This article is extracted from Investment Outlook – January 2016, Smith & Williamson
Investment review Concerns from 2015 may intensify
Looking back over an eventful 2015, a cocktail of global concerns has been served up to the markets. Lower economic growth and low inflation have persisted and market volatility has ramped up, with only a handful of markets and asset classes delivering a positive return over the last 12 months. Despite the ever-growing threat of deflation looming in the eurozone, equity and bond markets in the region began the year strongly, reacting positively to the announcement of a QE* programme by the ECB*. ECB President Mario Draghi finally put his words into action, marking the start of a significant monetary policy divergence with the US Fed* and inspiring a rise in interest rates in December. The US dollar, the world’s reserve currency, has risen notably over the past 18 months in anticipation of the Fed beginning to raise rates, while most of the world’s central banks have continued to ease policy. Optimism that the ECB’s liquidity injection could improve the economic prospects of the eurozone was tempered by the emergence of the far left, anti-austerity Syriza party in Greece, again showing the political fragility of the region. Months of extended brinkmanship and a number of false dawns between Greece and its creditors (the so-called ‘Troika’) garnered headlines globally, again raising the risk of a ‘Grexit’ (Greece leaving the EU), with the potential ripple effects causing further uncertainty for markets. Although the near-term risk of a disorderly ‘Grexit’ has subsided, the more significant threat of a ‘Brexit’ (Britain leaving the EU) remains at large and is likely to feature heavily in 2016. David Cameron will want to get negotiations with the EU and a referendum wrapped up in 2016 before French and German elections in 2017 complicate matters further. Economically, the UK was a stand out performer in 2015. A combination of rising wage growth and declining consumer price index inflation helped boost disposable incomes, while unemployment has fallen to levels last seen before the onset of the great financial crisis.
Globally, the three key features of 2015 have been the appreciation of the dollar, the further decline in commodity prices (oil in particular) and heightened concerns over Chinese growth. It’s this trio that has hit emerging markets the hardest, particularly those commodity-exporting economies with large amounts of dollar-dominated debt and a reliance on Chinese demand. With Chinese GDP* growth continuing on a lower trajectory, the shock 3% depreciation of the yuan in August added to concerns that Chinese policymakers had lost control of the economic slowdown. This was ultimately the key catalyst for a significant risk-off move over the summer, which saw most equity markets decline over 10%. Weaker demand and excess capacity in China has been a key factor behind the decline in commodity prices over the past year. Oil prices have fallen and remained low, as supply from Saudi Arabia continues to outweigh demand — a deliberate strategy by Saudi Arabia to drive out higher-cost producers in the US and maintain its own market share. It has been the persistence of low commodity prices that has held back global headline inflation levels which, in turn, has been a key factor behind loose global monetary policy. One disappointing aspect has been the lower oil prices, so far failing to translate into significantly higher consumption expenditure as initially anticipated. However, we still believe lower commodity prices remain a positive for consumption and input costs in the developed world.
Looking into 2016, the key risk for markets is likely to be that the concerns that emerged in 2015 will intensify. A continued decline in commodity prices and further rise in the dollar creates a debt-deflation trap in the emerging world. The Chinese slowdown accelerates, negatively impacting corporate confidence and continuing to add to deflationary forces throughout the globe. Lower nominal GDP growth continues to translate into lower company top line revenue growth. As in 2015, the risk of exogenous shocks cannot be ignored, particularly those resulting from ongoing geopolitical concerns. However, there are reasons for investors to be optimistic going into the new year. With US interest rates finally lifted (albeit very modestly) in December, the Fed appears confident that it is tightening into a stronger US economy. Markets remain cautious and the success or failure of the US economy to absorb higher interest rates will be key for the global economy next year. However, if there is stronger-than-expected US data in Q1, we could well see the US yield curve steepen (ten-year minus two-year) and an increase in risk appetite. In this scenario, US equities are likely to perform well after a largely flat 2015. The terminal rate of interest ultimately remains the key factor for markets, firms and households and we expect this rate cycle to be slower and shallower this time. Although concerns over China are unlikely to go away overnight, the economy has shown signs of stabilisation in the second half of 2015 and sentiment has improved. The worst of the downturn appears to be over, particularly with the larger services sector continuing to expand. This will limit the need for any sudden and heavy-handed policy responses from Chinese policymakers. Further stabilisation in China may also be key in any possible turnaround in commodity prices. Any rebound in commodities would be a positive for the muchunloved cyclical sectors that have underperformed in recent years. Overall, the world of lower growth and lower inflation is likely to persist throughout 2016. In this environment, global central bank balance sheets are likely to continue to expand, despite the Fed slowly raising rates. Monetary policy will remain accommodative and financial repression will still be in play. In this scenario, we still believe equities will deliver a superior return over cash and bonds.
Market highlights Equity markets
It was much ado about nothing for most equity markets in 2015. After a strong start to the year, driven by the prospect of a wave of liquidity from the ECB, markets experienced a notable period of turbulence over the summer months. This was triggered by a number of exogenous shocks, from Chinese yuan depreciation to the VW emissions scandal and the extended Greek saga. In the UK, the theme over the last few years has continued with the more domestically-focused FTSE 250 notably outperforming the larger FTSE 100 in 2015. The latter, with its larger skew towards commodity and mining stocks, has fallen victim to the rout in the commodity complex this year. In the US the S&P 500 barely kept its head above water in 2015, only bailed out by the outperformance of a handful of large, mainly technology stocks in the latter part of the year. Market breadth has been weak and concerns over high US valuations have persisted. With the Fed finally starting to raise rates gradually and US QE behind us, corporate earnings will once again need to take up the baton as the key driver behind US equity markets over the coming year. Q4 earnings season will again be closely observed at the start of the new year.
Among developed markets the two outperformers have been the eurozone and Japan, two regions where quantitative easing is in full swing. This suggests central bank liquidity remains a key driver behind markets. Looking into 2016, we expect the eurozone and Japan to continue to outperform in light of ongoing policy easing. Emerging markets were again hit hard in 2015 by the commodity rout and the rise in the dollar leaving valuations at a large discount to those of developed markets. The key catalysts for a recovery in emerging markets will be a sustained pick up in commodity prices, signs of further stabilisation in China and no further appreciation of the dollar. The commodity-importing markets of emerging Asia (which also have largely current account surpluses) look like a relatively safer bet for those wanting to participate in emerging markets.
2015 was a year of recalibration for most developed bond markets with the key feature being the divergence in monetary policy between the Fed and ECB. Government bond yields in the US, UK and eurozone have largely remained at historically low levels, in part reflecting the current environment of lower nominal GDP growth across the developed world. The ECB’s asset purchase programme, which was extended out until at least March 2017 at the central bank’s December meeting, has seen government bond yields across the eurozone fall to unprecedented lows this year. By contrast, US treasury yields have drifted higher as markets have begun to factor in a Fed tightening. Twoyear yields, which are more sensitive to base rates, have risen around 70 basis points since January. With the first modest interest-rate hike out of the way, markets will again be assessing the path of US interest-rate increases. The Fed will remain data dependent. The key indicator to watch is the spread (difference) between the ten and two-year treasury yields. The shorter two-year yield rising above the longer ten-year (a reflection of growth expectations) has historically signalled a recession. The year ended with another rout within the high-yield corporate bond space. Large-scale redemptions and further liquidity issues among a number of large high-yield bond funds saw yields on lower-rated bonds spike in December, fuelling concerns that this could be the ‘canary in the mineshaft’ for a wider market crash, as witnessed in previous cycles. However, the spike in corporate yields has largely been confined to those within commodity exposed sectors, where the number of defaults has been increasing. Indeed, good-quality, investment-grade corporate bonds have remained relatively stable and default rates are low. They offer an attractive spread over government bonds. The lack of liquidity within the corporate bond space does remain an area of concern. We still see the benefit of holding a small weighting in highly liquid assets, such as UK gilts within a balanced portfolio, even though the potential for capital growth is limited with yields at lower levels.
FX and commodity markets
With monetary policy clearly diverging between the US and eurozone, the Bank of England remains caught in the middle and the outlook for sterling remains more uncertain. So far, Mark Carney has succeeded in keeping rate-hike expectations in the UK relatively well anchored, with dovish forward guidance. With inflation still near zero, early signs of wage growth slowing and the ongoing fiscal squeeze, we don’t expect a change in policy from the MPC* until the middle of 2016 at the earliest. This suggests that sterling is likely to continue its recent downward move against the dollar, while strengthening against the euro. However, looking ahead to the next year, other forces, particularly the risk of a Brexit, may influence the pound. Our view is that the UK will remain within the EU, however as we witnessed with the Scottish independence vote in 2014, nothing can be taken for granted. Increased uncertainty over the outcome is likely to lead to money exiting the UK and to sterling weakness. The continued fall in commodity prices has been a major feature in 2015. The 35%-plus fall in the oil price in particular has rippled through many asset classes. However, a key question going into 2016 is whether we have reached the bottom. The rhetoric from the Organisation of the Petroleum Exporting Countries’ latest meeting in December is that Saudi Arabia, the world’s largest exporter, is intent on maintaining output despite facing a budget deficit of almost 20%. Considering the US rig count has fallen over 60% in the past 12 months, we suspect we could soon be approaching levels where we see the US shale industry buckle. This could be enough for Saudi Arabia to cut output levels, causing prices to rebound. However, it could be another 12 months before we see this. With Iran soon to be free of international sanctions and producing a further 500,000 barrels a day, prices are set to remain low for the foreseeable future.
UK sector performance
Equity markets by region
Equity markets by country
We continue to favour quality developed market equities, although volatility is likely to persist. The inflationary pressures remain weak in the US, UK and Europe, in this environment we prefer conventional bonds over index (inflation)-linked.
Glossary of terms
ECB — European Central Bank. The euro area’s central bank which sets key interest rates and monetary policy.
Fed — The Federal Reserve. The central banking system of the US. Sets key interest rates and monetary policy.
FOMC — Federal Open Market Committee. The branch of the Federal Reserve board that determines the direction of monetary policy. It meets eight times a year to set key interest rates.
GDP — Gross Domestic Product. The monetary value of all the finished goods and services produced within a country’s borders in a specific time period. This includes all of private and public consumption, government expenditure, investments and net exports.
MPC — Monetary Policy Committee. The Bank of England’s interest rate and monetary policy setting committee.
QE — Quantitative Easing. An unconventional monetary policy in which a central bank purchases assets (mainly government securities) from the market in order to lower interest rates and increase the money supply. This, in turn, encourages financial institutions to lend to the wider economy.
Bonds — the relationship between price and yield. Yield is the return you get on a bond. When the price of a bond changes prior to maturity, due to supply and demand pressures, so does its yield. When the price of a bond goes up due to demand, the yield goes down to compensate. This is so the bond’s fixed rate of return (coupon) remains relatively constant — and vice versa. A bond’s price and its yield are inversely related. A key factor which influences a bond is the prevailing interest rate. When interest rates rise, the prices of bonds fall, thereby raising yields. This is because the older bonds are sold in order to buy new higher-yielding bonds.
Please remember the value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.