Here is what can go wrong:

Reduced off-take in US government debt and rising interest cost

The downgrade by Fitch could limit the number of investors able to buy U.S. government debt, especially those who are constrained by ratings.

Some investors who are required to put money only in AAA-rated securities may need to look elsewhere — though the number of other countries that still have the top rating is dwindling — potentially nudging up interest rates’, says the New York Times in this article.

What is likely to emerge is that rates will go up across the board on all sorts of debt to compensate for the added layer of risk. ‘The knock-on effects is that there will be higher mortgage and credit card rates,’ said Jon Maier, chief investment officer at Global X ETFs.

On the flip side, consumers could earn a more robust interest rate on fixed income products, resulting in a more balanced portfolio between stocks and bonds, if so desired.

Further fiscal deterioration and USD weakness

There is big possibility that the fiscal mismanagement will continue. ‘Fitch is not confident in policy measures being agreed and implemented to address the fiscal deterioration’, said Richard Francis, Fitch co-head of Americas sovereign ratings, in a Bloomberg TV interview.

‘The creditworthiness of U.S. treasury securities has long bolstered demand for U.S. dollars, contributing to their value and status as the world’s reserve currency. Any hit to confidence in the U.S. economy, whether from default or the uncertainty surrounding it, could cause investors to sell U.S. treasury bonds and potentially weaken the dollar’, says this article.

A depreciation in the US dollar may reduce demand for US assets and contribute to higher import costs, adding further inflationary pressures.

Over the longer term, investors may not find USD assets lucrative enough and may seek better returns elsewhere. This may further weaken the economy. 

Loss of confidence and a slowing economy

A downgrade could signal concerns about the country’s economic growth prospects, potentially impacting consumer and business confidence, foreign investment and economic activity. The US government may need to implement stricter fiscal policies, such as reducing public spending or raising taxes, in order to address the concerns raised by the downgrade and demonstrate their commitment to fiscal responsibility.

Further, due to the emerging dollar weakness, gold and other dollar denominated assets may start to lose value too. Events of such nature are also likely to induce further volatility in the US stock and debt markets.

To my mind, the potential economic slowdown, rising interest costs, further borrowings by the US government, volatility and weakness in the dollar will lead to a weakening value proposition for US Equity investors and future investments call for caution and selectivity.

© Anu Maakan August 2023

The WHY and HOW of investing in commodities

The commodity trading industry set an all-time record in 2022 for gross margin, surpassing $100 billion, as per a report from Oliver Wyman. Key commodities driving the rise in trade were oil and natural gas. Metals trading was active in 2022, but overall flows weren’t as disrupted by the energy crisis. Some agricultural products also saw strong global demand.

As per McKinsey, commodity trading value pools have grown substantially, almost doubling from $27 billion in 2018 to an estimated $52 billion of EBIT in 2021 (Exhibit 1). The majority of this growth was fuelled by EBIT from oil trading, which were estimated to have increased by more than 90 percent to $18 billion during this period.

Why Commodities?

We interact with several kinds of different commodities every day, directly in the form of food / farm products or in the form of inputs into end products. Main categories of commodities include:

Energy – crude oil, natural gas, refined products.

Precious Metals – Gold, silver, platinum and palladium

Agriculture – Grains, Soft commodities (such as sugar, cocoa), Livestock

Industrial Metals – Copper, Aluminium, Zinc and Tin

Commodities are ‘real assets’ that benefit from rising inflation. As demand increases, the price of these goods and the commodities used to produce those goods and services also increases; thus providing the portfolio with a hedge against inflation.

As per PIMCO, ‘Commodities are a distinct asset class with returns that are largely independent of stock and bond returns. Therefore, adding broad commodity exposure can help diversify a portfolio of stocks and bonds, potentially lowering the risk of an overall portfolio and boosting returns.’

Commodity prices are driven by the forces of supply and demand, and their prices are determined by a variety of factors such as competition, political and policy changes, macroeconomics.  

As per a World Bank report, ‘Global commodity prices fell 14 percent in the first quarter of 2023 and by end-March they were roughly 30 percent lower than their historic peak in June 2022.  The decline in prices reflects a combination of slowing economic activity, favourable winter weather, and a global reallocation of commodity trade flows. Commodity prices are expected to fall by 21 percent this year and remain mostly stable in 2024.

The EIU too expects most commodity prices, especially softs, to recede in 2023 in the face of slowing demand globally.

Pros of Investing in Commodities

• Commodities have low correlation to stocks and bonds illustrates what may be the most significant benefit of broad exposure to commodities: diversification. 
• As discussed previously, commodities are a hedge against inflation 
• Commodities give us exposure to underlying inputs rather than final product.

Cons/ Caveats of Investing in Commodities

• Commodity prices are easily influenced by events around the world; Example – oil price crash at the start of the pandemic and the ongoing hike in food prices after the Ukraine war.
• Commodities may not perform well during cyclical downturns in the local or global economy, when consumer and industrial demand slows. Treasury Secretary Janet Yellen recently told Bloomberg that China’s slowdown could have a “negative” impact for other economies, including the United States.
• More severe trade flow disruption scenarios could occur, including the potential formation of trade blocs, with the impact felt differently by each commodity class.
• Commodity trading can be complex and requires good SME knowledge of the underlying products, trading opportunities and emerging trends.
• The volatility of spiking commodity price levels has significantly tightened collateral requirements and increased the size and frequency of margin calls. This may continue to be the case.

How to invest in Commodities

Individual securities –  we can get indirect exposure to the commodity market by buying and selling the shares of companies that are involved in the mining, extraction, growth or harvesting of any type of commodity.

Physical ownership – This is the most basic way to invest in commodities. But unless these are small, transportable assets like precious metals, it can be impractical.

Futures and Options contracts – These contracts are available on every commodity you can think of, and they’re traded widely across the world. The vast majority of commodity based financial instruments are traded by professional investors and fund managers.

Mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs) – these provide exposure to a range of commodities or commodity-linked stocks from a single position. Some ETFs hold physical assets while others synthetically mimic the underlying market. Commodity index funds can provide exposure to a cross-section of commodities.

Hedge funds or private investments specializing in commodities are also an option, albeit these are more complex and carry a high degree of risk and volatility.

Trends to consider

The post-global financial crisis era of loose monetary policy and low and steady inflation has since come to an end. Most pundits predict a more persistent inflation in future. This bodes well for opportunities in commodity trading in general, though specific opportunities will need to be scouted.

Some factors to keep in mind as we try to make commodity picks:

• The effects of climate change and adverse weather events
• Trends in oil consumption and alternate energy sources
• ‘Possible disruptions in the supply of energy and metals (in part due to trade restrictions), intensifying geopolitical tensions’, as per the world bank.
• War in Ukraine may still affect agricultural commodities markets in 2023.

As per McKinsey, ‘Commodity trading is on the cusp of the next normal. The energy transition will cut across and integrate the various global food, energy, and materials systems. This transformation is likely to increase structural volatility, open new arbitrage opportunities, redefine what it means to be a commodity, and fundamentally alter commercial relationships. All these developments will create unique opportunities and challenges.’

© Anu Maakan July 2023

Fixed Income investments in times of high inflation

Global inflation levels as per The New York Times

Inflation is an economic term.

An economic term that has made its itself felt in everyday life; in every purchase decision. Be it basic goods & services, travel, fuel, recreation etc, households are facing the stress from lost purchasing power, depleted savings / investments and higher mortgage payments.  

The end of the pandemic released large pent-up demand into the market and a resultant spending spree. Most companies couldn’t keep up with the increased consumer demand, and prices started to rise. 

The global economy expanded strongly in 2021 and 2022, although China and the US fell short. Slowly, the expansion lost some of the momentum, with Ukraine war headwinds, supply constraints, energy constraints, Omicron.

To try to get inflation under control, central bankers have rapidly lifted interest rates, trying to slow their economies in hopes of cooling prices.

Officials at the U.S. Federal Reserve have raised their policy rate to just above 5 percent from near zero in March 2022, and they forecast raising it above 5.5 percent. Policymakers at the European Central Bank, also expect to continue raising rates.

Our inflationary future

Economists and industry pundits do not foretell an easing out of this quagmire of high inflation and consequent monetary tightening and high interest rates.  Global inflation remains persistently high, having crossed the 20% mark in Hungary and 110%+ in Argentina. Something has fundamentally shifted.

The Bank of International Settlements (BIS), has warned of the risk of lasting high inflation globally. ‘Interest rates will need to remain high until 2027, while many governments will have to reduce spending and increase taxes to cool price growth’, said the organisation.

Gita Gopinath first Deputy MD of the IMF said that central banks must remain diligent about bringing down inflation rates “even if that means risking weaker growth.”

So what does this mean for investing in fixed income products?

Fixed Income investments in times of high inflation

Inflation is usually negative for bonds as the real value of their fixed payments is eroded, while rising interest rates may also negatively affect the value of conventional fixed income assets.

The global bond market suffered unprecedented losses in the last couple of years as fixed income investments were volatile and investors lost money. Concerns over persistently high inflation and a tightening in monetary policy triggered a sharp sell-off in the bond market. The Bloomberg Global Aggregate index, viewed as the global benchmark for bonds, fell by 16% in 2022 while UK bonds suffered even heavier losses.

A slowing in interest rate hikes could provide a welcome tailwind for bond markets, while expectations of a recession may enhance the safety appeal of bonds.

After the big re-set in 2022, government bond yields are offering reasonable reward for interest rate risk; spreads available in parts of the corporate, financial and emerging debt markets are attractive. Government bonds yields are at or near the highest levels since before the financial crisis.

With high levels of inflation and central banks moving to tighter monetary policies, fixed income assets yields are picking up. In this environment, investors should consider expanding their asset allocation to help capture additional yield.

As market participants and central banks remain focused on inflation, there are bound to be more market interventions / rate hikes followed by rate cuts possibly in early 2024. As expectations of rate cuts and actual rate cuts shape up, prices of fixed income products may start to rise.

Fixed Income Investment Options

Investors looking to get exposure to fixed income products from various products such as Fixed term Deposits, ETFs (tracking a range of bond indices, country specific / global corporate and government bonds) and Gilts amongst others.

However, there are a number of strategies that can be used to help mitigate the negative impact of rising inflation or higher interest rates. Longer-dated fixed income assets are most susceptible to rising interest rates, so strategies that focus on higher quality, floating rate or shorter-dated bonds may offer greater resilience in a rising rate environment.

Fixed term Deposits

Banks, building societies and other financial institutions have been offering higher rates on deposits in line with the enhanced interest rates in the market. Some of these institutions are offering rates in excess of 4% AER. However, these remain below inflation rates as it stands in the UK.

UK Gilts

Gilts are gaining in popularity as they provide higher yields as compared to savings products. The two-year gilt yield is now at a 15-year high of around 4.9% and that makes it the highest yielding two-year bond in the G7. Investors are also pricing in additional hikes by year end, which could see gilt yields rise further.

The 10 year gilt is at 4.587% as in the graph below.

According to this Bloomberg article, wealthy UK investors are buying up gilts at a frenetic pace to take advantage of tax perks (capital gains are tax free) and rising yields.

Government Bond Funds/ ETFs

These funds invest in government bonds/ T-bills and may be actively or passively managed. They may also be tracking the performance of a particular bond index and may be specific to a country or region.

High Yield Floating Rate Funds/ ETFs

These funds / ETFs invests primarily in high yield floating rate instruments, a subset of the broader high yield bond universe. These bonds can provide protection against inflation due to their higher levels of income, while also effectively removing interest rate risk thanks to their floating rate coupons. Floating rate notes are also an attractive subset of these.

High Yield Income / FRN (floating rate notes) funds/ ETFs

High Yield FRNs are issued by non-investment grade companies (below BBB-) and, as such, can pay significantly higher coupons than investment grade credit. An investment manager will invest in these instruments if they believe their expected total returns will more than compensate for any of their potential additional risks.

Inflation linked, corporate bond funds

These funds combine inflation-linked protection with the attractive yields that can be found on high-quality corporate bonds. They may also offers a short duration profile, meaning a low sensitivity to interest rate changes.

Short duration bonds/  funds

Traditionally, savers tended to look at two areas for low risk sources of income: interest rates on cash deposits in the bank, or bonds issued by the most credit-worthy governments. Today, neither provides much in terms of income.  Short duration strategies are an attractive alternative, as they offer a potential route to cash-plus returns for a limited increase risk. 

A note of caution

While the income level on bond funds is higher than it was a year ago thanks to rising interest rates, some managers may be boosting yields even more by adding riskier bonds into their portfolios. These bonds could be backed by commercial or residential mortgages, auto loans or even credit card debt. It is important to look into the portfolio composition to check for the nature of investments and ascertain risk levels.

Recently, in the US better than expected jobs report has increased the odds that the Federal Reserve’s benchmark fed funds rate may be raised to 5.50%-5.75% by the end of its September meeting. In the Eurozone, workers, who have borne the brunt of high inflation are expected to recoup some of their lost purchasing power by getting wage raises this year. This may force Eurozone policymakers to take harsher action to slow the economy.

Since fixed income bonds / funds tend to be worth more when interest rates and inflation are low or expected to fall, it would be prudent to factor in the oncoming rate hikes into our investment decisions and wait until the rate hikes are near completion.  

© Anu Maakan July 2023

The weakening case for equities amidst bank failures

HSBC is buying out the UK subsidiary of S.V.B. (Silicon Valley Bank) for £1. Yes!

Something must have gone seriously wrong? Yes!

Explained simplistically, S.V.B. invested large sums into long-dated securities. With the Fed’s drive to increase interest rates, its investments began to lose value and investors started to pull out funds. It was also functioning without a head of risk for several months.

Federal regulators have announced that all customers of both SVB and Signature Bank would have access to their money. The immediate turmoil in the US banking sector seems to have been arrested.

This episode raised additional questions for the sector. Are there other banks vulnerable to interest-rate risk? Will the acquiring institutions be as friendly to start-ups as S.V.B.? Who will start-up founders trust with their money….. and will they continue to be funded as before?

Let us not forget the underlying issues forces that led us here:

• The Fed’s unrelenting focus on bringing down inflation via increasing interest rates (and hence the reduced valuation of bank stocks).
• Poor risk management practices at some banks.
• Reduced regulatory scrutiny on banks, following on from Trump’s populist era.

Jim Reid and a team of strategists at Deutsche Bank explained, ‘SVB’s woes are a combination of one of the largest hiking cycles in history, one of the most inverted curves in history, one of the biggest bubbles in tech in history bursting, and the runaway growth of private capital. ………. it’s just more of the boom-bust cycle we’re stuck in.’

In the aftermath of the 2008 financial crisis, Congress passed the Dodd-Frank Act to protect consumers. Wall Street chief executives, their lawyers and lobbyists spent millions trying to defeat it. Greg Becker, the chief executive of S.V.B. was one of them.

Biden has started to talk about bringing back more banking regulation!! When will those kick in? What will they entail?

Bank runs are considered quite dangerous because they may induce panic and concern amongst customers about their own deposits. In an interview on Sunday, former FDIC chairman William Issac said ‘there’s no doubt in my mind: There’s going to be more. How many more? I don’t know.’

There are big clues that there’s more pain to come, look to the market. There is potential for a cascade of bank failures, reflected in their shares prices on Monday.

First Republic, PacWest, Western Alliance, and Charles Schwab are among the major names that sank on Monday as investors grew anxious about banks’ ties to the tech industry and their massive unrealized losses. According to the FDIC, at the end of 2022 US banks were sitting on $620 billion in unrealized losses on their bond assets. 

Moody’s Investors Service has downgraded the ratings of the collapsed Signature Bank to junk. It has also put the following six banks under review – First Republic Bank, Zions Bancorp., Western Alliance Bancorp, Comerica Inc, UMB Financial Corp and Intrust Financial Corp.

A volatile future!

Does the global economy remain a fundamentally sound place? Will there be more surprises in the stock markets?

Equity investing seems to have gotten more complicated and vol. Some factors to consider:

• What about escalations in the Russia-Ukraine war and its impact on supply chains and cost structures across the world?

• Will the inflationary risk and interest rate risk spill over to other sectors?

• Could there be an impending funding crisis for technology companies/ start ups?

• What about the impending recession, cost increases and unemployment resulting from central bank policy?

• Could political tensions mount, especially that of US-China and in South Asia under China’s growing need to show dominance?

There seems to be a more stock market volatility coming our way and certainly not the tail end of bad news.

© Anu Maakan March 2023

Results speak!

Some of us have bid farewell to that exotic holiday, the new vehicle, yet others have cut down on shopping/ grocery trips, deferred a gadget purchase to that Christmas sale – all in the midst of an inflationary onslaught. While not all consumers are not behaving in the same way, and sufficient numbers are earning big dollars, yet some belt tightening is evident.

Pullback in consumer spending, higher costs, political bickering and conflict / wars are impacting corporate results. Margins are under pressure as companies face higher costs, lower margins and overall higher inflation.

Wage bills, energy and raw material costs together with overall supply chain constraints is not painting a pretty picture either. While some businesses are trying to cover rising labour costs and higher input prices, others are increasing prices to swell their profits.

Slowdown in corporate revenues / profitability and lower guidance is manifesting in layoffs, spending cuts and impending consolidation. As per Layoffs.fyi, major tech companies have announced about 100,000 layoffs this year.

Suspicions of an extended slowdown are being confirmed by industry experts. Goldman Sachs group has lowered earnings estimates for the S&P500 index for each year until 2024, saying margins contraction in the third-quarter signals more pain ahead. Inflationary years with high interest rates are lie ahead.

What Tech Corporate Results are telling us

Tech companies, which led the U.S. economy and stock market upwards, have declared poor Q3 2022 results, confirming the impact of global economic jitters, soaring inflation and rising interest rates.

Social media companies too have seen a pullback in digital advertising, smartphone and computer sales and cloud computing are showing signs of slowdown. Some shoppers have enhanced spending on travel, concerts and sports, rebuilding on experiences.

Here are key highlights from some tech company results for Q3 2022. Amazon sawnet sales increase 15% to $127.1 billion in the third quarter, compared to $110.8 billion in Q3 2021; yet this fell short of wall street expectations. Net income decreased to $2.9 billion, Operating cash flow decreased 27% to $39.7 billion, compared to $54.7 billion for the trailing twelve months ended September 30, 2021.

AWS declared revenues of $20.5 billion vs. $21.1 billion expected, accounting for all of the company’s profit, with an operating income of $5.4 billion; yet this was its slowest growth since 2014. AWS saw 200 points of margin compression. Data centers and hardware are driving up the company’s costs. Amazon expects fourth-quarter revenue between $140 billion and $148 billion, as against street expectations of over $155.15 billion.

Microsoft shares have fallen over 20% so far this year, while the S&P 500 stock index is down 19% over the same period.

It declared revenues of $50.1b, an increase of 11%, with an operating income of $21.5 billion (up 6%). Net income at $17.6 billion and was down 14%.

It also gave a guidance $52.35 billion to $53.35 billion in revenue for the fiscal second quarter, which implies 2% growth at the middle of the range (as against street expectations of revenues of $56+ billion). 

Similarly, Apple has shown revenue growth of only 2% year-on-year, closing at $83billion. iPhone sales were at $40.67 billion vs. $38.33 billion estimated and service revenue at $19.60 billion (up 12%). This sudden slowdown in tech earnings is exposing a weakness. They haven’t really found a new, very profitable idea in years. The iPhone, 15 years after it upended the industry, still drives Apple’s profits.

The computer market is fast deteriorating. “There were so many PCs purchased in the last two years that there’s no demand,” said Mikako Kitagawa, a technology analyst with Gartner, a market research firm. “Plus, hiring is frozen, so businesses don’t need new PCs.”

Industry researcher Gartner said earlier this month that PC shipments in the quarter fell 19.5% year over year, and chipmaker AMD issued lower-than-expected preliminary quarterly results tied to a weaker than expected PC market and significant inventory corrective action across the PC supply chain.

GOOGLE reported revenues of $69 billion for the quarter, up six percent versus last year.  Operating and Net income were down by around $4 billion and $5 billion, respectively. The company saw search ads rise only 4% in the third quarter, and YouTube and third-party ad networks each fell 2%. 

Google Cloud reports revenue of $6.86 billion, up from $4.99 billion in 2021. Its losses widened slightly, from $644 million to $699 million.

Sundar Pichai, CEO of Alphabet and Google, said: “We’re sharpening our focus on a clear set of product and business priorities. Product announcements we’ve made in just the past month alone have shown that very clearly, including significant improvements to both Search and Cloud, powered by AI, and new ways to monetize YouTube Shorts. We are focused on both investing responsibly for the long term and being responsive to the economic environment.”

Despite years of investment in new businesses, Google and Meta still rely mostly on ad sales, leaving them vulnerable to the disruptive upstarts that they once were. YouTube, which is owned by Google, and Meta’s Facebook and Instagram social media platforms are being challenged by the much younger TikTok.

A few days later, the chip maker Intel announced a $10 billion cost-cutting program and lowered its profit forecast for the year. “It’s just hard to see any points of good news on the horizon,” its chief executive, Patrick Gelsinger, told investors.

Demand could begin to wane for more products and services as families spend down their pandemic savings and struggle to keep up with climbing costs, especially if the job market begins to slow.

With massive layoffs being announced by tech companies, costs will come down and the market may begin to appreciate the belt tightening, as it has done after the announcement of 10,000+ layoffs by META. Improved CPI data has also cheered markets in the last few days.

Yet, the era of explosive growth and low inflation are over. Market pundits have announced the onset of an inflationary decade.

© Anu Maakan 2022

The timeless lure of IPOs

Saudi Aramco holds the record for largest IPO (Initial Public Offering) of all time. It raised $29.4b on 11^th December 2019. It is closely followed by Alibaba at $25b.

Biggest IPO of all time (Source: Statista)

IPOs are leading to enormous wealth creation, globally. It is no longer a phenomenon of the developed world. Nasdaq and Shanghai stock Exchange led the number of issues in 2020, with 272 and 220 each.

‘2020 has seen the highest IPO capital raising activity in a decade, with USD 331 billion raised across 1,591 listings – a 42% increase compared to 2019’, says Baker McKenzie.

Snowflake raised $3.36b in 2020, Zoom raised $1.5b and Kuaishou Technology, a short video platform sold 365.2 million shares at the Hong Kong stock exchange, raising $5.4 billion, amongst hundreds of others.

The Financial sector led with 360 issues and $108b in capital raised. They were followed by Technology, Industrials, Healthcare and Consumer Products. The Asia Pacific region saw immense growth, with 167 listings, up from 123 in 2019. Mainland China was the top issuing jurisdiction by volume, in 2020.

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  Global IPO 2019 v. 2020 (Source: Baker McKenzie)

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  Top Issuing Nations (Source: Baker Mckenzie)

The hunt for yield

Be it our search for new frontiers or higher yield, there is a certain timeless appeal to it all. IPOs occupy pride of place in this arena. Not only do they offer an opportunity for superior returns (alongside the risks), they also bring the excitement and sheen of the new and unknown. Companies go through a fair bit of scrutiny when they file for IPO, especially on the prestigious stock exchanges. They need to publicly disclose financials, accounting information, tax and profits amongst other details. IPOs also carry significant costs and hence only serious candidates would take this route.

$10,000 invested in Snowflake Inc. on 16^th September 2020 would be worth 2.5 times today, similarly, $10,000 invested in 10X Genomics on 12^th September 2019 would be worth $46,625.64 today, i.e. 4.6 times the original value (as of 4^th Feb 2021). Yes, there are numerous stories of loss and disappointment too. Lyft and Super League Gaming to name a few. $10,000 invested in Lyft would be worth $7190.28 today.

IPOs are a definite opportunity to uncover value from a newly listed corporation. Unlike listed companies where information sharing and regular trading has allowed for price discovery, IPOs belong to younger and/ or new to market companies which provides much higher scope for discovery of value.

No 2 investments are equal, neither are any 2 IPOs, neither are the risks & returns.  We need to be able to evaluate a good offer from a not so good offer and monitor them on an ongoing basis.

A successful IPO helps companies raise their public profile, gain exposure and access capital directly from investors. It is also an opportunity for initial founders and investor groups to cash out. Increasingly, companies are taking the route of Direct listing as well. Direct listings allow its existing shareholders and employees sell shares to new investors, instead of issuing new stock. Spotify, Palantir and Asana have all taken this route.

What to look for in an IPO?

Before we plough in our monies into IPOs, there are a number of criteria to consider. Amongst them:

• Who are the promoters of the company, what is their experience in the business and depth in management?
• Does the business have a solid foundation and a sustainable future? Are they able to leverage technology? Are they already making money?
• What’re their business prospects and financial projections? Have they broken even?
• Who are their customers, do they provide repeat business?
• Do they face any unique risks and threats, such as disruption from new technology?
• What is the valuation of the company compared to its peers? Is there room for price appreciation?

We should be able to find detailed information in the listing documents with the exchange, called the S-1 form in the US, an ‘intention to float’ or ‘AIM Schedule 1’ in the UK. Companies must also produce a Prospectus or Factsheet prior to listing. Detailed review of the finances, business plan, risks & liabilities will give us a good sense of the investment opportunity at hand.  

How to invest?

Most retail investors are able to invest in IPOs post their listing on a stock exchange. Management, employees, friends and families of the company going public may be offered the chance to buy shares at the IPO price in addition to investment banks, hedge funds and institutions.

Large account holders with the broker taking the company public, may have the rare chance at the IPO prior to listing.

Flavours for 2021

As economic recovery catches on and vaccine cover expands, companies from multiple sectors are preparing to access the capital markets with healthier financials. Technology, Lifesciences and Innovative tech such as Healthtech, Edutech, Fintech and Biotech are expected to dominate the VC and IPO markets.

Apart from the conventional IPO and direct listings, the recent popularity of SPACs (Special Purpose Acquisition Companies) is likely to continue well into 2021. ‘The strongest trend that I see is the proliferation of SPACs sponsored by reputable asset managers, family offices or known industry players’, says Steven Canner, partner Baker McKenzie.

Amongst the hundreds of planned issuances for 2021, the most prominent ones include Coinbase, UIPath and TikTok. Coinbase operates the largest cryptocurrency exchange and boasts more than 35 million investors across more than 100 countries, driven by the growth in popularity of cryptocurrencies. This business is likely to see ongoing growth with crypto-trading and digital asset issuances increasing in times to come.

UIPath provides a platform for robotic process automation (RPA), i.e. it enables automation of repeatable business tasks and processes. It is now a $10.2 billion company, with $255 million of funding from top-tier investors. Revenues are said to be on track to exceed $400 million in 2020.

Potential Downside of IPOs

There are numerous success stories of early investors in large issues such as Amazon, Netflix, Alibaba. The real winners have been long term investors, who have kept a close watch on developments.

There are also stories of investors doubling money in less than a year, but this is high risk terrain. There is need for caution when pursuing short-term opportunism. Many IPOs have seen flattening or drop in prices after a period of sharp rise, as value is unlocked and no immediate upside is visible. Take Snowflake, Square or Alibaba, all of them have seen a correction or flattening after a period of sharp growth. We need to be able to weather these downs as much as the all-time highs. Trouble begins when we start believing that the IPO graph only goes upwards and that returns continue at the same pace year-on-year.

Ongoing gains will only come from ongoing business and financial performance. IPOs like most other investments need to be monitored and their place in your portfolio will need to be re-evaluated based on your investment objectives, risk profile and investible surplus.

© Anu Maakan February 2021

https://anumaakan.wordpress.com/

(Disclosure: This article is for informational purposes only and is not investment advice of any investment strategy)