Investment View April/May 2015
Equity markets suffered a little of end-of-quarter profit-taking in March as analysts welcomed signs China will take monetary and fiscal action to support the world’s second-biggest economy. However, those hopes, and more M&A, got the new quarter off to a good start for US, European and Chinese benchmarks, but investors have turned more cautious, made wary perhaps by concerns over the upcoming corporate earnings season and worries over Greece as the euro slips back.
This caution is further exacerbated in the UK as the General Election fast approaches with all polls suggesting that the formation of a Government will be tricky to say the least and likely require both significant compromise and time to produce a solution. If this likely outcome comes true on May 8th it should not be a surprise to markets. But no doubt there will be some negative reaction until clarity is achieved. We will need to be patient to see what can be delivered.
Many portfolios have a holding in Royal London’s UK Mid Cap fund which has been a very satisfactory performer. The Fund manager produced a commentary which I found interesting and relevant. “There are a number of reasons why the second quarter of 2015 could be more volatile. The FTSE 250 has risen by 7.4% in Q1, more than it achieved in the whole of last year. Such a strong Q1 performance will meet with inevitable worries about firstly, the forthcoming election, secondly, the potential impact on equity markets of the first US Federal Reserve rate hike, and thirdly, the usual seasonal advice of sell in May and go away. However, the election may be less toxic for mid cap returns than many anticipate as can be seen in the table below. Since 1987, when we first had pricing information for the FTSE 250, there have been six elections in the UK. The average return of the mid cap index during these six election years was +12.9%, delivering gains in five of the six occasions. If we were to start counting from two months prior to the election (until the year end December), the average gain is still 11.6% for the FTSE 250. Even on a short-term basis, from two months prior to election day, the mid cap index was up on average by 3.8%.
Should the election not deliver the required result, there are other positive drivers that could push mid caps higher by year-end: the macro remains supportive, with the lower oil price boosting disposable income for consumers; inflation remains subdued which is likely to keep interest rates low for longer, again helping the consumer; Bank of England policy remains largely accommodative; and real GDP growth remains not only positive but robust compared to other developed markets.
Fundamentals continue to look solid, with balance sheet strength an important factor. While earnings growth remains disappointing, the balance sheet hides significant value with the average Net Debt/EBITDA (a measure of gearing), for mid caps standing at just 0.8x. Moreover, around 44% of UK mid caps have more cash than debt, suggesting that dividend growth and Merger & Acquisition activity should pick up from here”.
Therefore, the message is there are plenty of positives (not just for Mid Caps). It is also worth remembering that UK equity markets do not particularly perform better or worse under particular administrations. It is easy to believe at times like this that it might be smart to nip out and in of markets. As we have often stated timing the market is difficult. Our emotions make it even harder to get it right. As a result, most get market timing wrong and often very badly wrong. As a result most investors in collective funds do not realise anything like as good a return over the years as the published performance figures suggest we should.
A recent study in the US reported that over the past 30 years, the S&P has managed an annualised return of 11.6 per cent, far outstripping inflation, which has averaged 2.7 per cent. That should have provided a fine engine for Americans to turn their savings into a good pension. But over the same period, the average investor has managed a return of 3.79 per cent. The report concluded that the overwhelming driver is bad timing by investors. This is worst during extreme events. The months with the worst underperformance over the past three decades are headed by October 2008, when the S&P dropped 16.8 per cent in the wake of Lehman, but many investors bailed out before a rally at the end of the month, crystallising an average loss of 24.2 per cent. So our message is be patient. We don’t believe the forthcoming election will be an extreme event, just a period of unwanted uncertainty and volatility. Volatility provides fund managers the opportunity to buy assets at good value.
Since the start of the year, the outlook for US earnings has become less attractive, not least due to the strength of the US dollar. Although many have been forecasting a stronger dollar for some time, most did not expect the scale of the move seen since the start of 2015 and it is likely that further earnings downgrades will be seen in the coming months. It was never likely that US markets would repeat the strong performance of 2014. While we still expect to see corporate earnings growth in the US and UK, supported by strong domestic economies, both of these markets are affected by a mixture of currency strength, low commodity prices and eventually some monetary tightening. In contrast, companies in Japan and much of Europe are seeing earnings upgrades as analysts realise that both economies are recovering from weak growth in 2014, while QE will support profits growth through yen and euro currency depreciation, boosting exports growth and via a profits translation effect
In Europe equity valuations look relatively attractive and monetary policy will be supportive. European fund managers are unanimous that opportunities are prevalent. For the first time in many years the number of companies beating their profit forecasts is increasing. The euro has been the main beneficiary of dollar strength as it has weakened significantly, providing a boost to corporate earnings. We continue to include European funds in almost every portfolio and believe this support will be rewarded.
We do tend to include Japan in portfolios through exposure to a variety of Global funds and allow the manager to allocate as appropriate. How effective Abenomics has truly been so far remains unclear. Certainly, investor sentiment is moving in Japan’s favour and it likely exposure will creep up in the months ahead.
There is little to report on fixed interest or property over the period. The fixed interest managers watch the Fed’s every move avidly, whilst property continues to flourish. Interestingly, the Fixed Interest managers are also looking at the UK election outcome with perhaps more anxiety than equity managers as a Conservative led Government will likely bring a vote on Europe, which will put pressure on Sterling.
Recent stock market highs have caused some commentators to worry that a fall in market values is imminent. That cannot be dismissed but market valuations have not become stretched nor have economic or business conditions altered adversely. Again, whatever the outcome over the next few weeks, avoid the mistake of rushing to make changes as the trap of mistiming could catch you out. Also beware of Greeks not bearing gifts.