FYI Autumn 2014
FYI: For Your Investments. Autumn 2014
The summer is now officially over. Although, this period was characterised by some market volatility on the back of geopolitical issues, the S&P 500 in the US continues to beat its historical high record on a weekly basis. In the Eurozone, the broad Stoxx 600 Index is showing a performance close to 6% in total return, while in the UK the performance is only slightly positive on a year-to-date basis.
We continue to anticipate a global supportive economic environment in both Developed and Emerging Markets. Of course there are some big discrepancies among regions and the Eurozone growth is unlikely to exceed +1% next year. The US and the UK are expected to grow respectively at +2.5% and +3.4%. On the Emerging Market side the economic situation in Russia and Brazil remains fragile, China is decelerating but only slightly on the back of structural reforms and India is picking up.
Central banks continue to be supportive in their monetary policy and are working very closely together, as we saw this summer with the Jackson Hole meeting. The US is gradually starting to normalise its action, on the back of their strong economy, but should not raise its interest rate before mid 2015.
In this context, and after the “No” victory at the Scottish referendum, we continue to be fully invested in equities and to avoid long-term bonds. We also expect to see a global positive outcome from the European Central Bank (ECB) review of banks assets and as such remain overweight on financial bonds and equities.
Fears over the Scottish referendum on independence rose rapidly in September. For a long time it had been assumed that the “No” vote would have a comfortable majority, but a poll showing a lead for the “Yes” vote undermined the complacency. The biggest market impact was on sterling which fell sharply in the lead up to the vote. Gilts also sold off in the period immediately before the vote, but they moved broadly in line with US Treasuries, so it is unlikely that they were primarily being driven by the vote. Despite the circumstances, the equity market was relatively stable with the lower pound providing some support.
In the long term, the impact of Scottish independence would have been small on most companies in the FTSE 100. RBS and HBOS would almost certainly have had to relocate to England as Scotland is too small to support such a large banking sector on its own. Iceland, Ireland and Cyprus have all shown the dangers of an outsized banking sector.
The "No" vote was a relief to markets, but the Scottish vote also highlighted other political risks. In Spain, Catalonia is seeking independence and the Spanish Government is resisting with all its strength. To lose one of the strongest economic regions from Spain's already weak economy would be a body blow. Tensions also exist in Belgium which could
lead to the country breaking up along linguistic lines.
However, perhaps the most important question for UK investors that has been highlighted is the uncertainty about the UK's continued membership of the European Community (EC). The removal of Scottish MPs would have made Parliament more eurosceptic, but even without this change, there is a significant chance that there will be a referendum on UK membership of the EC during the life of the next parliament. There appears to be little appetite amongst other countries within the EC to allow the UK to negotiate significant changes to the membership rules, so a vote may be hard to avoid if the Conservatives are in power. Given the mood of the country and the hostile attitude of much of the media towards the EC, it would seem that a UK exit from the EC is a distinct possibility and the Scottish referendum has made more people focus on this prospect.
If and when such an exit appears likely, we would expect sterling and, to a lesser extent, gilts to come under pressure. The probability and timing of such events are difficult to predict, but holding a reasonable proportion of a portfolio in non-GBP assets (typically overseas equities) provides some degree of insurance against such events. The impact on the FTSE 100 would be more complicated to predict. Many companies are multinationals which would see their earnings in GBP boosted by a weaker exchange rate, but an exit from the EC could have many negative implications for current business models.
Events in both the Ukraine and the Middle East have implications for US energy markets. In order to reduce European dependence on Russian gas supplies, plans are being made to increase US exports. Supply constraints in the Middle East provide support to the oil price. These factors have supported our investment in US oil and gas-related equities; an area of development that we believe is having a major economic impact.
Despite these political issues, the global economic recovery has continued, with notable differences from country to country. The US continues to lead the way with steady growth suggesting that a rise in interest rates may not be too far away. Inflation remains low, but there has been some pick up in wage growth recently which may feed through into future price rises. We expect growth to continue to be reasonably buoyant in the US as there is still a moderate amount of spare capacity, cheap energy from the fracking of shale oil and gas fields which is helping the competitive position and the housing recovery has plenty of scope to continue. The relatively strong position of the US has been reflected in the dollar strength of late.
However, the Eurozone has struggled to develop any positive economic momentum. The overhang of debt and associated austerity measures have led to a lack of both consumer and capital expenditure. Reasonably strong growth in Germany was providing some relief, but there has been a slowdown. This is, in part, linked to economic adjustments in China which has been a major export market for Germany. In contrast, Spain has made some progress in returning to growth as wage cuts and increasing labour market flexibility have made them more competitive. However, the threat of Catalan independence casts a shadow over this progress. A breakaway would make their fragile situation significantly worse.
In Asia all the largest economies, China, Japan and India are experiencing significant change.
In China the new leadership is trying to rebalance growth, whilst reducing pollution and tackling corruption. This has led to some reduction in economic growth and increased uncertainty, but in the medium term it looks like being a healthy adjustment and growth remains robust by global standards.
Whilst Japan has been in the deflationary trap for many years, they are finally showing signs of breaking free. Wage growth is picking up and an increase in sales tax has been digested, albeit with some pain. They are now attempting labour market reforms, which, if successful, should make the economy more dynamic.
In India, a landslide election victory for Prime Minister Modi replacing the ineffective Congress government is leading to major economic reforms. Plans include simplified and reduced taxation, a wave of privatisation and closure of state-owned businesses, reduced subsidies on basic commodities, an improved electricity supply system and labour market reforms.
Overall, we believe global growth will continue at a reasonable pace and the lack of inflation will allow central banks to remain very supportive. Equities continue to offer the best prospect of reasonable returns, with Asian markets looking particularly attractive at the moment due to a combination of relatively low valuations and good growth prospects. Political turmoil has the potential to increase the unpredictability of returns in the short term, but with cash rates and bond yields so low, some degree of risk is required to earn a return on investment. However, consideration of the longer-term implications may offer routes to mitigate some of the risks.
The UK equity market rebounded in August from the weakness
shown in June and July as the low level of volatility witnessed
within the markets continued to prevail.
Tesco delivered the standout news in the corporate world after
it released a trading update in which it said that its profit for
this year would be below its previous expectation and due
to this shortfall the interim dividend will be cut materially.
As a result, the shares fell sharply and continued their poor run
over the summer period. On a more positive note, Legal & General
reported strong profit growth and also raised its dividend by 21%.
On the macro front, consumer price index (CPI) inflation
fell below estimates to 1.6% in July from 1.9% in June. Retail sales
also came in lower than expected which is likely constrained
by the continued weakness in wage growth. This comes on
the back of a relatively soft patch for UK manufacturing and industrial
The Scottish referendum vote provided some distraction to
markets in early September, but sterling weakness and the
global nature of many FTSE100 stocks meant that the market
was quite resilient.
The S&P 500 continues its relentless outperformance of
global equity markets, with investors retaining confidence in
US Inc's ability to grow earnings. Valuations now are frequently
questioned by investors with, in particular, the mid-cap space
priced for some very good earnings growth that may well suffer
should this not materialise.
With recent economic releases suggesting that investors may
have to bring forward their expectations of rate hikes, investors
should be cautious that the beginning of this rate-hike cycle
can often lead to temporary market corrections. Last year's
market moves in May and June following the Federal Reserve
(Fed) tapering announcement acts as a stark reminder; and it is
the assets priced with the highest built in assumptions that will
usually suffer the worst in any setback.
After long expectations of a stronger US dollar, this finally
began to materialise in the third quarter, helped along
by very weak growth numbers in Europe and a new scheme
of asset purchases weighing on the euro, along with heavy
selling of sterling in anticipation of the Scottish independence
referendum. This move has taken the dollar to 12-month highs.
It was a quarter of mixed results for Eurozone equities.
Weakening economic data and intensifying political tit-for-tat
sanctions with Russia led markets down in July, but latterly,
hopes of further ECB action have stimulated a recovery.
Data released at the start of July confirmed that manufacturing
growth in aggregate continues to weaken and is now close
to signalling outright recession once more in the Eurozone.
Inflation has fallen to near zero and domestic demand remains
Whilst fears of an escalation of sanctions with Russia may
account for some of the current weakness, it is the real
possibility of a slip into deflation that Mario Draghi highlighted
in his recent speech at the Jackson Hole conference in the
US as an ongoing danger. His promise to take further action
buoyed markets and when the ECB met on 4 September,
investors were surprised by positive plans to purchase
asset-backed securities (ABS) in addition to a further cut in
Recent significant euro weakness is to the liking of most
of the Eurozone and should make exporters more competitive,
whilst ABS purchases should be a positive for peripheral
banks still working to improve their balance sheets ahead of
the Asset Quality Review.
To help Japan escape the "Lost Decade", Shinzo Abe promised
the "Three Arrows": the first arrow being aggressive monetary
policy targeting inflation at 2% annually and quantitative easing
to depreciate the yen, which was implemented successfully last
year, and Japanese equity had a buoyant year in 2013.
The second arrow was the fiscal policy to increase the sales
tax in two stages, lifting it to 8% in April 2014, and then to 10%
next year, aiming to balance the national budget. The first rise
has a big impact as Japan's GDP fell by 6.8% annualised in the
second quarter. We believe the ultimate success of Abenomics
now hinges upon the successfully implementation of the third
arrow, reforming of the Japanese labour market.
Signs so far have been encouraging, as wages grew by 2.6%
in July, and the equity market is recovering from a poor start
to the year. However, with poor demographics and a labour
force that lacked skill after being unemployment for a long time,
we remain cautious about the Japanese market. We do keep
a keen eye on how the situation unfolds, taking any potential
opportunities that may arise.
Having begun the year with an underweight stance for Global
Emerging Markets (GEM), our optimism has now returned.
More specifically for the Asia Pacific region which we believe
is now one of the few regions in the world to combine attractive
valuations (i.e. shares in the region are reasonably inexpensive
on average), potential upwards earnings forecasts and
supportive monetary and fiscal policies.
Chinese economic data has improved, with second quarter
GDP growth of 7.5% exceeding expectations. Reform is a key
theme, with several state-owned enterprises named in a
pilot programme that aims to raise corporate governance and
efficiency, bringing a greater focus on shareholder value.
China is now one of our preferred investments in the
Elsewhere in the Asian Pacific region, recovery and reform
continue. The change of government in India has been well
received, with the inaugural budget proposing subsidy reforms
and a more streamlined tax regime. Thailand has stabilised,
with the King having endorsed the junta, enabling approval of a
2015 budget which allocates 450 billion baht for infrastructure
In contrast to the Asia Pacific region's recovery path, Latin
America continues to face headwinds, despite some recent
strong performance from equity markets.
The sustained fall in Latin American growth since 2010
shows that the region was unprepared to face the onslaught
of a commodity-led slowdown. In the absence of required
structural reforms, domestic sources alone will be insufficient
to lift growth. As a result, Latin America (ex-Mexico) faces a
prolonged period of low growth, high current account deficits,
low fiscal balances, and pressure on currencies and other
asset classes – particularly when the US monetary tightening
cycle begins in 2015.
Holders of Gilts will be happy with returns this quarter.
Geopolitical tensions, ongoing concerns about economic
stagnation in Europe and the mixed messages from Mark
Carney have all helped yields edge lower. Even concerns over
the Scottish referendum did little to hurt Gilts. After the Bank
of England (BoE) August Inflation Report and the accompanying
press conference, the governor conveyed a rather more
dovish message which contrasted to his hawkish Mansion
House speech in June.
Last year investors focused on the unemployment rate as a
barometer for impending interest rate rises. The attention has
now shifted to wage inflation which is falling. As pay packets
are declining in real terms, it is unlikely we will see a rate
rise near term. At the beginning of the quarter the 10-year gilt
yielded 2.8% but touched a low of 2.4% at the end of
August before rising slightly.
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 below 1%. 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
throughout summer with Spain's 10-year debt almost
The summer holidays are coming to an end and the credit
market is in great shape. Total returns for investment grade
credit are in the region of 5%, having been helped by the
collapse in sovereign yields. Yields are currently very low and
the scope for future returns is now very modest.
The story of the summer has been of the resilience in risk
assets and the hunt for yield trumping all other market
For FX market participants, battle-weary euro shorts finally
got some relief as EUR/USD trended lower, falling more sharply
since the beginning of May. The main driver has been a higher
conviction towards monetary policy divergence between
the Fed and the ECB. It is our expectation for this trend to
continue, albeit at a slower pace.
After hitting a 6-year high of 1.7192 on 15 July, GBP/USD
mirrored a similar trend, falling rapidly over the summer.
Market concerns over the Scottish Independence vote and
expectations reduced for a hike in interest rates by year
end weighed on the currency. However, it did recover some of
the lost strength when it became apparent that the Scottish
were going to vote "NO".
We have seen the beginnings of a US dollar rally over the
summer. we expect this to continue, but the pace will depend
on interest rate expectations and economic data releases.
During the summer we have had continued tension between
the West and Russia over the Ukraine and escalating conflict in
the Middle East, with the threat of ISIS ever more apparent.
In these circumstances one might expect oil prices to gain due
to supply fears and gold to benefit from a flight to safety, but
both commodities have suffered significant price falls.
Gold is being weighed down by the prospect of interest rates
in the US rising in the foreseeable future. It has also lost its
attraction to many as a reliable store of value. After a prolonged
period of falling prices, gold has made investors question its
Oil supply has held up surprisingly well from the Middle East
and it is also benefiting from rapidly growing US production,
where fracking is becoming increasingly efficient. Although there
are restrictions on the export of crude oil, lightly treated oil can
be exported and this is being done in rapidly increasing volumes.
The situation in the Middle East remains unpredictable and we
are not expecting further price falls.
The market in natural gas is also being changed by the fracking
of US shale fields. Prices in the US are far lower than in Europe
and Asia and in response to this export facilities are being
built at US ports. The tension with Russia and Europe's current
dependence on Russian gas is accelerating the process,
which should in time reduce the price differences significantly.
Industrial commodities have suffered from weaker Chinese
growth and platinum and copper have both fallen significantly
in price over the quarter. We currently hold only very limited
exposure to commodities within discretionary portfolios.
In the third quarter, GBP benchmarks benefited from falling longer-term bond yields which led to good returns for most fixed income. The lack of evidence of wage inflation and
a desire for more resilient assets drove this move. Sterling fell sharply over the period partly due to the Scottish referendum and partly due to dollar strength as investors focused on potential interest rate rises in the USA.
This currency move generated gains in the GBP benchmark due to non-GBP equity components. Conversely it reduced returns in the USD benchmarks. All benchmarks continue to show healthy medium term returns.