Archives for July 2014

A Quietly Profitable First Half

At the beginning of 2014 we forecast that investing in markets this year would be less profitable but more volatile than in 2013. So far in 2014 the first aspect of our forecast has been borne out, with most asset classes showing total returns of between 0% and 5%, the major exception being UK commercial property with a total return of about 8%. However, markets have become less and less volatile and investors have become progressively more comfortable about the outlook for market returns. We continue to expect volatility to increase in the second half as the time for interest rate increases in the US and the UK is nearing. This note explains our views on recent market developments and the rationale for our tactical asset allocation positions for the second half, which remain Smaller Company Shares and Commercial Property in the UK, and Asian and Japanese Company Shares.

The first half of 2014 in financial markets can best be described as “quietly profitable”. It was profitable in that both bond and equity markets provided investors with modest gains (in low single digits). It was quiet in that markets did so with very little volatility or drama; in addition, transaction volumes in most financial markets have been surprisingly low, as investors, who have little desire to hold cash, which earns little to no return are struggling to find attractively valued investments to purchase. However, most economic and geo-political developments during the first half are more easily interpreted as negative rather than positive for markets, as follows:

  • The IMF has reduced its forecast for global GDP growth in 2014 from 3.8% in January to 3.4% in June, principally due to weak performance from the US and China, which are the world’s two largest economies. In the US, this has been ascribed to dreadful weather in the first quarter, which led to a contraction in the economy over that period; for example, the Goldman Sachs estimate of Q1 growth in the US has been revised down from 3% in January to -2%. The authorities in China have changed tack and are now seeking quality rather than quantity in their GDP growth. They are allowing the private sector rather than the public sector to lead economic development, which should mean that growth is based on profit-maximisation rather than employment-maximisation.
  • In both the US and the UK, the central banks are moving away from the extraordinarily easy policies of the last five years. In the US, the QE programme is being steadily reduced and is likely to have ended by Q4 this year, while in the UK, the rapid fall in unemployment has meant that markets now expect an interest rate increase by year end. These reversals in policy direction are likely to prove to be a headwind for both bonds and equity markets during the second half.
  • In Europe, the rate of inflation has fallen to extremely low levels. Over the Eurozone as a whole it is now 0.5%, but for many of the weaker economies it is now negative, creating a problem for debtors as the real burden of their debt increases. The ECB produced a raft of technical measures to loosen its policy, including negative interest rates on deposits left at the ECB by the banks, but failed to announce the QE programme which the markets believe will be required.
  • The Russian annexation of Crimea and the subsequent uncertainties in Ukraine have highlighted Europe’s dependence on Russian gas and on the goodwill of President Putin. The Western powers have found no meaningful response to Putin’s actions. Their dilemma was reinforced by the announcement of a 30 year deal for Russia to supply gas to China from 2017, the implication of which is less availability of supply to Europe – and less reliance of Russia on its European gas customers.
  • More recently, the Islamic State uprising in Northern Iraq has also left the West struggling to formulate a response, and it is clear that there is no longer any political will to commit significant numbers of troops on the ground or intervene in such troubled areas. However, Iraq is the world’s second largest oil exporter, and a threat to production in Iraq is likely to lead to a sharp rise in the oil price.
  • Following May’s European parliamentary elections, about 25% of the MEPs now represent anti-EU, anti-Euro parties. This is not enough to force any change in Brussels, but should send the message to Europe’s politicians that the political choice in most of Europe between abandoning austerity or remaining in the Euro, is beginning to move against the Euro. France and Italy are the two countries where this key political decision is being increasingly debated.

With bond yields having declined and share prices having risen faster than corporate profits, financial markets have become less attractively valued over the first half of the year. In addition, there are indications that investors are becoming overly confident. US-based investment advisers are the least bearish they have been for several years, there is a record level of US shares bought on margin (that is with borrowed money) and the debt covenants accompanying recent non-investment grade corporate bond issues have become materially weaker. The levels of implied volatility in bond, equity and currency markets are all at the very low levels last seen in 2006/2007, suggesting that investors are ascribing a very low probability to any upsets in markets. History suggests that, following a five year bull market, such an assumption is fraught with danger.

Western equity and bond markets are thus vulnerable to setbacks in the second half. However, markets in Asia and Japan are more attractively valued, have better growth prospects and have investor bases who are much less complacent about the future than investors in western markets appear to be.

In the UK, the domestic economic recovery has continued to accelerate, though with little assistance from demand from the US or Europe, the UK’s two main trading partners. This domestic recovery is expected to continue and supports our emphasis on investments in commercial property and in smaller company shares, rather than mid-cap shares. Both property and small caps have performed poorly over the last decade but appear ready to make up for these disappointments through their sensitivity to the recovery in domestic spending.