7 Minutes on Markets - Q4 2023 Market Update

Wen: Welcome to 7 Minutes on Markets. I’m Wen, a Junior ESG investment analyst at 7IM, and today I'm here with Ahmer Tirmizi, our Head of Fixed Income Strategy.

Ahmer: Hi everyone.

Wen: So, we've come to an end of the third quarter and a lot has happened this quarter that I would love to unpack here with you. A couple of months ago, we saw huge hype around AI, which drove the performance of global equities, in particular S&P 500 and what we call the Magnificent Seven stocks.

But then that cooled down in August and September, stock markets were under pressure as rising bond yields start to worry investors once more.

The 10-year U.S. Treasury yields hit 16-year high, which was driven by fears of higher-for-longer interest rates. This is also fuelled the recent bond sell-off. Ahmer, could you firstly explain why interest rates are high right now and what's causing the recent rise in bond yields?

Ahmer: Sure Wen. So you kind of said it yourself when you touched upon it there, you know, you've had central banks trying to cool inflation down. Inflation has been very strong for the last couple of years now, central banks have had to react by raising interest rates in order to slow down demand.

And you know that these things don't happen in a linear fashion. They don't happen one for one, but the markets have decided to price in that the central banks are going to hold these interest rates for longer. They were expecting them to cut rates sometime this year or early next year, but actually they've decided that they're going to hold that hold, that cutting process for a little while longer.

Wen: Thank you. And given current interest rates are high, we've seen an increase in cash rates as well, 5% and above in fact, which we have to say are pretty attractive. Why invest in markets when cash rates are so high?

Ahmer: Absolutely, It's a great question and you know, it's interesting we, we would definitely agree with that, at that rate, Cash rates are attractive or at least the level of level of cash rates are attractive. Now, if interest rates are attractive, I think it stands to reason that right, why would you lock it in for just a year? Because that's what you would have to do with cash. You'd lock it in for a year and then a year later you'd have make a decision. Why not lock it in for longer? You can lock it in for five years, six years, 10 years, even longer If you really wanted to, and that's what the bond market offers. And if you look at, if you look to lend to, let's say, a U.S. government or the UK Government, amongst the safest borrowers out there, you can lock in the same interest rates, inflation beating interest rates, for a much longer period of time. And that's why we would say, rather than hold cash, investing is a better way to you get exposure to those interest rate, higher interest rates I should say.

Wen: Thanks Ahmer. And you know, at 7IM, we believe that over the next 12 months, a period of sluggish growth is most likely or another way we've been describing it is sideways with volatility. So some people may ask,

why should we then hold any equities?

Ahmer: You know, it's a great question. Now we've established that when it comes to investing in a low risk profile, it is crucial for investors to get exposure to some bonds because you can lock in today's high interest rates for a longer period of time. But that isn't enough if you want to hit your savings goal. If you want to hit your inflation-beating savings goals, you need to hold equities alongside those bonds. Now one of the things that tends to be one of the things that that tends to be a hurdle for our clients to get over is that they're worried about how volatile equities are. You know, when they look at the news and they see the headlines, they can be, it can feel quite scary. But often what you find is that that short term, that volatility tends to be in the short term. But actually what happens is that equities gravitate towards long-term fundamentals and those long-term fundamentals are essentially economic growth. They're profits, and companies are there simply to make profits. And what they tend to do is they make profits and they pay them back to investors, usually in the form of dividends. And you can see this in some an example like the FTSE 100 where, over the last 15 years or so the price return, the return waiting for the price to move up really hasn't delivered very much, about 0 or a little less than 1% a year. However, if you throw on the dividend on top, which is essentially paying back those profits, those returns end up being something like 5% a year, a return that has been meaningfully above cash, meaningfully above inflation over that time frame. So you need to hold equities alongside those bonds.

Yeah, that's also a great question.

You know, one of the things that we've, you know, one of the things about equities is that the, there isn't a a immediate and obvious payoff when it comes to bonds as we just discussed, there is a coupon and which is essentially an interest rate that the the borrower will pay back to you.

But when it comes to equities, it's a lot less clearer.

You have to rely on profits and you have to lot rely on dividends coming through, and that is exactly you know what the script that and try that again?

Now, as we just talked about, locking in higher interest rates as I keep and crucial part of.

Investor portfolios, multi asset investor portfolios, but it isn't enough. Even if interest rates are delivering inflation, beating returns over the long run, what you really want is an exposure to equities in order to make sure you essentially hit your savings goal because they are one of the highest returning assets out there. Now, what's often thought of with equities is that they are these uncontrollable volatile, you know, asset classes that are very difficult to forecast what will happen and when. But the truth is that equities generally just follow what's happening in the economy. When profits grow, equities deliver returns. When companies make money, they tend to pay it back to shareholders. Now if you take an example of the FTSE 100, which is an equity investment that most of our listeners will will know of and you take it all the way back to just before the financial crisis and the price return was particularly mediocre from the financial crisis to today. And that includes 2 recessions, but once you throw in the total returns, once you throw in things like dividends, things that actually add to the total returns of an equity investor, you'll have generated return that's closer to 5%. And that's what you get when you win best in equities.

And so the really important thing is to make sure that you hold bonds and equities together.

Thank you.

Wen: So we’re in an environment of high interest rates, high bond yields, high volatility and the last few years have been quite underwhelming. When do you expect investors to see a return on investments?

Ahmer: You know, absolutely. It's one of the main questions that we're getting at the moment.

And when it comes to, particularly the lower risk profile clients and low risk profile multi asset portfolios, they do have a decent allocation to bonds. And as we've discussed, as bond yields have risen, those prices have fallen, and now there's what has that's essentially delivered those underwhelming returns that you talk about. But on the flip side, the bond yields falling. Also, the price is falling and the bond yields rising has also increased and the attractiveness of those same of exactly those same asset classes.

So if you look at a lower risk profile, I'll take the 7IM Moderately Cautious. Portfolio.

The guideline returns, the returns that we would expect those those portfolios to deliver, assuming you hold it over the long run, have gone up from about 3.5% just two years ago to 5.5% now.

Now that two percentage points doesn't sound like much, but if you compound that over the realistic time horizon, that a client should be holding these portfolios for that makes for a really meaningful return and it will definitely make up for the return that hasn't really been there over the last couple of years.

So the thing I would leave listeners with is, you know this chance to lock in those higher interest rates won't last forever, and the cost of moving from investing, from moving from portfolios to cash could become very costly very, very quickly.

Wen: Thank you so much, Ahmer, for sharing your thoughts. That is all from us here at 7IM