FYI Summer 2014
FYI: For Your Investments. Summer 2014
Overall, the last six months have been more positive and most
asset classes have performed well in this period.
The more volatile emerging markets have recouped some ground and the bond markets, both government and corporate, have ontinued to reflect the high level of investors confidence.
At the economic level, the picture is also positive with the US ecovery proving to be sustainable and the Eurozone, peripheral ountries gradually implementing the required reforms. The UKhas taken all economists by surprise in a positive way, and is howing a growth level of 3% for 2014.
Within this positive environment, the market is starting to anticipate hat central banks, in the US and the UK, will gradually normalise their monetary policy.
As this will have a negative impact on the bond markets, we have recently reduced our exposure to corporate bonds especially investment grade. In the meantime, we have increased our exposure to absolute return vehicles which we anticipate tooutperform in the coming month.
I wish you a very good summer.
A few years ago, it was not a foregone conclusion that deflation would be the most prominent risk in the aftermath of the global financial crisis. Widespread deleveraging has acted as a brake on the recovery. Bank lending has only recently started to pick up in the US, while outstanding Eurozone credit continues to contract. In the UK, credit has expanded. This is driven by government schemes such as "funding for lending" and this seems to be steering growth upward after a prolonged period of stagnation.
Although it is probably too early to conclude that the "new normal" of lower economic growth and tamer inflation than before the crisis is here to stay, the recovery still appears more subdued than during previous business cycles.
In developed markets, central banks are maintaining a very accommodative stance, delaying the withdrawal of extraordinary stimulus measures as they fear a repetition of the Japanese "lost decades" of the 1990s and 2000s. The European Central Bank (ECB) had been lagging its developed market counterparts, but it has now been forced to introduce credit easing measures and is about to embark on fully fledged quantitative easing as deflation risk appears increasingly entrenched.
However, 2014 is set to be a transitional year for the US Federal Reserve (Fed), which leads the global recovery. The Fed's asset purchase programme is due to be phased out before year end, but the reduction of its balance sheet will take years and no asset sales are on the cards for the moment. There now seems to be a real possibility of rising central bank rates both in the US and the UK within a year.
Forward guidance on interest rates has become a common tool for central bankers as a way to anchor yields at low levels and to influence investors' expectations. Until early 2014, the market consensus had been more aggressive, with expectations of a significant pickup in US yields reflecting a sanguine view of US economic momentum.
US yields are set to be a key indicator of monetary policymaking, nominal growth prospects and asset price trends. As already observed when Bernanke, the Fed Chairman at the time, hinted at a gradual winding down of the asset-buying programme in May 2013, the US housing market is highly sensitive to a run-up in yields. Additionally, under-employment persists, with figures for long-term unemployment and part-time workers willing to work full time well above historical averages. All this means that the Fed is in no rush to hike rates, although investors will try to anticipate the first move.
Asset performance has presented a puzzling picture year to date, with only Japanese equities and oil in negative territory. Most asset classes, both safe havens and risky ones, have performed well. This unusual outcome reflects both the decline in US bond yields, which supported developed market fixed income assets, and the positive dynamics for equity markets sustained by loose monetary policy and portfolio reallocation in favour of equities.
Moreover, within asset classes dispersion has started to increase. Asset correlation shot up in the wake of the Great Recession (the sharp decline in economic activity in the late 2000s). This increase was largely due to the surge in macro volatility in the post-Lehman period. Concerns about a major macro crisis have receded to such an extent that the interdependence between assets is now back to pre-crisis levels, generating opportunities for talented asset managers to reap higher returns. This high-diversity environment means that different specific factors are now the main drivers of asset classes.
From an asset allocation perspective we keep a pro-risk stance on developed market assets, as abundant liquidity, easy monetary policy and the recovery are set to continue. However, with the steady rise in valuations, it is increasingly difficult to find attractive opportunities and even more challenging to find value within markets.
Concerning the key features of our asset allocation:
We conclude that yields will rise, reflecting the
improving outlook and gradual normalisation of monetary
policies in the US and in the UK, where we prefer
short-duration exposure. In the Eurozone, where recovery
remains patchy, we maintain durations at 3-5 years, in
the UK we have slightly shorter duration exposures.
Within the fixed income universe, we still like Eurozone
peripheral bonds and some bank debt. While spread
compression has run its course, we still favour the high
yield universe, which remains more appealing from a
risk-adjusted standpoint than sovereign or investment
We continue to find some value in equities,
but much of the developed market is now fairly valued after
strong recent performance. Peripheral Europe is the latest
area where valuations have caught up with events. We
consider the best remaining value in Europe is Germany,
which is on lower valuations and is more linked to global
growth through its strong exports.
We are also now more constructive on Asia-Pacific
stocks, where we see the biggest potential for the months
ahead. Japan, Australia, Singapore, South Korea and
Taiwan offer the best mix of sound macro fundamentals,
growth and positive earnings momentum.
Within emerging markets, we also see more value than last quarter.
We see Chinese stocks as undervalued,but we prefer to keep a neutral stance as
slowing growth will drive policy intervention to engineer a soft landing.
Regarding India, the new government offers bright prospects for structural reforms,
but we prefer to adopt a wait-and-see attitude after the impressive
performance of the equity market.
Alternatives which depend on managers asset selection,
funds, such as merger arbitrage and long-short equity can provide a
good source of diversification. Many are now available in liquid UCITS (Undertakings for the Collective Investment of Transferable Securities) vehicles.
We think the environment is now favourable for such funds.
After struggling to find much direction in the first quarter, the
FTSE 100 re-discovered some upward impetus from mid-April,
largely on the back of mergers and acquisitions (M&A) in the
pharmaceutical sector. There was also a distinctive market
rotation as investors switched out of mid and small cap stocks
into larger cap and defensive stocks.
AstraZeneca saw its price rise by approximately 20% in April,
as it received a series of bids from Pfizer, their final offer being
£55 a share, which was rebuffed by the AstraZeneca board.
Other companies which have been flagged as possible takeover
targets include Smith & Nephew and InterContinental Hotels.
The FTSE 100 looks a little stretched based on traditional
valuation measures. When combined with the relatively low level
of volatility, it would not be a surprise if markets were to take
On the upside, the UK economy continues to improve in
areas such as consumer spending and the housing market.
Unemployment too continues to fall and stands at 6.6% in the
three months to April. It has now been declining steadily since
2012, taking the overall rate down to its lowest level since
Christine Lagarde, the International Monetary Fund (IMF) chief,
said her organisation had "underestimated" the strength of
the recovery in Britain and the IMF now believes that the UK will
be the fastest growing of any major economy in 2014.
Whilst the US earnings season showed year-on-year sales
and earnings growth, overall economic data from the US
remains mixed. The US economy shrank by 2.9% in the first
quarter of the year (revised down from initial estimates of a
0.1% rise). This weak quarter largely attributed to drawdown
in inventories as companies chose not to restock in the face of
extreme weather conditions. On the other hand, employment
continues to improve and exceeded the pre-recession peak for
the first time. This should go some way to increasing consumer
spending later in the year.
The S&P 500 continues its charge, pushing on to new highs
in June, as investors once again focused on the prospects of
steady global growth. This equity market strength coincided
with a rally in the bond market, where the ten-year government
yield came all the way back down to 2.4%.
On a bright note, the surge in M&A activity continued during
the second quarter. Pfizer attempted to buy UK's AstraZeneca,
a bidding war erupted for Hillshire Brands and Priceline.com
purchased OpenTable: just a few of the large bids involving
US firms and giving a clear sign of the significant confidence
now coming from the corporate sector.
European markets continued to trend higher into the first
quarter. However, more recently volatility has started to pick
up in response to geopolitical concerns in Eastern Europe
that are perhaps disguising the improving backdrop for
Protracted protests in the capital Kiev led to the overthrow
of the Ukrainian President, Viktor Yanukovych, in February.
In response, Russia has occupied parts of Crimea to counter
the perceived threat to the Russian-speaking community in that
part of the country. In turn, the international community has
threatened sanctions against them. Were these to be imposed,
it is likely that Russia would reciprocate, to the detriment of
European exporters and energy importers.
This would be a shame, because we continue to see signs of
the nascent European economic and corporate recovery taking
hold. Factory orders and industrial production have continued to
strengthen in the region as a whole and in Germany, the Centre
for European Economic Research (ZEW) survey of business
expectations is at its highest in 4 years.
The ECB loosened monetary policy significantly in June and
there is sufficient momentum now for investors to start seeing
value in equity markets.
The lack of volatility and decisive movement in either direction
was the defining characteristic of both the Japanese stock
market and the yen during the second quarter of 2014. This
was perhaps in reaction to the non-action of the Bank of Japan
to take any additional measures to enhance its Qualitative and
Quantitative Easing policy despite a downward revision to their
economic outlook for the rest of 2014 and 2015.
First quarter, sterling was confirmed to have come in at a better
than expected 6.7% spurred by brought forward activity ahead
of the 1 April sales tax hike. This helped the more domestic
sectors of the market generally outperform their more globally
exposed peers with food and beverage and household products
leading the gainers and the export-orientated technology and
consumer durables sectors being the laggards.
Global emerging markets have bounced back during the
second quarter, following a difficult start to the year. Tensions
have eased slightly in the Ukraine, with Putin now taking a
more conciliatory stance. Although the situation is not
resolved, emerging markets have reacted positively to the
easing political tension.
Political change has provided a positive catalyst for the Indian
stock market which rose strongly following the election of
Narendra Modi's Bharatiya Janata Party (BJP) – and perhaps
more importantly for the first time in 30 years the Government
of India now has an overall majority. The market has high
expectations for the delivery of a package of economic and
policy reforms. Our own view is less optimistic, as we feel India
still faces severe economic challenges, meaning these reforms
will not be easy or quick to deliver.
Thailand has suffered some volatility following the military coup,
but overall the direction was positive, and the severe market
draw-downs experienced last year have not been repeated.
With all the political activity elsewhere, attention has
perhaps been drawn away from China, which remains one of
the biggest influences on the outlook for emerging markets.
Can China's impressive growth rate be sustained? Is there a
property bubble? Will it burst? Will the shadow banking system
collapse? All these questions remain a concern for investors.
Our central view is that China can avoid a 'hard landing' and
that the Chinese government do have sufficient resources to
manage a slowdown. Their reform plans should ultimately lead
to a freer and more balanced market. We recognise the risks
for short-term volatility, but believe the longer-term outlook is
brighter and steady if lower growth can ultimately be achieved.
The UK economy has shown consistent signs of recovery
so far this year and this has led investors to question how long
rates can stay low.
Unemployment has fallen below the level where the Bank of
England (BoE) said they would start considering a rate rise.
Initially Mark Carney (the Governor of the BoE) reassured the
market by saying there was considerable slack in the economy,
but recently he has warned that a rise may come earlier than
markets expect. He has, however, emphasised that he expects
rate rises to be gradual and limited.
Against this background the 10-year gilt initially fell from around
3% to just over 2.5%, subsequently retracing about half of this
fall. The 5-year gilt yield fell less and rose more reflecting the
expectation that rate rises will occur earlier, but will be limited.
We take the view that gilts offer more risk than reward and
investors should remain underweight.
The story in peripheral European debt has been the dramatic
decline in yields. Investors have returned to the periphery
because it was massively under-owned in the first place,
offered a significant yield pick-up on core Europe and after the
recent ECB announcements is now perceived as relatively safe.
Who would have thought, even 6 months ago, that Spain can
borrow for 10 years at a similar level to the US, circa 2.65%.
With the ECB considering further measures and the US terrified
of turning off the stimulus taps too early, credit, even at current
levels will remain relatively attractive. Additionally, we expect
credit fundamentals to remain solid. In a global environment
of limited and vulnerable growth and low inflation, corporate
bonds are likely to remain well supported.
It is not clear whether the measures taken by the ECB will
remove the risk of goods price deflation, boost credit creation,
or do much to weaken the euro. However, they will probably
boost asset prices further, especially if we do eventually see
full-scale quantitative easing.
Although the early signs look encouraging, in the short run,
the euro may continue to trade around or above the 1.35
mark. In due course, as the market prices in the first rate hike
in the US, the euro may soften further, underpinning a modest
softening of the single currency by year end, with our target
set at 1.32.
With buoyant activity in the UK, sterling has remained strong,
underpinned notably by real estate-related capital inflows.
The forward guidance set out by the BoE about the need to
keep interest rates low has been ineffective so far. Markets
have priced in a first rate hike for the first half of 2015. However,
we believe sterling has overshot and the widening current
account deficit is a negative factor. We expect the currency
to start losing ground going forward.
Oil markets felt the heat in June as the situation in Iraq took
a turn for the worse after Islamic extremists seized control of
large parts of Mosul, Iraq's second largest city. While the
probability of the conflict reaching the southern oil fields and
Basra terminal is low, such an outcome would be likely have
to have a significant impact on crude prices given supply
disruptions in other oil exporting countries, in particular Libya.
Gold has traded sideways through the second quarter.
Downward pressure due to impending interest rate normalisation
was offset by by support as a result of geopolitical tensions
in Eastern Europe and Iraq. With the US economy continuing to
improve, the likelihood of a rate hike draws closer and with
this further downward pressure on the gold price.
In spite of China's slowdown, the outlook for copper demand
is improving on the back of a strengthening global economy
and with a significant change in the Indian political landscape,
following the clear majority win by the BJP. If the new
government is able to ease the policy gridlock characterised
by the previous administration, the economy could
be unlocked for potential growth and copper could see
In the second quarter low inflation data from the major economies helped to maintain low interest rates. This supported modest positive returns for bonds and lower risk composite benchmarks. It was also supportive for equity markets and hence higher risk strategies. Unrest in the Middle East was a key factor in the tailing off of markets in mid-June. Prospects of an interest rate rise in the UK driven by stronger growth numbers as well as house price strength have supported Sterling and this has lowered the returns from non-GBP equities in Sterling terms, hence moderating the returns from the higher risk GBP benchmarks.