FYI Spring 2015

FYI: For Your Investments. Spring 2015

In brief

The first quarter of 2015 has been very strong for markets, especially in Europe. As I write, the FTSE 100 is up by 7% since the beginning of the year, the German DAX is showing an increase of 21% while the S&P 500 has risen by a modest 2%. The Fixed Income market has also performed well globally, especially in the Eurozone where the Quantitative Easing (QE) programme by the European Central Bank (ECB) has started to be implemented.

With regards to currency, the euro has continued to depreciate and is now down more than 20% versus the dollar and down 13% versus sterling compared to a year ago. This phenomenon coupled with a very low oil price and the intervention of the ECB is starting to boost the confidence of the Eurozone. In turn, we are seeing economists gradually raising their economic forecasts on the region. Of course some risks prevail, especially relating to the Greek political situation.

As we highlight in this edition, we are running a prudent approach on UK equities for the coming months. Uncertainties should linger until the election and even later if a coalition is not soon formed or if the Conservatives stay true to their promise and call for a referendum on Britain’s exit from the European Union (Brexit).

In the current environment, we continue to favour equities, although we could see some more volatility after the strong rally in some regions. Valuations may appear expensive in some markets, but we anticipate that the ample global liquidity will be supportive for the asset class. In contrast, in Fixed Income markets, yields are now so low that it is difficult to find good opportunities.

Inside track

 

The upcoming UK election is both very unpredictable and potentially very significant for many sterling investments. The Conservative and Labour parties have been neck and neck in the polls for some time and smaller parties are expected to attract a significant proportion of the votes.

UKIP polled very strongly in the European elections and although it is not expected to do as well in the General Election, it is likely to attract a reasonable percentage of the votes. However, it is difficult to predict how this will affect the main parties under the first past the post system, where the distribution of votes across seats is critical.

The Scottish nationalists may also do very well in the Election at labour’s expense and they have indicated that they do not want to be part of a coalition government. The decline of the liberal Democrats and the growth of the Green vote also complicate the picture.

The most likely outcome is that no party has an overall majority and that a coalition is created, but it will be a challenge to create one with stability. This could make economic decisions very difficult to make and result in damaging uncertainty.

Assuming a viable government can be formed, led by one of the two main parties, there will still be plenty to concern investors.

 

A Conservative-led Government and the risk of a Brexit
The Conservatives are usually considered to be the most business and investor-friendly party and the prospect of policy continuity would be a positive. However, they go into this election promising to hold a referendum on the UK’s membership of the European Union (EU) no later than 2017. Whilst we suspect that the electorate would opt for the status quo as a last resort rather than risk the uncertainty associated with an exit, there is plenty of room to doubt this and the economic consequences of a Brexit would be considerable.

The Conservatives have promised to renegotiate the terms of the UK’s membership of the EU in the hope that they will be able to get improved terms focusing on free trade, whilst enabling the UK to take some powers back and allowing more control on immigration. Unfortunately there seems to be no appetite in the EU for such concessions and even if there was, the complexity of making treaty changes is a huge hurdle. Given this background, the risk of failed negotiations leading to a referendum and a vote to leave the EU has to be taken seriously.

Since the UK joined the EU, trade with the region has increased from about 40% of the UK’s total to about 50%. Dealing with changes in regulations and potentially tariffs would create considerable uncertainty and a lot of work for UK companies. The finance industry could be particularly adversely affected if global finance companies focused activity on a centre within the EU.

We would also expect foreign direct investment into the UK to be weak leading up to a referendum and after a Brexit.

In this scenario we would expect UK equities to be weak and sterling to also fall as investors sold UK equities and foreign direct investment was subdued. Shorter-dated gilts would probably be supported by flight to safety money, but longer- dated bonds might suffer due to the weak currency and a lack of foreign buying because of the uncertainty.

 

A Labour-led Government
A labour-led Government would be less keen on spending cuts and would therefore be likely to run a larger budget deficit, potentially damaging the UK’s economic credibility. This would be expected to be a negative for both gilts and sterling, although any stable Government would probably be viewed better than a prolonged period of uncertainty.

On the equity side, much of the FTSE100 is so international that their earnings would not be significantly impacted by a new labour led Government. However, specific measures proposed by labour could be negative for utilities and banks.

Energy utilities could be hurt by labour’s green agenda, setting higher targets for renewable energy and decarbonisation as well as a possible windfall tax on nuclear energy. Talk of a price freeze for energy bills is also negative for the sector. The overall regulatory environment for utilities could be expected to be less shareholder friendly.

Labour would also be bad for UK banks as a proposed increase in the bank levy and a one-off tax on bonuses would add to costs.

 

The Scottish question
Whichever party has the most seats after the election, there is a good chance that the Scottish nationalists will have enough seats to exercise considerable influence and obtain still greater devolution of powers. This in turn is likely to strengthen the calls for Scottish mPs, as well as other non-English mPs, to be excluded from votes that do not affect them. Such an outcome could lead to Governments with a majority for some issues, but not others. Overall this is a further cause of policy uncertainty and a negative for UK assets.

 

Managing portfolios leading up to the election
We do not see any election outcome that is clearly beneficial for UK equities, so we prefer to be underweight and increase our exposure to international equities. For Japanese and European holdings we hedge the currency exposure back into sterling as the printing of money in these areas is likely to leave their currencies weaker than sterling. With other markets we are happy to have currency exposure, believing that sterling will not be strong.

For fixed income exposure, we are comfortable with shorter-dated instruments, but are cautious on longer-dated bonds. With interest rates likely to rise reasonably soon we prefer to limit interest rate risk, particularly at a time of such uncertainty.

We are also keen to keep a good level of exposure to the US dollar as relative economic strength in the USA is likely to lead to further appreciation of the dollar, particularly during periods of heightened uncertainty.

We cannot tell you the shape of the next UK Government, but we will be carefully monitoring the risks to portfolios and taking steps to mitigate them.

 

 

Insight

 

United Kingdom
2015 started positively with most major global equity markets showing gains. The benchmark UK FTSE 100 was no exception and it was dragged higher at the start of the year, although gains were muted compared to many other markets. However this, as most of the good news for investors, came from outside of the UK and the large weighting to the poorly performing energy and mining companies within the FTSE benchmark proved to be a drag on performance.

The overhanging fear of tightening monetary policy and the forthcoming general election in may 2015 also held back investor appetite for UK shares. Businesses perceived to be most vulnerable to political uncertainty; regulatory challenges and rising interest rates were by far and away the worst performing areas of the market with utilities, banks and healthcare companies lagging whilst economically sensitive sectors performed strongly. Amongst which, consumer orientated areas did particularly well, with retailers, media companies and industrials leading the way higher.

Heavyweights within the FTSE including household names such as HSBC, royal Bank of Scotland, Anglo American, royal Dutch Shell and Centrica did not fare well and fell during the period in contrast to Tesco which rallied over 20% after its much publicised problems in 2014.

 

United States
The headline inflation reading actually fell during the first quarter by 0.2 percent versus one year ago, illustrating the impact of the falling oil price on the wide economy. The severe impact of oil is laid bare once food and energy are excluded, leaving the core year-on-year Consumer Price Index rate with a more healthy 1.6 percent increase. The Fed Chair, Janet yellen, did not view this with concern and described this weak number as transitory.

The market is focused on the consumer and on businesses, which are gaining more discretionary income with these lower costs, while at the same time the labour market is stronger than expected.

It is now broadly accepted that there will be a rise in interest rates this year, despite the weaker headline inflation print and the consensus expectation is for somewhere between June and September. This belief was further reinforced when the Federal Open market Committee (FOmC) dropped the “considerable time” phrase from their minutes, replacing it with “patient”.

The US dollar has also moved along with these expectations, with a relentless rise versus its main trading partner the euro, with strong anticipation of a move back to parity. The strength of the dollar will be a drag on earnings of US companies and we would expect gains in US markets to be relatively subdued this year.

 

Eurozone
It was a long time coming, but the European Central Bank (ECB) finally committed to a monetary ‘bazooka’ in January – €1.2 trillion in QE has been pledged to bond purchases over the next 20 months and ECB President, mario Draghi, promised this would be extended if necessary.

Concurrently we have started to see some signs of a nascent recovery in the Eurozone economy and this, combined with easing austerity measures this year leads us to be more positive about the prospects for European equities.

So far this year, the most significant effect of QE has been a dramatic weakening in the euro, particularly against the dollar. This is good news for European exporters and looks particularly positive for the powerful German manufacturing sector. The sharp fall in the oil price will also help this part of the economy.

The recent Asset Quality review (AQr) of European bank balance sheets gives us comfort that the sector is now broadly well capitalised. This should provide a solid lending base as demand for credit gradually improves, but with interest rates expected to remain low for an extended period we see limited upside for bank shares in the short term.

 

Japan
Investors returned to Japan and bid the market higher at the start of 2015, with broad-based gains across most sectors seeing both domestic and export orientated parts of the market rising. Gradual yen weakening and ongoing hopes of further structural reforms seemed the main catalysts, although there is also an increasing view amongst investors that the Japanese market represents increasingly good value and has some of the best global earnings momentum on offer.

As we saw elsewhere, pharmaceuticals and retailers led the way higher whilst defensives such as utilities and energy companies underperformed. Japanese pension funds have been large buyers of equities and we expect domestic demand to continue to support the market.

 

Emerging Markets
Our view at the start of the year was to favour Asia and remain cautious on latin America and the Europe middle East & Africa (EmEA) region. This call has proved to be correct, as Asia Pacific indices have outperformed the wider Global Emerging market indices and also the mSCI World Index (performance in USD terms as at 28 February).

Our ‘overweight’ view on Asia Pacific remains, but we should flag the potential for increased volatility brought about by the Fed hiking interest rates. This has already caused some stress in exchange rates for some of the weaker latin American and EmEA countries, but has yet to manifest itself in equity markets. Selecting the strongest economies and companies is key in this environment.

The disparity between commodity producers and commodity consumers remains and we favour the latter, with lower oil prices reducing inflation and helping the current account balance of importers. As a big importer of oil, India is a clear beneficiary and coupled with ongoing political reforms and infrastructure spending the outlook remains attractive.

The other Asian heavyweight is China, where the Government continue to target GDP growth of 7% whilst steering the driver of growth away from infrastructure investment towards consumer demand.

Compared to developed markets, emerging markets are attractively valued, with an estimated P/E ratio of 11.6x versus 16.7x for developed in 2015. Emerging market P/E ratios also stand at a discount to their 10-year average, whereas developed markets trade at a premium and are looking slightly expensive.

 

In an uncertain market environment, volatile price swings are likely. Investors are trying desperately to gauge when interest rates will normalise. At the end of January, UK 10-year Gilt yields had dropped to a low of 1.3%. A great start to the year for holders. The release of the January Bank of England (BoE) minutes saw two hawkish members of the committee withdraw their support for an immediate 0.25% rate hike given the expected downward pressure on inflation. This was not anticipated as previously they argued that the committee should look through near-term pressures. However, in February the release of the BoE quarterly inflation report conveyed a fairly hawkish tone, consistent with the view that the weak headline inflation is largely driven by a drop in energy and should therefore be temporary.

The 10-year yield was close to 2% at the beginning of march. Unfortunately it does not look like the investment landscape is going to get any clearer with additional factors influencing yields.
1 - The strength of sterling. Carney commented that the performance of sterling will help determine the ‘pace and degree’ of interest rate increases as a strong sterling imports disinflation. About 45% of the UK’s trade is in goods within the euro area, with the pound trading near a 7-year high.
2 - The ECB €1.1 trillion bond-buying plan has dragged down sovereign rates across Europe. The yield difference between 10-year gilts and German bunds recently reached the widest since 1997. The German 10-year yield is approximately 0.25%. The lower we see suppression of yields in Europe, the more relative value of gilts stands out, thus attracting buyers.

On balance we continue to believe the risk of rising interest rates makes it prudent to focus on shorter maturity bonds.

 

CURRENCIES

The US dollar has enjoyed a period of sustained strength fuelled by speculation that the Fed will raise interest rates within six months, while other global central banks either embark on or further embrace monetary stimulus. At the time of writing, the US dollar Index had gained almost 10% for the year.

The fall of euro versus US dollar has been spectacular. mario Draghi, President of the ECB, finally succumbed to full blown QE via the Public Sector Purchase Programme (PSPP), effectively buying €60 billion per month of Government, agency and supranational debt. He cited deflationary pressures and the hope to further stimulate growth in the ailing Eurozone economy.

The Japanese yen slowed its pace of depreciation; it remained weak against the US dollar, but regained some strength versus the euro.

As a General Election looms in the UK, sterling could come under pressure. Neither the Conservative or Labour parties seem likely to secure an outright majority or even a viable coalition. Investors are starting to ponder the effects of potential weak alliances or even the prospect of a second election.

 

COMMODITIES

This quarter saw some positive moves in oil prices through February which were initially triggered by the widely publicised decline in US rig count (weekly Baker Hughes US Crude Oil rotary rig Count Data) which is seen as a leading indicator of future US supply growth. The decline in the number of rigs suggests a fall in future production. However, the sharp rise was short lived as production continued to reach record levels and oil prices retreated from their February highs.

We believe that commodity prices will remain under pressure for some time as slowing demand is met by increased supply following large company expenditure during the commodity bull cycle. Company Capital Expenditure (“capex”) was increased, to meet demand, in response to increasing prices through 2000-2010. The increased capex does not bring about immediate supply growth as projects can take many years to complete and come online. Over recent years, supply has caught up and there are still many committed projects in the pipeline, resulting in a negative imbalance between demand and supply which could be a drag on prices for an extended period.

Informed

 

Sterling benchmarks showed solid gains in the first quarter with the more equity focused ones doing best. Bonds showed only modest returns as uncertainty over the timing and magnitude of interest rate rises led to a lack of consistent direction in the market. UK and US equities showed modest gains, whilst European and Japanese equities rose sharply. The rise in European equities was partly offset by weakness in the euro. The US benchmarks show only small gains as the strength of the US dollar held back US equities and reduced the value of non-dollar assets.

The data for the final month, march 2015, covers the period up to the 12 march and will not agree with valuations which will be based on data for the full month.

SGPB Hambros calculates composite benchmarks appropriate for different investor objectives, based upon mSCI Equity indices, Bloomberg/EFFAS Bond Indices, merrill lynch 1-10 years UK Gilt, merrill lynch 1-10 years Sterling Corp. The proportions vary according to strategy and are available on request.

Past performance should not be seen as an indication of future performance. Indices are for guidance purposes only.

Investments may be subject to market fluctuations and the price and value of investments and the income derived from them can go down as well as up. your capital may be at risk and you may not get back the amount you invest.

All information is based on current tax legislation, which can change. SGPB Hambros Group does not provide tax advice. The level of taxation depends on individual circumstances and such levels and bases of taxation can change. you should seek professional advice in order to understand any applicable tax consequences.

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SGPB Hambros CI and SGPB Hambros CI, Guernsey Branch are regulated for banking, investment, funds services and money service business by the Jersey Financial Services Commission. SGPB Hambros CI, Guernsey Branch is also regulated for banking and investment business by the Guernsey Financial Services Commission.

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Societe Generale Private Banking Hambros is part of the wealth management arm of the Societe Generale Group, Societe Generale Private Banking. Societe Generale is authorised by the Banque de France and the Autorité de Contrôle Prudentiel et de Resolution (Prudential and Resoution Control Authority) in France and under the prudential supervision of the European Central Bank – ECB. It is also authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.

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