FYI Winter 2014-15
FYI: For Your Investments. Winter 2014-15
2014 was an eventful year. It included geo-political shocks, such as the Russian invasion of Crimea, the collapse of the oil price by almost 50%, the Argentinean technical default and very recently the second potential meltdown of Greece.
Fortunately the situation in the UK has been better, with the economy growing at around 3% and the decision of scotland to stay in the UK. In this context, our strategies have been able to benefit from the performance of the bond market, although we did not fully anticipate the rally of long term gilts. Our allocation on equities has also been globally positive, especially in the us which was certainly one of our best calls for the year. In a low yield environment, our Balanced Income Plus strategy, focusing on income, has also been very successful.
Looking forward, we think that the environment will continue to be supportive for investors. The US economy should carry on growing at around 3% to 3.5% next year and China will only decelerate at a modest pace with 6.8% growth anticipated for 2015. We believe central banks policy will remain accommodative, although we might see a gradual adjustment in the US. The weakest link for this year will come from the Eurozone and some emerging countries, especially in South America.
With the volatily levels normalising in 2015, investors who want take advantage of opportunities should be prepared to see significant price swings, inherent to listed investments, and hold their nerve when they occur.
On behalf of the investment team and all of us at SGPB Hambros, I would take this opportunity to wish you a very happy and prosperous year.
At the end of 1985, Saudi Arabia launched a price war in the oil market. The price of West texas Intermediate (WTI) fell from $31.82 on 20 november 1985 to $9.75 on 1 April 1986 – a decline of almost 70%. What led them to this course of action?
In 1985 the Soviet Union became the world’s largest oil producer; there were multiple reports of cheating on quotas by Organisation of the Petroleum Exporting Countries (OPEC) members; and the Saudis were supporting the Iraqis in the Iran Iraq war. Then, and now, Saudi Arabia was the world’s low cost producer of oil so the price war protected it’s market position, disciplined other OPEC members and undermined Iranian finances.
This year, thanks to the remarkable developments in extracting shale oil, the United States has become the world’s largest oil producer. there has been surprising strength in oil supply from countries like Libya, Nigeria and Iraq and there is a new and more complex version of the Sunni Shia struggle being played out in Iraq and Syria. Once again, Saudi Arabia launched a price war making pretty clear that the aim was to protect it’s market share. The similarities between 1986 and today are reasonably clear as is the Saudi response. To date, the price of WYI has fallen below $60, a fall of over 40% and recent comment suggests that the long term equilibrium price is likely to be around this level. How realistic is this expectation?
For the 5 December 2014 issue of the Economist, the cover title was “Sheikhs v Shale”. there is a fairly widespread assumption that the shale producers have break-even costs somewhere above $60 a barrel and are therefore likely to be amongst the prominent victims of the price war. Interestingly, the producers in north Dakota and Texas do not seem to have read the memo as us oil production to early December was still shooting up, despite 6 months of falling prices.
Why no supply response, yet, in complete contrast to producer behaviour in 1986? We believe there are several reasons. the first reason is that very low interest rates have reduced the cost of debt capital for the exploration and production companies which have driven the boom. Marginal businesses slash all other costs to focus on producing enough oil revenue to cover the funding costs. this will probably persist for rather longer than most of us would think reasonable.
Secondly, we should not underestimate the speed of the technological revolution in shale production. In November 2014, the Energy Information Administration published a report showing that oil well productivity in the Permian region of texas had been running at 1.5% a month for over a year. This is the equivalent of the breakeven cost of production of oil falling at a rate of a dollar a month. This sort of rate of improvement is often claimed (and sometimes believed) in the technology industry; to see it in a business which is over 150 years old is a really eye-catching achievement.
Thirdly, some oil producers have hedged a lot of future production. Concho Resources, for example, have hedged a substantial portion of 2015 production and perhaps half of 2016 production.
Lastly, outside the United States there are many producing countries such as Venezuela or Libya who need the oil receipts and will no doubt try to hold up or even increase production to try to maintain the flow of dollars.
How long can Saudi Arabia finance a price war? In October 2014, Saudi Arabia’s foreign currency reserves were reported to be almost $750 billion – roughly the size of their own economy – while debt levels are minimal. they are in a position to pursue the price war for a long time to come.
With neither side seemingly yet ready to shift their position, it seems reasonable to expect that the oil bear market will last a long time and will see prices fall much further. In early December the Energy Information Administration revised its expectation for the growth in oil demand in 2015 from an increase of 1.12 million barrels a day to 880,000 barrels a day. It is only a small drop, but it illustrates how hard it will be and how long it might take to get the oil market back into some sort of balance.
At some time in 2015 it is likely that we will start to see some production cuts – marginal producers in marginal shale fields will no doubt be part of this process – but more obvious candidates are those working in hostile environments far from markets: deep offshore and the Arctic production looks vulnerable to cut backs. Companies servicing and providing equipment for that production are likely to experience difficult trading for some years to come. More broadly, the distress in some countries which are large producers is already obvious.
Deep recessions and large devaluations will be a part of their economic life for years to come. Unexpected losers from the process will probably include financial companies who turned out to be the ultimate counterparts of the hedging transactions taken out by oil producers.
The obvious beneficiaries are consumers and oil importing countries. Those benefits will probably flow through over the next 2 or 3 years. Lower inflation rates should mean that interest rates in, for example, Britain and America rise less than looked probable 6 months ago. Reduced spending on energy should free up consumer demand for all sorts of other products and services. In the 1980s, lower energy prices underpinned the expansion in the second half of the decade which only came to an end with rises in interest rates in 1990 in Japan, as they sought to burst the property and equity market bubbles, and in Germany post reunification, and in the United States, which ultimately triggered the crisis in the Savings and Loan industry. If history is any guide the fall in the oil price is likely to provide a favourable backdrop for the economy and securities markets for some time to come. It also, however, suggests that success will ultimately lead to excess so all of us should be on alert for the warning signs that the favourable trend is deteriorating.
And the oil price? Apart from a brief spike up during the First Gulf War it stayed between 10 and 25 dollars a barrel until the end of the century. This time, who knows, but a long period of subdued prices looks likely to lie ahead.
The UK equity market has been buffeted by mixed domestic data, but more so by the dramatic fall in oil prices, continued weakness in the Eurozone and concerns over the timing of a rise in US interest rates. It is no surprise to find then that the energy and materials sectors have been the weakest performers, whilst the transportation companies have been one of the main beneficiaries. Whilst the equity market is not particularly cheap in absolute terms, it looks attractive compared to other asset classes.
In company news, BT is in talks to buy EE or O2 in a deal that is seen positively by the market as it would make it the largest UK phone carrier with both landline and wireless services to complement its broadband and TV offering.
On the economic front, the Bank of England’s last inflation report was more dovish than expected as it lowered inflation estimates to below 1% over several months and also reduced the outlook for UK gross domestic product (GDP). The property sector, which has shown signs of cooling in recent months, received yet another boost in early December ahead of an election after the Chancellor announced a reform to stamp duty rates.
In a normal cycle, the Federal Reserve (Fed) would have been expected to raise its key interest rate some time ago. However this time round in the US, given the weakness and uncertainty, the Fed has been keen to ensure that rate rises would not choke off any nascent recovery, and opted to remain behind the curve in tightening; this appears to have now finally paid off. Growth numbers in the third quarter have virtually confirmed the US recovery to be in full flow, negating the very weak start to the year attributed to cold weather. With growth running at an annualised rate of well over 3% and importantly unemployment is also below its long-run average.
This recovery has been spurred on over the last three months with the strengthening of the US dollar corresponding to the weakening in commodity prices, in particular to the oil price. Falling gasoline prices act rather like a direct tax cut to the us consumer and spur both consumer sentiment and spending.
This has been supportive for the consumer sectors in the US, along with the energy heavy transportation and industrial sectors, while energy companies have been hit hard as projections for the nadir in the oil price are being revised down.
The last quarter was again volatile for European markets. Investors had to navigate a raft of significant news; weaker economic data and a deteriorating outlook for recovery on the one hand, set against another flood of global liquidity, growing expectation of European Central Bank (ECB) quantitative easing (QE), a weaker euro and the falling oil price on the other. For now, investors seem prepared to see the glass as half full.
Further Japanese QE kicked off a recovery across most major markets, but it is speculation about the ECB’s response to this move that has arguably provided most support to European equities. It is clear a weaker euro would be welcomed by most European exporters and the sharp fall in the oil price (though muted by currency) can only help. Further weak German data, auguring economic contraction, may offer the ECB their best chance to gain consensus for looser monetary policy.
Without a clear valuation case, and with reservations about the ability of the EU to transmit looser monetary policy into the real economy, we remain cautious near term. We prefer to own those internationally diversified companies that benefit from the weaker euro, and consumer-related stocks that should benefit from the lower oil price and the attendant increase in disposable income.
Despite entering a technical recession, the Japanese market was amongst the best performing ones in the quarter. Prime Minister Abe continued the quest for reform with the calling of a snap election in December to cement a second term in office and ensure no loss in economic and policy momentum. This was taken positively by investors who pushed up the equity market and sold down the yen. Despite a disappointing contraction in GDP, investors focused on the approaching restart of 48 nuclear reactors, the continuing weakening of the yen and the fall in oil prices as being considerable tailwinds for Japan. Falling commodity prices lead to oil and mining stocks lagging whilst transport and chemical sectors gained. Japan has been one of the stronger markets this year, but investors have needed to be currency-hedged as otherwise the weakness in the yen would have offset the impact of rising share prices.
We entered 2014 with a cautious view on global emerging markets, concerned on how the end of US QE would impact on the weaker emerging market (EM) economies, potential outflows of capital from these countries and weakening currencies. We also highlighted the disparity between the stronger and weaker economies within the emerging market universe.
As the year progressed we did indeed see a big disparity in performance between countries and regions, and some steep currency depreciation in the weaker countries. In general, the Asia Pacific region has performed well, led by India and China, whilst Latin America and russia have been weak.
What has changed during the year? Too much to list, but perhaps the most significant changes are the steep decline in the crude oil price and the end of US QE.
Markets have survived the end of US QE, but not without some weakness and were buffered by the almost simultaneous launch of the Japanese QE programme – with further expectations of stimulus from the ECB.
A sustained lower crude oil price will bring huge disparities between the countries which produce and export oil (Russia, Brazil) and those which import (India, and in fact most Asian emerging countries). For the importers, lower oil represents a stimulus to growth, and an improvement in trade balances. It will also contribute to lower inflation, perhaps allowing Governments to ease monetary policy. For oil exporters, balancing the budget will become painful, more so for those with weak foreign currency reserves.
Entering 2015, we continue to favour Asia and remain cautious on Latin America and the EMEA (Europe, Middle East and Africa) region.
The strength of bond markets continued to surprise commentators in the fourth quarter as the yield on gilts fell again. Falling oil prices, stagnation in Europe and slowing growth in China have reduced inflation expectations which are already weak.
Although yields are much lower than the start of the quarter, it has not been a one-way ticket. Any data which questions a us or UK recovery, yields fall and data which allays economic concerns, yields rise. At the beginning of October, US inflation dropped surprisingly and the UK 10-year yield dropped from 2.4% to under 2%. However, US jobless claims posted a sharp fall in mid-October and the 10-year yield was soon back over 2.2%. In November the falling yield trend resumed after the quarterly Bank of England (BoE) Inflation report proved dovish. All told, this suggests that there is little need to tighten policy in the near future.
It has been a similar trend in other "safe-haven” government bonds. Expectations of further ECB action and non-existent inflation across Europe, saw the 10-year German Bund yield drop to 0.7%. As the hunt for income continues, the yield pick up available on peripheral Europe sovereign debt is proving attractive. Both Italian and Spanish yields fell with Spain’s 10-year debt below 2%.
Next year monetary policy should continue to diverge between the US and the rest of the world. The market consensus is for a first rate hike in mid 2015. However, there is much disagreement on the pace at which rates will rise. With the ECB looking likely to open the coffers again next year, it will certainly make 2015 very interesting.
The US dollar strength has been persistent, partly aided by improving domestic economic data, but largely due to co-ordinated large-scale easing measures by Japanese and Eurozone central banks.
The yen experienced renewed weakness after the bank of Japan (BoJ) unexpectedly expanded its asset purchase programme to Y80 trillion from Y60-Y70 trillion, as the 2% inflation target was at risk given sluggish inflation readings. In December USD/JPY went through Y120, a level not seen since 2007 and incredibly, nearly 60% weaker since 2012.
For the euro, the ECB is under pressure to enact full blown QE as deflationary pressures persist. This will weigh on the currency and despite a 10% decline in the EUR/USD rate, from 1.38 to 1.23 between June and December, we expect further downward pressure. We target 1.17 over the next 6 months.
After a short-lived relief rally following the Scottish referendum, the sterling has turned down again. Market expectations of the first BoE rate hike have been pushed back. Weak inflation readings may explain the sterling's current lack of legs, as the central bank is not under pressure to tighten soon. Elevated twin deficits carry further downside risk for the pound in the year ahead, but for the time being we anticipate a period of stability.
The headlines have been taken over with news of the falling oil price. Having started the quarter at $89 per barrel and continued to decline, the rapid fall in prices has markedly affected global markets performance and shaped their future also. With OPEC not looking to cut supply we suspect the price has further to fall creating winners in the transport sector and further losses in the energy sector. Oil export countries are likely to feel the pinch, whereas net importers such as the US, China, Japan, India and South Korea should feel the benefits.
The multi-year downtrend in gold should continue during 2015 once the Fed adopts a more hawkish tone and the market starts pricing in a faster pace of rate hikes. Added to lower inflation expectations from a cheap cost of energy, gold is likely to be a loser next year.
Base metals prices have held up remarkably well this year despite the weak performance of many other commodity prices and despite the ongoing slowing of the Chinese economy. Aluminium was helped by production problems and nickel, zinc, lead and tin prices have been underpinned by expectations of future supply constraints.
The most striking feature of the last quarter was the rapid fall in the oil price. This led to lower inflation expectations and a continuation of the bond market’s recent strength. Equity markets have reacted more nervously, interpreting it as a sign of weak growth, although part of the story is clearly one of growing supply. The FTSE 100 has been particularly held back by a high weight in energy companies. Overall, benchmarks with a high bond content have continued to show strong returns, but equity-focused benchmarks have struggled.
The data for the final month, December 2014, covers the period up to the 11 December 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/EFTAS Bond Indices, Overnight Libor cash rates and HFRX Global Hedge fund indices. 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.
From the start of 2015 we will be using revised benchmarks for the core GBP strategies. The changes will not change the risk profiles of the strategies or benchmarks. The new breakdowns are shown below:
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