Investment View November/December 2015
The chaotic and huge volatility of the summer has somewhat subsided, at least for the moment, but it would be foolish to believe it has gone and volatility banished. For several weeks we substantially suspended rebalancing portfolios as the daily movements both upwards and downwards were ridiculously large and potentially costly to investors. Buy on a high day, sell on a low day when a 2% change could easily be suffered within a day or two.
Principally, there were three issues that troubled investors over a troublesome summer – namely the precise timing of the Fed’s first rate rise, the subdued pace of global growth and the ongoing macroeconomic uncertainties in China – do not seem that much closer to being resolved now than they were back in the summer.
The Fed, for its part, has worked very hard to try and keep the December policy meeting alive (current market pricing suggests that a December hike is now likely, having been less than a 30% probability prior to the October meeting). Nonetheless, it is still impossible to predict with complete certainty whether or not the Fed will move before the year ends, particularly given the seasonal decline in market liquidity that is seen in December. Critics of the Fed would argue that the Federal Open Market Committee (FOMC) has simply been too transparent, and that policymakers have painted themselves into a corner. If the FOMC itself is not sure about what it should do, it is impossible for anyone else to predict what the Fed will do with any accuracy. The FED’s next meeting is scheduled for 16th December and we will await with keen interest.
While the Fed’s moves (or, indeed, non-moves) have occupied the lion’s share of the financial commentators attention in recent weeks, it is the muted tone of global economic data that is perhaps most worrying. The Lehman crisis took place well over seven years ago, and yet signs of a traditional cyclical recovery remain very hard to find. If anything, the current concern in markets is overcapacity in China and what that will mean not only for commodities and energy producers but also industrial profitability in general. As Columbia Threadneedle recently commented “Whilst we do not expect an economic recession, it is clear that life for a number of global industries is very difficult and likely to get worse. Talk of a recession in industrial profits may sound alarmist, but is probably not too wide of the mark if you happen to be a maker of mining equipment or agricultural equipment, areas where there is significant global oversupply. If you produce a commoditised, undifferentiated product – such as steel plate, for example – life is incredibly tough and companies are failing” We have seen the impact in the remnants of the steel industry here.
Global growth remains subdued and it is hard to find anyone who believes that will change anytime soon. One explanation is that while QE has created the conditions (i.e. near-zero interest rates) for companies to invest, it only makes sense for companies to invest if they think that there is demand for what they will then produce. Post crisis, that demand has been notable by its absence, outside of emerging markets. Of course emerging markets are now under significant pressure, particularly the ones that have built their economies to feed Chinese demand for commodities, meaning that the global consumption outlook is muted at best. In that context, it is perhaps not surprising that companies have chosen to cut costs and use spare cash to pay dividends (or special dividends) and latterly they have used financial engineering (such as share buybacks) to support their share prices.
In a world where organic growth is hard to find, it makes much more sense to buy back shares than committing to expensive, long-term projects involving huge amounts of capital expenditure and uncertain pay-offs – as many mining companies have found to their cost. A lack of corporate confidence to invest is only part of the story. When oil prices slumped, we expected the consumer to benefit from a ‘cheap energy’ dividend, but this simply has not emerged in the way that was anticipated.
Rather like corporations, which are reluctant to spend on large-scale investment projects, many consumers are simply thankful to have a job in the post-crisis world and are therefore banking the gains they have made from low energy prices. Perhaps more significantly, and despite tightening labour markets in countries such as the US and UK, wage gains have been very modest. We should also not forget that a generation of people who left school or college in the late ‘noughties’ will have grown up without ever knowing the abundant finance that was available pre-Lehman. Consumption based on debt is not returning in the US or elsewhere and this will have a material impact on the level of GDP growth we will see next year and in the coming years. To put this another way, the unholy trinity of tighter regulation, higher legal costs and tougher capital requirements will mean that retail banks will increasingly look like utilities in the future.
Organic growth will be difficult to find and that perhaps explains the recent pick-up in mergers and acquisitions (M&A). Companies that have already reduced their cost bases and used financial engineering to lift their share price have few other options left . The fact that growth is likely to be subdued means that interest rates will be lower for longer. Interest rates may take a very long time to rise to 2%, much longer than was ever anticipated post the financial crisis.
Theoretically, this is positive for bonds but it is hard to get excited about government bonds given where yields are and the fact that the Fed will be raising rates. M&A activity tends to be good for High Yield. A low discount rate (the minimum interest rate set by the US Federal Reserve and some other national banks for lending to other banks) is also in theory a major positive for equities but all the issues discussed above suggest that economic growth – and therefore earnings – are likely to be weaker than they would have been if some of the excess global productive capacity had been burnt off. Fund managers will be highly focussed on a selective approach to equities and this should pay off, particularly as Chinese growth concerns are unlikely to diminish any time soon. Passive investing will catch all that passes and we don’t think that is the way to go. We also think that investors will focus more on valuations and fundamentals as global liquidity continues to recede, and in that world investors should be ready for more stock-specific disappointments. There have been quite a few this year. Fund managers are alert to this. In future, the Fed will not be underwriting equity markets and despite the likelihood of further action by the ECB, there will no longer be a rising tide of global QE that lifts all boats.
As the chart shows property has continued to prove resilient and very steady through difficult and turbulent markets. It has provided the backbone for many portfolios during the last year. The chart compares the main UK property index with an index of multi- asset funds and the picture is quite dramatic. In a difficult year, and I think few would argue with us that 2015 has been anything other than difficult, a portfolio comprising individual funds provides enormous benefit and is a strategy that is ignored by far too many. This is particularly true if the portfolio is required to provide a source of income and for almost all our clients in retirement this is key. Losses are very hard to recover from. It is probably optimistic to expect property to progress through 2016 at the same rate, but it remains and is likely to remain a key component. So at least some good news!
Next month we will look closer at what might be in store for 2016, but the message is very clear that the global economy is subdued and that is not likely to change.