Irregular Roundup, 22nd July 2024

We begin today’s Irregular Roundup with cyclical value.

Cyclical value

Joachim Klement looked at a new study of the outperformance of cyclical value stocks.

• Cyclical stocks should outperform since they are more exposed to the business cycle (ie. their prices should be more variable/volatile).

The study adds sensitivity to GDP growth forecasts (from the Livingston Survey, which I hadn’t come across before) alongside market beta in the simplest version of the CAPM model.

It makes a big difference – plain old CAPM doesn’t explain any of the variation in stock returns, but CAPM plus GDP explains 71% of the variation.

The stocks that are most sensitive to GDP outperform after adjusting for the usual four factors of market beta, value, size, and momentum. This outperformance of cyclical stocks is stronger for large caps than small caps, which is the opposite of what normally happens.

The outperformance is particularly large for cheap (value) stocks.

So now you know what to buy. Cyclical stocks with low valuations. Value investing is already psychologically demanding, but value investing in highly cyclical companies is a step up from that.

Savanta wealth survey

In the FT, David Barks of Savanta wrote about his firm’s regular wealth survey.

• Savanta surveyed 25 of the UK’s leading wealth managers and 500 high-net-worth individuals (at least £1M in investable assets) in late May and early June 2024.

Three-quarters of the wealth managers surveyed acknowledge the [FCA’s Consumer Duty] regulation has had a positive impact on client experiences. 

That seems high, after such a short time since implementation.

The customers seem happy, too:

Very few wealthy UK investors consider their products are inflexible to their needs (3 per cent) or that their investments aren’t suitable for their goals or risk appetite (2 per cent).

84 per cent of UK millionaires believe they receive effective and clear communication that they can easily understand. Only 3 per cent of surveyed clients believe it’s unclear how much they pay for the services received.

And only 5% don’t think that their wealth manager offers good value for money (with another 15% unsure).

This high level of satisfaction could be the result of self-selection from those who are happy to pay for “advice” (which should really be called “hand-holding during bad times”).

• As a DIY investor, I’m far from happy with the range of products that the FCA allows me to invest in.

David puts the unhappiness – such as it is – down to performance.

[Value for money] is strongly affected by investment performance and the past couple of years has been a challenging period in the markets.

Things have certainly been volatile in recent years, but I’m sitting pretty close to an all-time high.

• The real problem for wealth managers is that as long as large-cap tech leads the market, there’s not much an adviser can do to beat cheap index trackers.

Even solid principles of diversification will lead to underperformance in the short term.

1M top-rate taxpayers

Also for the FT, Emma Agyemang reported that the number of people paying top-rate tax in the UK is about to pass 1M.

The freeze on income tax thresholds means the number of people paying the 45
per cent levy on earnings has more than doubled in the past three years, from
520,000 in 2021-22, the year before thresholds began to be frozen.

There will be 6.3M higher rate taxpayers in 2024/25, up from 4.4M in 2021-22.

Rachael Griffin of Quilter said:

The fiscal drag impact has far surpassed any original expectations the government had and we will continue to see the government’s coffers be topped up exponentially as more and more people are pulled in.

Long-term mortgages

Again for the FT, Joshua Oliver and Akila Quinio looked at whether long-term mortgages could help with the UK’s housing crisis.

Fixed rates are popular abroad, particularly in the US.

• They insulate borrowers from rising interest rates, but at the cost of locking up the property market (few people will move if their new rate is significantly higher).

In contrast, 90% of UK borrowers take out a fixed of 5 years or less.

Locking in for more than 10 years is the most common choice for borrowers in the Netherlands, Denmark and other European countries.

But short-term fixes tend to be cheaper (until rates start to rise).

• Most lenders are sceptical, saying there is little demand from borrowers for longer fixes.

Simon Gammon at Knight Frank said:

It always, invariably, looks much cheaper to get the two- and five-year fixed rate. The peace of mind of a longer term mortgage doesn’t look worth it compared to the rate.

We should also consider also the fees generated by regular mortgage renewals – it’s not surprising the industry is not enthusiastic.

The UK is approaching a risky period in mortgage lending.

• Rates have been rising for a couple of years, and have been one of the drivers of the recent high inflation.

Another 1.6M households will come off their low fixed rates during 2024.

A typical borrower who took out a two-year fix at 1.6 per cent in 2022 will face a 42 per cent increase in their monthly payments.

Home-ownership rates in the UK have been flat for a decade, after falling during the 2008 financial crisis.

• House prices are high and stiffer lending criteria mean that fewer people can afford the larger deposits needed.

The average first-time buyer deposit has risen from £22,600 to £68,700 over 20 years, increasing from 0.6 times average incomes to 1.2 times.

A move to longer-term mortgages would also impact banks and building societies, which fund mortgage lending from (short-term) savings.

• There are no 10- to 25-year retail savings to match to longer-term fixes.

The article begins with a case study of a Perenna customer.

Perenna is one of a handful of lenders now offering borrowers the choice to fix their interest rate for decades, in a bid to disrupt the £1.6tn UK mortgage market.

Perenna CEO Arjan Verbeek said:

Our mortgage market is not fit for purpose. All the European peer countries have better functioning mortgage markets. People are protected from a mortgage rate shock.

Incoming Chancellor Rachel Reeves agrees:

[Long-term deals could make sense] for a lot of people, especially for families. Potentially you would be able to borrow a bit more, to put down a bit less of a deposit. If you can take out some of that stress and instability, that will make a difference.

One advantage of long-term fixes is that they bypass the stress tests introduced after the 2008 financial crisis.

Someone buying an averagely priced house on a five-year fix at 4.84 per cent and currently paying around £1,300 per month might be stress tested to make sure they can afford a 9.5 per cent interest rate and monthly payments of close to £2,000.

The stress test is usually 1% above the current variable rate.

• Even renters paying more than the current mortgage payment can fail the street test.

With fixed rates, Perenna can ignore stress tests (since the rate won’t change).

• They also lend up to 6 times income and will lend to retirees, provided their income can support the loan.

The premium above short-term fixes is between 0.12% and 0.89%, depending on tenure and deposit.

Perenna does not take deposits, but instead plans to fund mortgages by packaging them into bonds that can be sold to investors. It plans to sell the first bonds this year once it has enough mortgages on its books.

Pension providers appear to be the target investors.

It will be interesting to see if long-term fixes take off, but I’m not sure at which part of the interest rate cycle they would look attractive.

• Certainly, at present, borrowers might expect rates to fall over the next couple of years, and so might prefer a short-term fix.

Labour watch

Having pulled the reintroduction of the LTA that was frightening those of use with large pension pots, Keir Starmer undid all the good work with a pledge to abolish the tax-free cash lump sum on starting to access a pension.

• Labour called it an “old-fashioned mistake” and that’s at least true in part, as Startmer appeared to believe that the LSA comes with a sunset clause.

Starmer said:

It runs out in a number of years. We’re not going to renew it.

The Tories were not convinced. Treasury secretary Laura Trott (a former pensions minister) said:

Keir Starmer has now opened up a third front to Labour’s war on pensioners by making it clear the ability todraw on 25 per cent of your pension pot tax-free is not safe under a Labourgovernment, punishing people who have saved their whole lives.

Steve Webb of LCP (and another former pensions minister) said:

Politically, abolishing tax-free cash is unimaginable. Many millions of workers have saved into a pension in the expectation of a nicetax-free lump sum at the end, and scrapping it would be political suicide.

But he didn’t rule out cuts to the LSA:

The current lifetime cap of just over £268,000 could be reduced to£200,000 and still be at a level that had no effect on the vast majority of pension savers, and with protections built in for those already over the limit.

Mistake or not, Stamer’s comments are quite revealing of Labour’s attitude to pension allowances.

• I think the LSA will be cut, but only for those below the pension age, and it might even be left to simply wither under inflation.

Quick Links

I have just one for you this week:

1. Alpha Architect looked at The Impact of Amortizing Volatility across Private Investments.

Until next time.