Investment Newsletter - March 2015

Neal FoundlyInvestment Analyst

Historic Highs Hit the Headlines!“FTSE Nears 7,000!”, “Nasdaq Breaks 5,000!”, ”German Yields Hit All-time Low!”, “Nikkei Jumps To 15-year High!”

It’s been a bonanza for financial headline writers in recent weeks as many financial markets have broken new ground. Equity markets have forged ahead and bond markets have continued to rise, pushing yields to historic low levels and even to negative yields, guaranteeing buyers a loss if held to maturity.

So, what’s going on?

Well, it’s not that the news has been all good, but – and this is crucial in asset markets, which discount future expectations - there have been no additional risks to cause investors to take fright.

Look at the issues that have headlined in newspapers and our blogs over the last six months: the implications of a possible Greek exit from the Eurozone; proliferating

deflation; the destabilising plunge in oil prices; the economic slowdown in China; a possible hike in interest rates in the UK and US; the geo-political issues in the Ukraine and Syria and the human cost of the Ebola epidemic.

What matters for markets is that at the margin, these risks are not getting worse and this has given the investors the green light to continue buying.

This is reflected in plunging risk indicators. One popular risk metric is the VIX Index that reflects the volatility in the S&P 500 Index in the US. The VIX has fallen 23% so far this year and currently trades at around 14, fairly close to the low point of its one-year range of 10 to 30.

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Investment Newsletter March 2015

No incremental bad news may mean markets don’t fall but why have they moved up?

Firstly, the economic news, particularly the headline-grabbers like unemployment, wages and inflation have been improving in many major economies. In the US and the UK especially, demand growth is prompting employers to take on additional staff. This is having a modestly positive effect on wage levels but as inflation has fallen, driven largely by weak energy prices, this has meant that wage growth has started moving ahead of inflation – “Real wages to rise for the first time since 2007” was the leader in many UK newspapers in February.

In the US, they add up the unemployment rate and

In the US, the QE programme has triggered a positive response in consumer spending which, at around 70% of GDP, is driving growth for the whole economy. That said, their stock market was quick to react to the announcement of QE and the subsequent positive news and moved up to levels that, we believe, discount an overly-optimistic outlook.

One reason for our caution, for instance, is that the flood of money into the economy has forced up the value of the US dollar against almost every other currency – it is up nearly 12% against the euro since the end of 2014 alone. The strong dollar has the effect of reducing the revenues of US exporters as the relative value of their overseas sales falls.

This became apparent in the recent corporate reporting season when many large US companies, such as Apple and Caterpillar, highlighted currency as a negative factor. Indeed, our caution on the US stock market is underlined by the fact that profits for US companies are looking like they may fall for the second consecutive quarter due largely to the strong dollar effect.

The UK and Japan have seen an improvement in economic conditions following their QE bond-buying programmes and we consider the valuations of the equity markets to offer better value. The UK has the General Election looming in May and this may increase volatility in stocks and the value of sterling in the short term.

The Eurozone countries have been the latest members to sign up to the QE club. The anticipation that this economic medicine will work has led to significant investment flows into European equities and bonds. As this global cash, plus the new QE cash, tries to find

inflation rate in what they call the Misery Index. The Wall Street Journal said it all with the headline, “We’re at Our Lowest Level of Misery in 56 Years”.

Secondly, there is a lot of cash sloshing around the global economy. It might not always feel like it at an individual level but after many years of quantitative easing (QE), there is significant cash in the system looking for a home. Including the European Central Bank’s QE programme announced in January, central banks have pumped around $5 trillion into the asset markets over recent years.

a home it has driven the value of government bonds higher and higher, that many now have negative yields. Investors are happy to pay to lend capital to European governments.

Whilst this may seem nonsensical, it shows what a wall of money will do in driving prices too high – potentially bubble levels.

As such, we have maintained a very underweight position in fixed interest bonds and also believe that a lot of ‘hot money’ (speculators, not investors) has been invested in Europe punting on any form of recovery.


No News is Good News

QE = GDP?


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Our caution against the background of these new historic highs can be neatly summed up by Howard Marks, a well-regarded veteran US investor, when he stated “there is nothing riskier than the widespread perception that there is no risk”. There is plenty of scope for disappointment at some of these valuations and we will not follow a wave of money chasing any returns at any risks.

Indeed, a few very well-respected investors have grabbed their own headlines recently with warnings of the grave consequences of ignoring the economic and geo-political risks. Lord Rothschild, Chairman of RIT Capital Partners, recently wrote that investors face “a geopolitical situation perhaps as dangerous as any we have faced since World War Two”, citing Russian aggression, extremism in the Middle East and lack of structural reform in Europe as key risks.

We share some of Lord Rothschild’s concerns and certainly believe many investors are complacent. In the context of the portfolios, we have not re-invested the proceeds from the Credit Suisse autocall (which kicked-out in February) back into the market because we do not want to chase prices upwards.

Instead, we would prefer (see the table overleaf) to remain in property where the structural undersupply continues and low interest rates – which may remain lower for longer if some of these risks transpire – provide a positive background for the funding of demand.

We also favour alternative equity funds which have the scope to short stock (sell stock they do not own) and take advantage of rising and falling prices in various assets.

Overall, we consider that all the QE programmes have pushed the valuations of some markets too far. The weight of money has led investors to buy with less regard to the risks. However, history tells us that there are always risks around the corner and that prices will fall once they come to bear.

At times like this, is it as important to take a reading of the market’s attitude to risk as it is to read the headlines.


Risky Business


General Economic OverviewThe forward indicators for economic growth show positive momentum in most of the developed economies. UK and US are strong whilst Europe and Japan are stable, supported by central bank policy to bolster growth with quantitative easing. In emerging markets the picture is more mixed with countries dependent on oil revenues notably weak.

Inflationary pressures remain weak although there is some evidence of a pick-up in real wage growth in the UK and US. Oil prices are around the same level as last month. The improvement in overall economic growth has led markets to discount a rise in interest rates in the second half of 2015 in the US and UK.

-1

-3

+1

-5

ScoreAsset Class

Market Views March 2015


The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Asset class key+ positive - negative = neutral (normal behaviour)

+5 strongly positive-5 strongly negative

We believe that fixed interest will return significantly less than our neutral 6% pa assumption over the next 18 months. Although our rating increased a little from -4 to -3, the outlook is still weak given the prospect for higher interest rates. Any rise in interest rates would have a larger negative impact on longer dated bonds and we therefore prefer shorter dated fixed-interest securities.

With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future. Rates may increase by 0.25% perhaps in late 2015.

Our equity score remains the same as last month at -1. Generally, equity markets are a little higher over the month. A score of -1 means we expect just under 10% pa in total returns over the next 12 months. We remain especially positive towards Japan and smaller companies in the UK.

A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5 means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.

These represent Equilibrium’s collective views. There are no guarantees. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.

Equity Markets

Fixed Interest

Commercial PropertyDemand remains strong in commercial property but after the significant rally in property values in recent years, we expect returns to moderate over the next 18 months. As such, we have marginally downgraded from a +2 to a +1 outlook.

Cash

For a typical balanced portfolio we are underweight fixed interest and overweight property, and slightly underweight equity.

Balanced Asset Allocation

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Investment Newsletter - March 2015