View From the Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: it seems hard to believe that the 2015 investing environment will be any less challenging than that of 2014. The equity bull market is now in its sixth year and bond yields are at record lows in many places. We still see value in selected asset classes, but note that something will likely have to give, especially since the scope for policy error remains high. Against this background, the recent pattern of volatile intra-month market swings looks set to continue for now. Our focus remains firmly on highly differentiated and uncorrelated investment strategies across all asset classes with an emphasis on what makes most sense, at the right price. We expect relative selected equity outperformance and further Dollar strength in the near-term.

Asset Allocation:

 Equities: We continue to see merits in favouring equities over other asset classes. Broad valuations are undemanding, particularly on a relative basis, and are helped by three factors: rising earnings revisions, ongoing corporate buybacks and expanding profit margins. On a regional basis, near-term prospects look most attractive in Europe and Japan, while in the medium-term, many emerging markets look compelling. After their worst year in performance terms since 2007, active managers also look poised to enjoy a better 2015.

 Credit: With around half of all government bonds yielding less than 1%(according to Bank of America), it is hard to enthuse about this asset class in broad terms while further declines would only reinforce its relative unattractiveness of credit. Investors need to be highly selective and focus on managers with flexible approaches, able to invest across all of the credit spectrum. After recent pressure, some areas of the high yield market are now, however, beginning to look more attractive.

 Currencies: The US Dollar is at an eight-year high, but expect further Dollar strength, given the effective exporting of deflation to America via continued loose monetary policy elsewhere. As a consequence, the Euro, Yen and Renminbi should weaken further. A stronger Dollar could also have negative implications for some emerging markets.

 Alternative Asset Managers: We continue to see a place in portfolios for event-driven strategies. Deal-based activity accelerated markedly in 2014 (up 30% year-on-year), but is still not close to cycle-highs, especially given current GDP trends. M&A should remain significant given corporate cash balances and CEO confidence levels. We also continue to review the case for other alternative strategies.

On the surface, the narrative for the year ahead remains the same: global GDP growth is improving and Central Banks remain highly accommodative, helped by a notable drop in the price of oil and other commodities in the last twelve months. However, it seems hard to believe that 2015 won’t be any less challenging than 2014. Despite notable volatility along the way, the previous year saw the smallest move for equities (measured by the All-Country World Index) in either direction since 1994, declines in most developed world bond markets to all-time lows and the most hedge fund closures since 2009. It is also notable that consensus remains almost as heavily skewed at the start of this year as it did at the beginning of the previous. Some 63% of investors think equities will be the best performing asset class during 2015 (at least according to the latest Bank of America Fund Manager survey) relative to fewer than 10% favouring credit.

While it is difficult to disagree actively with this consensual view, we are mindful that the returns environment remains generally constrained. It should not be forgotten that while many credit markets may be at record lows, the current equity bull market has now entered its sixth year. In other words, when a correction comes, it may be both brutal and abrupt. Given the current low rate/yield environment at present, there is clearly no room for complacency. Moreover, even if the thesis for benign global growth and monetary policy does prove to be the correct one for 2015, within this, divergence (in terms of GDP, interest rates and equity market performance) will likely be notable.

On the positive side, all the world’s major developed markets should benefit from the 40% decline in the oil price over the last 12 months. The varied reasons for such a notable fall have been discussed in much detail elsewhere, but the impact of such a drop is clearly evident. Viewed simplistically, consumption accounts for c60-70% of developed world GDP and so it is hardly surprising that consumers should be feeling more optimistic as a result of oil’s decline. In the US in particular, the University of Michigan consumer confidence index is at a seven-year high and November retail sales had gained 5% year-on-year. Furthermore, the US posted annualised GDP of 5.0% in Q3, its fastest rate in more than a decade. The other clear benefit to developed world economies from weaker oil is that it is inherently deflationary, implying that policymakers potentially have more flexibility in their mandates.

Monetary policy is where it gets interesting, where the potential for its outcomes to impact markets could be most significant. With regard to the US, it is a question of when the rate rise process begins; for Europe, the debate centres on when and how formal quantitative easing begins; and in Japan, uncertainty remains on whether its policy will prove effective. Further action may also be possible in China. In each geography, the scope for policy error remains notable.

In the US, the most recent projections from the Fed (the ‘dots’) point to interest rates of 1.1% at the end of 2015 and 2.5% at the end of 2016. While these figures have admittedly fallen relative to the last set of forecasts made three months prior – no doubt helped by oil’s decline – it still seems hard to believe that rates will rise so substantially in the coming year. Therefore, either the Fed’s guidance might not be credible or if rates do tighten this substantially, then bond investors will be set for an unpleasant surprise. Beyond monitoring carefully Fed rhetoric, it will be important to track wage growth. Currently running at 2.1% annualised, should this accelerate markedly, then so may rates need to rise.

Mario Draghi faces a different set of challenges in Europe. With 11 of the 15 Eurozone countries currently experiencing year-on-year declines in inflation, retail sales at their lowest in over a year and industrial production at its weakest in almost two, the case for quantitative easing would seem clear. However, the practical timing and implementation of such policy remains unclear. Furthermore, the effectiveness of any such policy may also be constrained by two additional interlinked factors: structural reform and domestic politics. Signor Draghi has stressed repeatedly the need for the former, highlighting that monetary policy can only do so much. Meanwhile, upcoming elections in several regions (particularly Greece) may not only delay reform but also create potentially broader uncertainty for both investors and policymakers.

The effectiveness of reform will also be a key topic for discussion in Japan. Now that Prime Minister Abe and Central Bank Governor Kuroda have a mandate through to 2018, the acid test for Abenomics will be whether reform raises growth. Clearly one should not expect immediate outcomes, but with the Japanese bureaucracy now safe in the knowledge that the current administration will endure for the next three years, the rate of policy implementation should be higher. In the near-term, this spring’s wage negotiations will be a crucial factor to watch. With corporate profits at their highest level in six years, it should be easier to make the case for wage increases. Should this prove to be the outcome then it may be possible to achieve some form of virtuous circle effect with higher wages provoking accelerated consumption.

Divergence will also likely prove to be a notable theme in emerging markets over the course of 2015. Country differences will likely be magnified by relative oil price exposure (with consuming nations clearly benefiting at the expense of producers), debt-denomination (local versus Dollar) and geopolitics. With regard to China, the natural tendency is to focus on slowing growth, with current industrial production at its weakest in a year, but it remains the case that the Chinese economy is still growing almost twice the pace of the US. Moreover, with inflation at its lowest in more than five years (helped again by oil), the scope for policy action remains notable.

Against a background of such diverse trends, the key challenge for investors is how to reconcile these factors most effectively. Our approach is twofold: be aware of valuations and also of technical factors. On almost all metrics, equities look more attractively valued than credit. And, within equities, Japan and Europe look significantly more undervalued among the major developed market regions than the US. These two former regions also offer superior earnings growth (15% and 12% respectively, versus 8% for the US, according to Morgan Stanley) and should benefit from falling currencies. By contrast, even if US GDP growth is accelerating, a stronger Dollar will, at some stage, begin to impact US earnings negatively, especially given around 40% of S&P revenues derive from outside the US.

US equities have also notably outperformed – albeit with perhaps good reason – in the last three years and so a case for some degree of mean reversion can also be made. Things only need to get a little better in Europe and Japan for outperformance here to be notable. The same argument could also be applied to the contrast between China and Russia, respectively the best and worst performing major emerging markets during the past year.

As persuasive as the above observations may be, fund flows also need to be considered. Where passive money finds a home may also be determined by currencies (a stronger Dollar means more money is likely to stay in the US) and by simply opting for the least risky outcome, following GDP growth (again favouring the US). Given the backdrop to which investors will increasingly have to accustom themselves, of lower returns than previously witnessed, creative thinking is to be recommended. Beyond diversification into more esoteric asset classes, within those that can be considered more conventional, our approach is to favour the relatively out-of-favour. In other words, our preference is for Europe and Japan in the near-term; and, emerging markets (especially China) over the medium-term.

Alexander Gunz, Fund Manager, Heptagon Capital