Making predictions is a fool’s game!
Making predictions is a fool’s game!
Looking at last year’s update we entered the year feeling somewhat optimistic. Despite the sluggish start the first quarter seemed to shrug off the December blues and delivered healthy positive numbers.
During the quarter the worries from 2014 still remained (China, Oil, Greece to name just a few) but the markets seemed unperturbed. In fact, the upward curve continued almost to the end of May.
It is something we are getting used to and it seems all good things have to come to an end. In June, two things collided dragging down the markets and undid some of the positive gains made in the first part of the year.
Firstly, the uncertainty with Greece escalated into a game of chicken with the EU, and secondly the equity bubble in China went pop.
Although Greece eventually lost its game of chicken, the markets remained spooked by China believing the demise of the equity bubble signified a wider economic collapse. This was exasperated further when the government moved to devalue its currency in August, and then the US Fed seemed to delay rate rises in September over concerns on China.
All of this made for a volatile and uncomfortable few months. However, once the dust had settled October saw a sharp correction and although November and December were fairly flat, investing in the right places would have delivered positive returns for investors.
This is perhaps a reflection of a more normalised market where investors should accept greater volatility alongside single digit returns. We have for some time indicated returns of between 5% and 8% and with inflation near zero these remain attractive figures. Obviously when events occur that are outside of what can be seen these figures could be dragged lower.
In this update we consider emerging markets, developed markets and cash, as well as what 2015 brought and what 2016 may bring.
Emerging, Asia and Frontier Markets
Before reflecting on China it is worth going back to the investment case for Emerging Markets.
According to the International Monetary Fund Emerging Market growth is expected to be 4.5% in 2016 compared to 2.2% in developed markets. Additionally, emerging markets have US $7 trillion of reserves compared to US $4.2 trillion in the developed world, and public debt to GDP is 30% compared to 100% in the developed world.
Going further there is massive untapped potential both in terms of resources and demographics. Three quarters of the world’s landmass is in emerging markets and four-fifths of the world’s population. We are also seeing many economies becoming more consumer driven in their own right.
Putting all of these facts together makes a compelling argument to invest in emerging markets. However, emerging markets are unloved which in turn forces down valuations because very few want to invest.
The difficulty is that emerging markets are seen as one large lump and clearly not all the economies are the same, with the biggest risks tending to be geopolitical and financial. For this reason, emerging markets tend to suffer disproportionally to negative sentiment, and this brings down the good with the bad.
Within the different economies India is one of the bright spots where reform is gaining momentum and in Korea there are early signs of a turnaround. Many managers favour Emerging Asia to Latin America and Emerging Europe. Therefore, to get the best returns requires careful management.
Of course we cannot talk about Emerging Markets and Asia without covering China. China dragged the markets down in June, August and September. 2016 has also started very wobbly. So what is happening?
The slowdown in China is challenging but it has to be considered in context. The core industrial side of the economy is slowing quickly, but the service side is much more resilient and now accounts for a much larger proportion of GDP compared to ten years ago. The economy is in transition and going through a change to being more consumer led.
The challenge is to manage the cyclical slowdown without undermining the structural move to a consumer led economy. The market’s reaction to news reflects the general nervousness but not necessarily hard facts. In June the equity bubble finally popped and Chinese shares had a sharp correction. Many interpreted this as a sign of a wider economic collapse which caused a further downward spiral.
This was compounded further when the Chinese devalued their currency in August, and then the US Fed seemed to indicate the reason for delaying rate increases was due to a possible Chinese slowdown.
The reality is twofold; firstly, China is in transition and growth will slow, all the signs are showing that it is on track to make the transition and secondly, the market is hyper sensitive to negative news and has a tendency to overreact as we saw last year and have seen at the start of this year.
In summary, the reasons why emerging markets should be seen as a long term investment remain. However, as an asset class it is out of favour and undervalued. When this might correct is anyone’s guess especially as the market overreacts to the slightest piece of bad news. This does mean in the short term it can be extremely volatile but over the long term the foundations are there in the fundamentals to reward investors.
Much of the year seemed to be dominated by the “when” question; when will the Federal Reserve raise interest rates?
Interestingly although the hint was that it would be September the markets had priced in a December rise! You might have thought that when rates didn’t go up in September there would be little negative impact. Of course, this was not the case and the markets spiralled downward. The main reason seemed to be the wording coming from the Fed at the time rather than the actual delay itself.
When rates went up in December there was a sigh of relief, but what September demonstrated was the potential risk going forward. Fund managers have voiced concerns that if the Fed loses control of the narrative when raising or holding rates the markets could become unsettled, creating volatility. It is therefore something we need to monitor carefully.
The move by the Fed reflects divergent monetary strategies across the developed world and this is likely to be reflected in returns moving forward. It is worth adding that there is no pressure on the US to be aggressive in raising rates, although recent job data is strong – putting it in context labour participation rates are still at 40 year lows!
Equities in the US are not cheap on average and earnings have tailed off. Excluding energy stocks, it looks better but margins will be under pressure with rising wages and wage expectations. Additionally, buybacks which have helped the market are likely to slow. The general view is that although the US can deliver positive returns these will be much lower and there might be better opportunities across other regions.
The UK is likely to be the next to move on interest rate rises but some are already putting this back to 2017. The BOE seems to be in no hurry to raise rates. Although we are seeing a moderate pick up in wage growth, inflation remains below target.
‘Brexit’ seems to be the main topic of discussion for 2016 and this will create short term volatility. Currently polls seem to favour the UK staying in Europe but nothing is certain and the uncertainty close to the poll will create tension in the markets (as we saw with Scottish Referendum and the Election). I am not a betting man but if the Scottish Referendum and the Election are anything to go by they show that fear drives the end result. It is the fear of the unknown that influences people to opt for the ‘safe’ option even if they don’t agree with it. If this plays out then it is likely the result will favour the UK remaining in Europe.
Turning to mainland Europe the fundamentals seem positive. We saw the game of chicken played out by Greece and in the end they achieved little if nothing other than to upset the markets. The likes of Italy, Spain and Ireland are now all showing positive signs of growth and it shows that rather than fighting against it, sometimes it is better to just get on with it!
There are lots of positives coming through. There are signs of a pick-up in bank lending which would indicate QE is feeding through to the wider economy. QE and loosening credit are part of the mix as are lower oil prices and Euro weakness. These should all help enhance the trading environment for European companies.
Eyes will turn to whether 2016 will see positive and growing corporate earnings figures. Growth in the Eurozone was 1.5% in 2015 and this is expected to increase in 2016 if all things go to plan. For this reason, the view remains that Europe will outperform the US as it less advanced in the economic cycle and therefore has greater growth potential.
Japan has enjoyed two good years of equity returns and this may slow in 2016. There are lots of positives to take away from Japan. They are making progress on their inflation targets, employment figures are looking healthy and there are signs that the structural reforms are feeding into the wider economy.
Valuations remain cheap in Japan and there is a cultural shift towards a more shareholder friendly attitude from companies, combined with a central bank which is supportive of risk assets. Similar to Europe Japan is also benefiting from lower oil prices as well as a weaker currency.
Although returns might be lower the view is that Japan has the ability to offer stronger returns compared to the US.
In summary we are starting to see divergent monetary strategies starting with the US (and the UK to follow) but continued monetary support in Europe and Japan to drive growth. The US has fairly full valuations when compared to Europe and Japan, and it is likely returns will be lower from the US but still positive. The UK is likely to remain volatile especially in the build up to the European referendum, expectations for returns are less clear at this stage and there remains pockets of weakness.
There were some recent discussions online about the use of cash as an asset class; the argument being that it is a ‘safe’ asset and carries little risk. This to some extent is true, but like any asset class to achieve any returns you need to be active (which in turn involves risk).
For example, if I have £20 in my pocket then in its purest form it returns nothing. In fact, just holding cash carries risk; I can spend it or hold it in a piggy bank and allow inflation to reduce its value in real terms.
To get a return I have to physically do something with it and that is where risk comes in. Prior to the financial crash banks and building societies were subsidising artificially high rates. The days of subsidised rates are not likely to return. I can therefore opt for the average rates (about 2%ish) or I can try to get something extra.
The challenge for cash investors is how to achieve those higher interest payments; some of the potential avenues are peer to peer lending, overseas banks (UK registered) and locking money in money for a longer of time (3 years plus). The problem is that all of these incorporate risk, and this is what investors have to now accept.
There is a growing argument that holding purely cash constitutes a considerable amount of risk especially where nothing is done. Investors should reconsider why they are holding cash and what alternatives are available to them.
For those prepared to take a step up the risk ladder bonds (fixed interest investments) have been an attractive alternative. However, there are concerns around the impact of rising interest rates and liquidity issues. Liquidity was the downfall of bricks and mortar property funds in the financial crash. It is at the point that everyone wants to get out that problems arise because the manager is forced to sell (and often at any price).
In December we saw a US investment firm freeze withdrawals from their high yield fund and some funds dropped to their lowest value for six years. Fund managers are talking this down but as highlighted in the previous update the FCA is concerned about liquidity within the sector.
The point of this is that the outlook for bonds is uncertain, there may be opportunities but there are considerable risks which no-one has a clear view on.
In summary to sit back and do nothing with cash carries risk, to achieve higher rates carries risk and to opt for bonds takes a step into the unknown. There are of course alternatives which again carry risk but might act as a middle ground.
What will 2016 bring?
The big question for many is whether we are heading towards a global slowdown. Lehman was nearly eight years ago and as investments move in cycles in theory we should be close to another one.
The signs are not there yet but the impact of QE remains uncertain. There is a strong argument that some companies which should have failed due to “creative destruction” have been artificially kept alive and this has produced excess capacity. At some point this will likely correct but there are no signs of this is anytime soon.
This risk shouldn’t be discounted but it is unlikely to play out in 2016. More pressing concerns are similar to 2015 – ISIS, China, Oil Prices etc. China will remain a big play on volatility as it filters out globally as we saw in 2015.
Emerging markets are going through a period of entrenchment and adjustment and where they bailed out the world economy when the developed markets were going through this, it is now the turn of the developed markets to carry the baton. The US is much further up the recovery curve and it is hard to see stronger growth moving forward, however Europe is further down that same recovery curve and likely to pick up the slack from the US. Of course this depends on many factors and eyes will be on corporate earnings.
Japan is still one to watch but unlikely to deliver the stellar returns we have seen in the last two years. In the UK there will be greater volatility as we move closer to the referendum and it will be interesting to see if fear of the unknown ensures that the UK remains part of Europe.
Our view is similar to 2015, we think returns will be single digit (between 5% and 8%) and volatility will be part of the normal events.
Source: Charts have been sourced from Morningstar. Other data sourced from Schroders, Templeton, Threadneedle, and JP Morgan.
NOTE: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.