Investment View March/April 2016
March has been a much less volatile month than January or February with the oil price recovering and the FED announcing no interest rate rise. The budget from the Chancellor did not provide any particular surprises that troubled the UK markets. All markets have in the main progressed throughout the month with many of the extreme anxieties that troubled investors at the turn of the year abating albeit not gone away, but perhaps no longer viewed as Armageddon.
In the UK the debate about Brexit continues to dominate and is likely so to do until 24th June or beyond if a vote to leave the EU wins the day. As we have stated many, many times markets abhor uncertainty and the referendum creates a huge degree of uncertainty both in the UK and Europe. In the next edition of Investment View we will look at the Brexit issue in more detail but broadly the consensus amongst Fund Houses is that an exit would be negative for UK markets in the immediate aftermath but thereafter views tend to dwell on the fact that nobody can tell what the long term economic impact might be. It was very evident that immediately following the referendum announcement we experienced significant volatility in sterling over concerns about what a Brexit might mean for the UK economy. The polls, although recent history must make us sceptical of their accuracy, suggest it is a close contest whereas the bookmakers, who have greater reliability of forecasting such results, suggest it is not quite so close and the odds are substantially in favour of a vote to remain in the EU. Most commentators are sticking with the 50/50 in/out position taken by the press, although betting companies are currently showing a bias towards 65% in favour of staying in. During the month Schroders produced the above chart. Entitled with what they consider to be the single biggest popular issue in the referendum they conclude that migration can be reduced without the need for Brexit. The data in the chart is very interesting and is at odds with how many politicians and commentators portray the EU migration issue. Forecasters currently expect the uncertainty ahead of any vote to have a negative impact on economic activity, with the most cautious suggesting this could subtract 1-1.5% from annualised GDP growth during the middle quarters of 2016, with a knock-on impact of a 1% reduction in 2017. This sentiment was reflected in the March budget recently delivered by George Osborne.
One of the consequences of the credit-fuelled growth model that China followed in the aftermath of the global financial crisis was that it dominated demand for many of the world’s commodities, drove prices higher, and encouraged people to lay down capacity in those ever increasing commodity markets. And as they’ve reversed and endeavoured to step back from expanding credit, and switch to a more consumer-led growth model, that’s had the consequence of undermining those very commodity prices that were rampant.
We’re living with the consequences of that, and that in turn has consequences for a number of things, particularly equity markets. According to the Bank of England, about half of the 60% fall in the oil price that we saw in 2015 was down to increased supply. We saw supply come on-stream in a number of places, particularly in North America, and encouraged a lot of shale oil production and new methods of extracting oil. The fall in demand had about another 20% impact in the fall of the oil price, as China stepped away from that investment-led growth model. The increase in supply has a significant consequence if oil is the major part of a country’s budget. For many of the oil producers, oil at $25 a barrel is absolutely ruinous for their economy. The fall in the oil price has had a big impact on inflation and it’s difficult to get too bearish about an uptick in inflation, which is one of the things that central banks globally are grappling with.
The big issue right now is the lower growth environment and what that might mean for markets. There is pressure being placed on the financial system by the fall in commodity prices, albeit something of a rally is underway, and companies in some sectors may well struggle. But the financial system is sound. There is more capital in the banking sector today. The fall in commodity prices will impact profit growth and GDP growth, and the aftermath of writing off a lot of capital that was invested in oil and gas exploration and production over the last five years, at rates that are now clearly uneconomic, will need to be dealt with.
One of the issues that equity markets are currently facing is that there has been a significant rerating over the last five years, driven in large part by low interest rates in quantitative easing. In the US and in Europe that rerating has been a significant contributor to the return that equity investors have earned. And as we come to terms with this lower growth environment, equity markets have de-rated, to face up to that environment. So we are currently seeing markets struggling to come to terms with this new world.
But there is still growth, and that’s the issue that we can remain positive about. Valuations are reasonable: companies are not wildly expensive, nor are they wildly cheap. And the dividend yield is still attractive. Moreover, interest rates are unlikely to be going up aggressively and, against that backdrop, the dividend yield that can be earned on equities is still relatively supportive.
This environment and the recent rally in the oil price and some commodities combined with light at the end of the tunnel for banks, is proving an attractive landscape for value investors.Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value.Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term.This approach requires a contrarian mind-set and a long term investment horizon. Value has been out of favour compared to growth for the longest period that data exists but we sense that the tide is turning and believe value will be a favoured style through 2016. We are positioned to take advantage of this potential change in sentiment.