Investment View April/May 2014
Earlier this year in Investment View we concluded that if companies report earnings that meet or exceed expectations then markets should respond favourably and allow a positive mood to grow. However, if earnings don’t meet expectations then a nervy mood will likely be experienced as markets consider whether the “P”, price, needs adjusted to reflect earnings. Equity market returns in 2014 may not be as robust in 2013 but a revival in profits means equities should outperform the returns from most fixed income assets.
The results season can be described as mixed at best in almost every market. Headwinds from the strength of sterling caused many currency-related downgrades to profit expectations. Disruption from severe weather in the US and flooding in the UK affected some. The ongoing slowdown in China and deceleration or disruption in emerging markets hit others. One month up, one month down has been the pattern of market moves over the first quarter leaving equity investors with the sense of much effort and activity expended, with little to show for it. Albeit, we have seen some bonds and property funds progress satisfactorily without a great deal of noise despite some very gloomy views on the fixed income space in particular. As the graph for the 3 months from the end of January shows bonds and property are providing a much smoother ride and provide a solid foundation to portfolios.
Equities cannot advance meaningfully out of the top end of their current 6,200-6,800 trading range on the FTSE 100 until there is stronger and more broadly spread growth in corporate profits. This is also the scenario in the US. Europe and Asia did not see major re-ratings during 2013 and so the picture is slightly different there, although growth in earnings will be important for confidence and progress.
Fortunately, apart from the currency headwinds, we believe that this is still likely to happen over the balance of the year. As the weather-related disruption in the US fades, the strength of private sector activity which was masked last year by public sector constraints should resurface. News flow in Europe points to continued improvement, notably in the periphery. The Ukraine remains a potential problem, which could adversely markets but hopefully a resolution will be found to avert any major crisis.
Meanwhile, here in the UK, growth continues. While we cannot rely on a further drop in the savings rate, which clearly boosted spending last year, the acceleration in housing transactions as government schemes improve credit availability is set to continue both this year and next. Housing transactions have finally risen back over the one- million-a-year mark but remain well below their long-run average of 1.7 million a year.
Rising job vacancies suggests the steady, persistent growth in employment we have enjoyed in recent months will continue. Counter to the doom mongers, growth in full-time jobs exceeded part-time jobs last year by 10 to one. At over 30 million, the number of people at work in the UK is at a new all-time record high, even though, courtesy of an expanding population, the employment rate is still a few percentage points below its previous peak.
Since the financial crisis, real wages have been falling in the UK. It is this, rather than austerity measures, which has been the main cause of economic stagnation and the public sense of gloom. At last, this year, the squeeze on real incomes should end.
Inflation is falling away under the combined influence of stable oil prices, some freezing of utility prices and intense competitive pressure among food retailers. Inflation may well fall to 1 per cent or lower this year, boosting real incomes just as further uplifts in personal tax allowances increase take-home pay.
In addition, inflation falling to the bottom of the Bank of England’s target range hardly provides strong ammunition for the central bank to start raising interest rates any time this year. Falling inflation, positive growth in real incomes, further growth in employment, increased housing transactions, gently rising house prices, a dovish Bank of England – all of this should maintain the momentum of recovery and growth in the UK.
In turn, this should drive the improvement in corporate profits which today’s equity valuations demand and which we need to push the market towards a sustained attack on the FTSE’s previous peak level of just under 7,000. Whether we breach this huge psychological milestone in 2014 or 2015 rests largely on how long it takes for this economic growth to feed through into positive profits surprise and earnings upgrades.
Emerging markets still remain challenging but should offer an opportunity. Until evidence of reforms is seen, scepticism over China’s resolve to rebalance its economy and ability to control credit growth will remain a headwind for markets in the region. However, China has proven in the past that it can change quickly when challenged and there have been encouraging developments in other economies across the region. In our view, now is not the time to despair about China and the region in general as we believe that very little hope is being reflected in market valuations.
Earnings growth expectations of 10% for the region in 2014 look achievable and fund managers tell us that they are still able to find what we consider to be good-quality companies at attractive valuations. There does remain some uncertainty over shadow banks and whether that will trigger a credit crunch that developed markets suffered almost 6 years ago. Undoubtedly China’s central bank has the firepower to deal with failures in the shadow banking sector but the risk remains that it could cause a shock to local markets and indeed beyond. Chinese policy makers are expected to take appropriate action to ensure a soft landing whilst a restructuring takes place across the Chinese economy. Growth is expected to remain about 7%, which is very satisfactory.
The first quarter has been a bit of a rollercoaster for most equity markets as earnings have been mixed. Markets will advance if confidence in earnings growth can be demonstrated. Europe in particular did not enjoy such significant re-ratings in 2013 as the UK and US markets and continues to offer attractive value. The death of the Bond is exaggerated and the bond funds we support have gently plodded on in a steady upward trend, doing the job they are employed to do. Property also continues to deliver very satisfactory performance. We remain optimistic that earnings will improve and that markets will advance through 2014, but when the FTSE will reach 7000 may not be until 2015. Emerging markets remain challenging but probably offers the greatest opportunity for investors just now but clearly not without some risk. It is likely the Ukrainian crisis will be a market focus during the next month or until the situation is resolved.