Articles

By John Redwood Chief Global Strategist, Charles Stanley

Many charities are long-term investors. Charities also want endowments to be evergreen. The ideal is to put some donations into a long-term Endowment Fund and grow the value of that fund by good investing. The charity can decide how much to spend from the income and capital gain the portfolio generates in any given year, preferably leaving a larger fund so more can be done in the future.

The Endowment model creates greater permanence for the charity, allowing it to draw down more in hard times. It offers greater possibilities to future generations by steady accumulation. It can, in most times, protect the charity against inflation by concentrating on generating real returns. Nevertheless, individual years may be challenging – as we have seen in 2022. A major increase in interest rates and a decision by leading central banks to slow economies sharply has directly led to substantial falls in the price of financial assets

It would be ideal if we could peer confidently into the future to choose longterm assets that we could buy and leave to appreciate. Today, some are asking if the usually reliable idea of buying a portfolio of shares and bonds designed to generate a reasonable real return will hold good in what could be more challenging conditions this decade. Could the poor conditions of 2022 linger longer, or will there be the usual recovery once inflation is tamed?

The strategy for an uncertain future

Markets do not deliver smooth, gentle appreciation of financial assets as economies grow and average earnings increase. Last year’s inflation hedge can be this year’s fallen angel. Last decade’s solid growth sector or company can be this decade’s problem as fashions change or management misfires. Governments can act as unhelpful referees, hitting business success with windfall taxes and more regulations. They can also legislate to promote new areas that investors need to consider. That is why savers are advised to have a portfolio with a spread of different assets – and why it is sometimes necessary to change the balance of assets selected to reflect a more modern reality. 

Investment managers need to live in the future, watching investments for possible success or failure from news announcements that are yet to be made. Because no-one can reliably predict tomorrow in markets – let alone ten years’ time – managers consider a range of possible future outcomes. Trying to live in the future requires plenty of study of the past. Past trends, past market behaviours in response to certain types of news and past valuations placed on assets inform judgements about what a portfolio should now look like and how it might perform going forward.

We at Charles Stanley choose to work from scenario plans, ascribing rough probabilities to the different possible outcomes. We concentrate on a one and two-year time horizon. The longer forward you wish to go, the more things will change, greatly increasing the difficulty of predicting what will happen. So, when I am asked will this decade be a decade of low growth and higher inflation, I have to say we cannot know. It is dangerous to extrapolate the bad experiences of 2022, a year of high inflation and tough policies to try to slow runaway prices, and think that this one year will determine a whole decade. There will be plenty of changes of interest rates, of governments and their budgets, of trade patterns and technologies before we get to 2030. As the decade advances so views will evolve. It is unlikely central banks and governments will settle quietly for stagflation for a decade. There is no reliable long-term answer for a portfolio which we can choose today and leave for a decade.

It is true predicting the shape of markets a decade ahead is a similar, though more difficult, challenge to predicting next year. To attempt it we need to start with a study of the past. That shows that longer-term investment in a well-spread portfolio of shares provide long-term real growth in the assets invested. It also indicates that it matters where and when you invested, with US shares doing the job, but with Chinese or Japanese shares letting you down if you invested at their respective market peaks of 2007 and 1989. Investment in real assets is often related to the growth of the underlying economies that sustain the companies selected. As economies grow, so turnover and profits grow, allowing higher dividends or higher company asset values as they plough back the profits in expansion.

Equity markets attract growth companies

The population of quoted companies can produce faster growth in their value than the underlying growth of the economies in which they operate, as the quoted sectors often represent more of the faster-growing areas

of an economy. The companies are able to borrow cash to increase returns, as buying more capacity could raise profits – if surpluses generated exceed interest costs. Even this is not an invariable rule, as the extraordinary growth of China over the last 15 years has not been reflected in the main stock market index. This probably reflects the dominant role of government and the heavy management of markets in that country.

The last century has seen world technical leadership pass to the US. From automobiles and TVs, to smartphones and digital downloads, the US has pioneered many of the world’s new products and new techniques for their manufacture. An abundance of relatively cheap fossil fuel energy has powered the waves of industrial revolution. Between 1870 and 2018, the US has averaged growth of 1.67% a year in output per head. Any long-term forecast is likely to start with this figure as a likely candidate for the longer-term growth rate going forward, although that assumes the country that has thought up or exploited so many good ideas will continue to do so. Other countries are spread out, with a group of advanced countries that are at similar levels of income and technology and a long tail of emerging market economies making varied progress to catch up.

Some emerging economies do emerge. Taiwan, South Korea and Singapore have shown how small countries with few natural resources can do so through enterprise and good education and training. Energy and commodity producing countries can often earn a good living out of their natural resources.

Some investors think it a good idea to concentrate on emerging market investment, as these economies can grow much faster than the US during a catch-up period. This does not always work, as too many emerging economies are prevented from catching up by poor government, heavy debt obligations and wrong policies. There are periods in the market cycle when emerging economies are out of favour, with too many struggling to find enough foreign exchange to pay the bills and with a strong dollar hitting them when it comes to servicing their dollar borrowings, which get more expensive in their local currency.

This year, the leading central banks had created a poor investment backdrop as they needed to rein in the excess money and credit that led to overextended bond and share prices. But we will move on from this. New patterns of demand and further technology advances will underpin new investment opportunities when the authorities decide they have slowed the economy enough. Mankind has not finished innovating and seeking a better world and better ways of doing things, a backdrop that underpins longer term equity investing. Successful investors need some optimism. The Endowment model remains a good idea for charitable organisations with big ambitions, but portfolio construction will require thought and some changes to the choice of assets to handle an uncertain future.