FYI Spring 2014
FYI: For Your Investments. Spring 2014
WELCOME TO THE SPRING 2014 EDITION OF FYI
In the first quarter of 2014 markets are showing mix results. As I write, the performance of the European and US markets are flat while the FTSE 100 is down almost -2%. Emerging markets show a global negative performance of -4% and Japan is suffering from a severe pull back of -11%.
On the currency side, the euro and the US dollar have fluctuated against sterling, but we are very close to the level of last year end.
There are many reasons to explain the recent market movements. Among some of them are: the weather-related downturn in the US economy; the Russia Ukraine crisis and the slowdown of the Chinese economy over the last few months.
Another factor to watch, which is more abstract, is investor's sentiment and its assessment of risks after 5 years in a row of positive performances for the Dow Jones Industrial, which has returned +117%. As we all know, investors have benefited from a liquidity injection "bonus" over the last few years and the Federal Reserve (Fed) is gradually withdrawing this stimulus. This is increasing the nervousness of some markets' participants who fear that economic and market recovery may not be sustainable without the central banks' interventions.
We had expectations last year for 2014 – one of which was the return of selectivity. You may recall us talking about more discrimination ahead on stock selection in an earlier issue of FYI. So, if you analyse more closely what has happened in the Eurozone over the last 3 months, you will see that there is a lot of dispersion as the Italian and Portuguese markets are up +11% and +13% respectively, while the German and Dutch markets are slightly negative. Market sectors show the same picture, as only 9 sectors among 19 are up in the Eurostoxx 600, while only one was negative last year.
As you will see in this issue of FYI, we continue to find value in markets and remain positive, especially on developed equities. At the same time and as markets condition normalise, we expect some larger swings in asset prices, namely volatility, which may bring back increased nervousness among investors.
SUCCESSFULLY NAVIGATING ROUGH WATERS
Written by Eric Verleyen, SGPB Hambros Group Chief Investment Officer (CIO)
The beginning of the year did not go as we had foreseen. Although all the elements supporting risky assets' performance were in place during the third quarter of 2013, some factors have changed the expected trajectory.
It would be very simple to say that unprecedented weather conditions negative impact on the economy have influenced our rosy scenario. The reality is that after a strong economic acceleration in developed markets during the third quarter, the US economy has taken a break raising investors' fears about another slowdown. Unfortunately, geopolitical risks in Russia and below-expectation economic figures in China have only added more noise to the already unclear global economic situation.
While economic waters were rougher than expected earlier this year, we believe that a good balance between easy monetary policy in most developed markets and ongoing improvements in the euro area may balance the risks coming from some emerging countries, namely Russia. Therefore, we keep our preference for equities in developed markets, including in the Eurozone.
THE SECOND QUARTER OF 2014 SHOULD PROVIDE SOME REASSURANCE ABOUT THE POSITIVE MOMWNTUM IN THE DEVELOPED WORLD.
In the US, weather-related weakness is expected to fade and private consumption as well as residential investment should advance further. We still expect capital spending to firm up through the year, but so far figures have been a bit disappointing.
In the Eurozone, easing credit conditions and tightening spreads in the periphery provide a welcome support, paving the way for a stabilisation of domestic demand and
unemployment in Southern Europe.
In the UK, the recovery is gathering speed with risks tilted to the upside as it is expected that the growth may be better than economists have forecasted.
In Japan, the scheduled Value Added Tax hike could dampen private consumption, but the macro impact should be mitigated by the tax break aiming at boosting business investment and by a new round of qualitative and quantitative easing later in the year.
As monetary conditions will continue to be very loose against a low inflation backdrop, most downside risks stem from exogenous factors such as credit crisis in China or geopolitical confrontation with Russia.
EMERGING MARKETS WILL CONTINUE TO FACE HEADWINDS IN THE MONTHS AHEAD
Addressing structural imbalances in the form of public or current account deficits take time and go through tighter monetary or fiscal policies, weighing on economic activity.
Excess leverage, mostly in the private sector, will continue to require close monitoring from central banks and prudential supervision as the period of cheap money is coming to an end. As such, some bubbly property markets could experience a downward price adjustment, particularly in Asia.
The announcement of the Fed tapering last year spelt the end of the chase for yields in emerging markets (EMs), triggering significant outflows from both fixed income and equity markets. This is to continue as US interest rates will go further up anticipating the first rate hike by the Fed.
Political risks have returned to the fore with the Ukraine-Russia crisis and several general elections to take place in significant countries such as Brazil, India, and Indonesia.
China is also facing major economic challenges since rebalancing growth and shoring up the financial system are not easy tasks. Although currency depreciation in some places helps to restore external competiveness and valuation in some equity or fixed-income markets start looking attractive, we prefer to stay on the sideline at this stage.
At the current juncture we see limited downside risks, although they may not be easily quantified. For a large part, these risks are EM-related stemming from purely political factors to economic policy management. Geopolitical risk related to a negative feedback loop as a consequence of sanctions applied to Russia could pressure down Eastern European assets and spill over onto other European markets.
In China, defaults in the financial system could create a shockwave and drive down local bonds and stocks, spreading over to the whole commodity and EM space.
In the advanced world, the US job slack could be smaller than many consider and a wage-driven price spiral could unfold, pushing up long-term yields and calling the Fed for action. Equities and long-dated bonds would be the most at risk.
Our overall allocation remains pro-risk as macro and micro environment remains quite supportive. Again, it is worth highlighting that despite rising valuations, equities look less richly valued than bonds.
It has been a mixed start to 2014 for equity markets. After a -3.5% decline in January, the FTSE 100 rebounded by 4.6% in February. March has seen a retreat on a combination of disappointing company results, weaker Chinese outlook and concern surrounding the Russian/Ukraine situation. This is against a backdrop of UK data that has remained relatively positive – UK house prices, manufacturing and construction Purchasing Manufacturer Index rising this year, although unemployment ticked up to 7.2% in February.
Disappointing corporate news has led to sharp share price falls, the standouts being BG; the banking sector; Rolls Royce and the food retailers. The banks had a difficult February with Lloyds and RBS reporting large losses. The food retailers suffered from rising competition from discounters Aldi and Lidl on the one hand and by the more upmarket Waitrose on the other. Rolls Royce surprised the market with its first profit warning in a decade, as it confirmed that this year will see no growth in sales or profits.
Despite these challenges we expect the market to besupported by continuing low interest rates and a gradual economic recovery.
The US has also had a rather mixed start to the year from an economic data perspective, with manufacturing confidence rolling over following a peak in December, while jobs numbers came in worse than expected. This was largely blamed on the extremely cold weather patterns late last year. However, consumer confidence levels continue on their trend higher supporting the changing sentiment toward the overall economic health of the US economy.
Some global turmoil initially involving the emerging markets in January, and latterly Russia and the Ukraine later in the quarter has led to volatility in many global equity markets. However, the US remained one of the most resilient, with each pullback finding new buyers to sustain the market highs. Valuations in the US are no longer as compelling as they once were and perhaps a period of consolidation is needed to allow earnings to catch up with the expectations that are being priced in.
There were some big high-profile acquisitions announced, with Facebook purchasing messaging service company WhatsApp for a phenomenal $18 billion, whilst Suntory came to the US to buy Beam Inc – perhaps indicating that the long awaited spending spree for the cash laden companies may well be beginning.
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 European equities.
Protracted protests in the capital Kiev led to the overthrow of the Ukrainian President Viktor Yanukovich 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 ZEW survey of business expectations is at its highest in 4 years.
The European Central Bank (ECB) did not lower interest rates in March, and investors were briefly disappointed, but there is sufficient momentum now for investors to start seeing value in equity markets.
Launched almost 18 months ago, it has not been until the first quarter of 2014 that we have seen investors and associated money flows really question whether the bold initiative of Abenomics will prove successful in it's goal to reflate the Japanese economy.
Despite expectations of corporate earnings continuing to grow at double digits, the Nikkei comprehensively lagged it's developed market peers and trade firmly in negative territory throughout the period. Many of last year's big winners proved vulnerable to profit taking, whilst money returned into more domestic sectors as the yen's hasty devaluation showed signs of moderating.
The economic impact of the planned April rise in sales tax from 5% to 8% will be the biggest focus for investors and likely key to the performance of the yen, Japanese Government Bonds and Nikkei for the rest of the year.
written by Paul Stappard, Senior Portfolio Manager
Recent events in the Ukraine have certainly kept EMs in the headlines, providing a stark reminder of how geopolitical tensions can undermine investment opportunities – although in this case our optimism for Russian investments had already waned due to the disappointing pace of economic reforms.
A couple of years ago we were attracted by the Russian equity market's cheap valuations when the price to earnings ratio was circa 5x. Price/Earning ratio (P/E), is a common ratio used in financial markets to assess the relative price of an asset. Although the P/E for Russia is very low and stands at 3.4, we do not expect this figure to increase as geopolitical tension remains.
In overall terms, Ukraine represents a minimal exposure within global emerging markets (GEM). However, any potential sanctions on Russia are liable to have a wider impact on other emerging European countries for which Russia is a key trading partner.
We started the year with a negative view on GEM and this view is maintained as we have seen continued weakness during the first quarter even without Ukrainian events. The other chief concerns are an economic slowdown in China, the fear of Fed tapering leading to investment outflows from GEM and structural imbalances (current account deficits, high inflation) causing currency weakness in countries such as Brazil, South Africa, Turkey, India and Indonesia.
With developed market economies still improving, our preference is for export-orientated emerging countries, such as Korea and Taiwan, which may benefit from an increase in global demand. At some point we expect to be presented with better opportunities for GEM investment, but for now we remain patient.
It has been a turbulent start to the year with developments in EM, Crimea and softer global economic data. In contrast to equities, fixed income's perception as a less risky asset class meant a solid start as core government yields edged lower. This is despite the backdrop of the Fed tapering and prospect of rising interest rates.
The US 10 treasury yield fell from over 3% to 2.7%. Bunds and Gilts moved in a similar direction. We saw good performance from peripheral Europe – particularly Italy. In 2011/12, Italian 10-year bonds yielded over 7%. It now yields 3.5%. There is a creeping feeling that the ECB will soon loosen monetary policy further as Eurozone inflation remains persistently low. Sentiment also improved with the arrival of the new government in Italy and Moody's revised its outlook to stable from negative.
The question of when the UK interest rates will rise continues to dog investors. Initially, Mark Carney tried to offer guidance by stating that a rate rise would be considered if certain conditions were met; namely, if unemployment fell to 7%. However, it has fallen sharply and in February the Bank of England (BoE) announced that it was abandoning forward rate guidance pegged to unemployment. For the moment, we can only canvass the opinions of officials who continue to suggest that rate hikes in 2015 are likely.
2014 highlights how defensive developed world credit continues to be, as it is supported by very strong fundamentals – companies have a strong cash position and ample access to the capital markets, earnings are not too bad and default rates remain low. They are also bolstered by a very strong, supportive technical picture with massive bond redemptions that gross issuance is unable to match. Local currency emerging market debt is best avoided for the moment as tapering has been driving weakness in these currencies.
The US dollar has performed poorly since late January, competing with the Japanese yen and the Canadian dollar for the worst G7 performance. This has happened even as Fed talk pretty much ignored the soft economic data following the harsh winter weather.
The dollar recovery will be slow unless the Fed shows its more hawkish stance. The 'forward guidance' policy is ripe for an update, as the unemployment figure is within reach of the 6.5% threshold. A reformulation may imply a lower degree of transparency, à la BoE, with the Fed likely to refer to a broader range of labour market indicators. This will make the market very data dependent, with nervousness rising as data improves.
While the Ukraine crisis has become a major source of concern for global markets, it has failed to translate into a significant correction within the wider emerging markets currencies. Of course, there is significant regional differentiation. The closer you are to the epicentre of the crisis, the more vulnerable you are to contagion risks. But overall, the asset performance since the crisis has been more or less flat, while Asia FX has actually gained over the period.
There are only four major EM currencies that have weakened against the US dollar since 21 February, namely the Chilean peso – for reasons unrelated to Ukraine, the Russian ruble, the Turkish lira and the Chinese renminbi.
Commodity indices are up strongly year to date. Returns are uncorrelated to other asset classes and they are providing a respectable hedge against both geopolitical risk and weather risk. As a result, commodity markets are rapidly returning to the radar screen of market participants.
In precious metals, gold and silver have had a good start to the year with prices supported by a weakening dollar, concerns about the weaker-than-expected US macroeconomic data, an ongoing degree of emerging market uncertainty and concerns about the possible escalation of the situation in the Ukraine.
Agricultural commodities have also had a good start to the year across the board in softs and grain. The outstanding performance coming from coffee as the worst drought in 42 years hits Brazil's south east, the main coffee growing region in the country. Estimates are that the drought might reduce the current crop from anywhere between 15% and 45%, but concerns extend to the irreversible damage that may have been caused to the coffee plants going forward.
The price of Brent is little changed since the beginning of the year and with growing supply from the US and potentially Iran and Libya the upside is limited.
It was a nervous start to the year for equity markets. Factors included weak data from the USA and China and instability in the Ukraine. The pending sales tax rise was an additional worry for Japanese equities. They were particularly hard hit as holders took profits after last years strong run. Inflation data across the developed world came in low helping government bonds to rally.
For the first quarter of 2014, the lower risk benchmarks performed best, but over longer time periods the higher risk benchmarks show stronger returns.
Written by Andrew Dalton, Deputy CIO