Investment View March/April 2015
March looks as though it will be a pretty flat month for most equity markets. We saw the FTSE 100 break the 7,000 barrier for the first time on the back of the budget, which was well received by UK markets. Although it has retreated a little since achieving this high point, the mark has at last now been reached. However, perhaps the standout event of the month was the US Federal Reserve (Fed) meeting, which led to the Fed taking the word “patient” out of its official stance regarding the future approach to interest rates, and injecting the view that any increases would be data-dependent.
The bank added an important caveat that data had recently moderated. This had the impact of pushing up 10-year bond yields and pushing down the seemingly unstoppable US dollar. That, in turn, led to emerging markets moving up, offering some relief from the pounding that their currencies have been taking from the stronger dollar. It also saw the Euro, which had been on a one-way track downwards, rally. This is about a change of positioning, given that interest-rate rises seem to have been pushed from June into September or as some suggest, into 2016. Looking at the US and knowing nothing else, one would see one of the weakest recoveries on record: low wage growth; a decade-plus high on the currency; negative economic surprises at a six-year high; and negative inflation, which it is likely will soon be confirmed. Therefore, shouldn’t we be talking about rates declining instead of rising at this stage? This thought was echoed by Andy Haldane, Chief Economist of the Bank of England, who believes that maybe the rates here should be moving down. It’s interesting that the Fed has moved from a place where it was prepared to look past the issues regarding oil to now worrying about the impact it’s having on inflation.
Inevitably, this uncertainty about rate rises continues to make fixed income markets challenging and until a clear direction of travel is obvious this is likely to remain the situation.Within fixed income, we are looking for yield opportunities, in investment grade and high yield credit markets and are less positive on government bonds on valuation grounds. Thus we continue to favour strategic bonds to provide the flexibility that market conditions impose. We remain very positive about property.
European equity valuations have recovered from their crisis levels. The 12-month forward price-to-earnings ratio of the MSCI Europe index is around 14.5 times, which is above its average since 2003. However, though they may not be cheap compared to their own history, European equities continue to look attractive versus other asset classes and other regional equity markets. For that reason, we do not see valuation as an impediment to performance in 2015.
An important point to note about European equities is that the share price gains over the past couple of years were driven by a relief rally as fears over Eurozone break-up subsided. However, corporate earnings in Europe still remain at very depressed levels. While US earnings are around 13% above their previous peak, Eurozone earnings still languish at around 32% below their prior peak. Many in the market expected Eurozone earnings to recover in 2014 but this failed to come through as the Eurozone economy appeared to slip into the slowdown phase of the economic cycle. The conditions are in place for Eurozone corporate earnings to surpass the US this year and drive the next phase of share price gains.
The precipitous drop in the oil price since autumn 2014 is a major factor that can support the Eurozone recovery. The oil price fall affects not only petrol prices but also the cost of any goods made using oil products. Calculations suggest that the price fall represents a €1,000+ boost to each European household – the equivalent of a massive tax cut. Secondly, the weaker euro relative to the US dollar makes for a more benign backdrop for many Eurozone businesses. Thirdly, funding costs have fallen significantly giving a boost to small and medium-sized enterprises in particular. We think these factors have in effect ‘short-circuited’ the economic cycle and have taken us back to the recovery phase.
All in all, we think European equities remain attractive and there are plenty of opportunities to be found. There are certainly risks to our outlook and we are mindful of these. However, our core view is that in a non-crisis environment, earnings can recover, corporates will resume spending and we should start to see a normalisation of the business cycle.
In the UK, the FTSE broke through 7,000 during the month, which many UK Fund managers have viewed as a critical psychological barrier that had to be breached and might then allow momentum to push markets onwards. Inevitably, some question whether we are heading for a similar type bubble that was experienced during the 1999 dotcom boom. Schroders have produced an interesting chart, which we think provides evidence that the fundamentals are different in 2015. At the previous peak at the end of 1999 the P/E ratio of the FTSE 100 was over 30. In 2015 the P/E ratio is 16.5. That is not considered unrealistically high historically and even in a low growth global economy it is not an unsustainable number. Clearly, earnings (the “E”) need to be delivered and hopefully exceeded and then we can progress. The other interesting feature is that the dividend yield delivered by the market has risen from 2% in 1999 to 3.4% currently. Opportunities for dividend growth remain across many regions and sectors at a company level, highlighting the benefits of a global approach to equity income investing which we adopt.
As we look forward into April and beyond, undoubtedly, the forthcoming UK election will create some uncertainty, particularly for the UK market and it will inevitably fluctuate until a new Government is formed, which may take some time if the polls are to be believed. We will also be watching the Greek position which continues to create uncertainty that could hinder wider European recovery. It remains that the US continues to lead the way and the strength of the dollar will also be keenly watched. Like the Fed, we, too, will be patient as we believe that will be rewarded.
Douglas Kearney C.A. Investment Director.