Investment View July/August 2014
We are now almost a month into the second half of the year. The global economy continues to recover. The upturn is primarily led by the developed economies, the US and Europe, whilst the emerging economies experience a more modest improvement. As we have discussed in previous Investment Views, the latter face the more significant challenge in adjusting to the post financial crisis world. Against this backdrop, inflation is expected to remain contained given the spare capacity in the world economy. Markets have progressed but performance is very variable across geographies and asset classes. Over the last four months we have witnessed a sizeable rotation out of quality, growth stocks into cyclical value stocks. Many portfolio managers have suffered as a result. However, over the long run markets are driven by fundamentals and it is these characteristics that should ultimately dictate returns.
This market rotation appears to have been triggered by a belief among investors that, after five years of gradual, if bumpy, recovery, the world economy may finally be on a normal growth path. Recent data, especially from the US, continues to improve. The US Federal Reserve has signalled that quantitative easing will end this year, while interest rates are set to rise in 2015. This suggests the Fed believes the world’s largest economy is strong enough to stand on its own two feet.
As with any market rotation, trading has at times been indiscriminate, with companies offloaded irrespective of their underlying fundamentals or earnings outlook.The temptation, of course, is to chase the rotation. However, we believe that there will be a more discerning assessment of the winners and losers as companies release their results over the coming months. As such, many of the quality firms that sold off since April could once again find their shares in demand. Those portfolio managers that stuck with their conviction in these names or, perhaps, saw it as a buying opportunity should therefore be rewarded as a result. We will be patient.
Despite the softness of the first quarter where US GDP fell at an annual rate of 2.9%, the recent improvement in the data suggests that the US could experience a sharp rebound in the second quarter, particularly as the disappointing first quarter was skewed by severe winter weather in the US. Elsewhere, the UK recovery is set to continue driven by the strong momentum in the housing market. However, the growth profile for the Eurozone and Japan is more subdued with activity in Japan likely to be held back by the consumption tax hike.
For emerging markets, the growth outlook faces domestic issues along with the prospective tightening of US monetary policy weighing on the region. Looking ahead, stability is more likely rather than a massive deterioration, with the global recovery providing support against weaker domestic fundamentals. However, markets need to become more confident on activity in the large economies like China and Brazil before the emerging markets can return to a stronger growth path.
For the rest of the year, the major developed central banks are expected to keep interest rates pinned to the floor. The US Federal Reserve is expected to complete tapering of asset purchases by October this year with the first rate rise anticipated in June next year. The Bank of England is assumed to start increasing rates in February 2015. However, the Bank of Japan is expected to step up asset purchases later in the year. In the Eurozone, monetary conditions are set to remain loose with the ECB providing targeted long-term financing operations with the prospect of asset-backed security purchases. For emerging central banks, particularly the BRICs (Brazil, Russia, India and China), the picture remains more mixed with further rate hikes expected for Brazil, but a likelihood of monetary easing in Russia, China and India in 2015.
Equity valuations are generally looking less compelling following a period of decent performance. However, we still believe that equities remain well-supported in the medium-term particularly as earnings growth comes through on the back of the global recovery. We continue to favour a global theme as we are confident that as the table produced by Schroders indicates, diversification allows the risk and return to be broadly spread across asset classes and geographies. Markets continue to require companies to deliver further earnings growth and maintain high profit margins. We are watching UK equities closely as due to the strength of the currency this may hinder UK listed companies progressing in step as a meaningful proportion of UK corporate revenues are generated overseas.
The market is pricing in a robust earnings recovery for European equities which has still to be achieved but value does remain. Emerging Market equities are looking more positive as valuations are more attractive and there are signs that exports are improving led by demand from the developed world. In addition, the recent policy stimulus by the authorities in China appears to be feeding through into activity measures, which is positive for the demand picture in the rest of Emerging Markets.
The UK commercial property market is now entering the stage where capital values are being supported by rising rental values. Most property fund managers are forecasting total returns of around 9/10% per annum driven mainly by the income return of around 5%. At the same time, rental growth of around 5% should compensate for any rise in interest rates as we move into next year. In the short-term, the risk to this view is that if the market moves too quickly this year, performance may become more front loaded than expected and returns could subsequently moderate. However, the income return from property continues to be attractive.
It would be wrong to think the road ahead will be without bumps. Government debt remains ridiculously high; impact of interest rate increases; world events spooking the markets; a China banking crisis. However, there are many improving signs that suggest that we are at least on the right road, albeit it will never be without blind corners and the odd dip here and there and long term quality shines through.