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Investment Update Winter 2017

26 January 2017

"A change is brought about because ordinary people do extraordinary things."[Barack Obama]

Buyers of US and Emerging Markets indices were the winners in 2016. Value investing, finally, returned to favour too, rewarding investors who have stuck tight. Much of this was driven by policy and politics but it is also a function of improved fundamentals in a large number of companies.

Looking ahead, we think equities will continue to deliver positive returns with dividends continuing to play an important, if expensive, part. Fixed interest looks set to have a trying year, at least if the press has its way. We have been waiting for a fixed interest Armageddon since 2009 but it has so far, thankfully, failed to materialise. We think rate rises are largely priced in with liquidity posing the larger threat but are cognisant of the position. We are also conscious of the fact that equities have reached heady heights on price expansion rather than earnings growth. In theory, this should not continue but stranger things have happened and policy looks favourable.

UK

We are likely to see some firmer talk on Brexit in coming weeks as the UK's self-imposed March deadline approaches. It was beginning to take on a dream-like, perhaps nightmarish quality with government delivering little by way of confidence and the consumer adopting a debt-fuelled "keep calm and carry on" approach to spending. UK consumer debt is a concern.

It may be a little unfair to pour scorn on the consumer's approach given that real wage growth has been attained over the last year but with the return of inflation, this is unlikely to continue, particularly taking into account growing levels of household debt. With a weak currency, exporters should benefit but are unlikely to be able to pick up the slack left by reduced spending.

GDP expectations for the last quarter remain unchanged highlighting resilience in the economy. In December 2016 the service sector index built on its November increase and followed similar headline data for construction and manufacturing, both ending the year positively following disappointing November data.

At its November meeting, the Bank of England's ("BoE") Monetary Policy Committee ("MPC") voted unanimously to keep interest rates on hold at 0.25% as a result of stronger than expected data. Near term economic grow has been revised up substantially to 1.4% in 2017 from 0.8% as the consumer, in particular, has been stronger than anticipated but as above we think the duration of this trend is limited. The MPC notes that the impact of Sterling depreciation will ultimately result in lower growth in the medium term, cutting its forecast for 2018, from 1.8% to 1.5%, as imported inflation starts to weigh on real income and consumption slows. A downgrade mirrored by the International Monetary Foundation forecast which for 2018 has been revised down from 1.7% to 1.4%.

Consumer Price Index ("CPI") inflation rose sharply to 1% in September, up from 0.6% in August, in November it was 1.2% and last week's figures confirmed the December figure to be 1.6%. This trajectory looks set to continue influenced significantly by Sterling depreciation resulting in, amongst other things, higher import costs. The MPC has once again revised up its inflation expectations, highlighting an overshoot of target to around 2.75% in 2018 followed by a steady fall to about 2.5% across 2019 before returning to 2% the year after.

Price rises, inflation and, let's not forget, austerity, which the government has signalled will continue, are headwinds for the UK, as is uncertainty which will only increase in the run up to, and aftermath of, Article 50 being triggered as initial agreements are put in place or not, as may be the case.

Brexit will continue to dominate and its impact on Sterling will give rise to a cautious approach to investment in the UK. However, the UK is in no way down and out and has much to offer by way of diverse industry, intellectual property (a large part of which is highly under-commercialised and which has been highlighted in Theresa May's pledge for an active industrial strategy) and dividends, which although under pressure and in some cases expensive, are not just limited to large caps and in many cases are sustainable.

With this in mind, we continue to believe the UK has a lot to offer investors and that the economy will continue to grow during 2017, however, we maintain that growth will be more subdued, at least over the next two years. We also maintain our view that there is a distinct possibility of a very small rate rise in the near term but expect the next MPC meeting to maintain the status quo. There is little that we can do as investors apart from take a step back and focus on companies with balance sheet strength and resilient characteristics.

US

The focus in the US is firstly on the extent and degree of what the Trump administration can, and actually wants, to deliver in relation to the issues raised during Donald Trump's election campaign and, secondly, the Fed's response and management of the federal funds rate.

President Trump has 100-200 days to implement, if rhetoric is to be believed, a great deal of change, much of which is business positive. And it looks like Trump does not intend to disappoint with a slew of Executive Orders signed in his first few days of office. In just under two years time much of the Senate and all of Congress is up for re-election so there is a small window and precious little time in which to agree and implement change. The main areas of focus are US trade, tax, healthcare and regulation.

Promises of reduced personal and corporate tax levels, specifically a promise of no more than 15% payable on profits by US corporations, have been made. We do not expect the magnitude of transformation to be quite so great, as the longer term effects of unfunded tax cuts are contemplated, nonetheless, we expect significant amendments to the fiscal policy as soon as politically and administratively possible benefitting the consumer and corporates alike.

China and Mexico are in the sight-lines of President Trump and his approach to multilateral trade is both a cause of interest and anxiety. A hard line approach has the potential to be far reaching and will initially have a hugely destabilising effect but is unlikely to be all negative. Any void created by the US, particularly in Emerging Markets, is likely to be filled swiftly by China, which in turn opens different opportunities.

Elsewhere, financials, banks in particular, should benefit from any relaxation in regulation, while pharmaceutical companies, which had initially breathed a sigh of relief following the Trump win have been dealt a blow as an unexpected warning that government will push for lower drugs prices has been delivered. Infrastructure and old energy companies may also see positives from a Trump administration given he has expressed a desire for infrastructure spend and his dismissive views regarding climate change - a prospect that seems more assured with orders to advance the Keystone XL and Dakota oil pipelines. Much of this positive anticipation is priced in but opportunity remains.

The Fed will tread cautiously. In December 2016 it raised the federal funds rate by 0.25% to a range of 0.5% to 0.75%, the first rise since 2015 and one that is seen as the first step towards a normalisation of policy. At headline level the US economy is in good shape, inflation is moderate, the unemployment rate has fallen to 4.6% and the oil price has stabilised at broadly $50 per barrel helping corporate profits, but there continues to be weakness, not least the cavernous social divide, which is in large part attributed to Donald Trump's election win. As a result, although further rises in 2017 are indicated by the Fed, it will watch and wait and is unlikely to be hasty in its decision making.

Europe

In 2016, real GDP in the Euro area saw a quarter on quarter increase of 0.3%, similar to that achieved in the second quarter and similar to what is anticipated in quarter four. The European Central Bank expects this trend to continue delivering a moderate but firming pace to expansion driven by stimulus that is supportive of domestic demand, improved corporate profitability and a recovery in investment.

The bank also expects an improvement in inflation, reflecting an increase in energy prices, given Europe is a net importer of energy. The effects of an increased oil price feeding through the system in tandem with monetary policy is anticipated to absorb slack in the economy meaning inflation should continue to increase to a projected rate of 1.5% in 2018 and 1.7% in 2019.

Overall, the macro position in Europe has shown strength, despite terrorist attacks and Brexit. There are many issues still to be addressed, however. The periphery remains weak and politically vulnerable and the Bank itself acknowledges that economic growth in the Euro area is likely to be dampened by the need for further and faster implementation of structural reforms and balance sheet adjustments in a number of sectors, the most noteworthy area being banks. To this end its projections for real GDP are currently 1.7% in 2017 followed by 1.6% in 2018 and 2019 with risk to the downside.

Despite improved consumer and business confidence the uptick in inflation and existing threats mean that the Eurozone remains fragile and the European Central Bank ("ECB") is unlikely to make any changes to its interest rate anytime soon continuing with its quantitative easing programme reduced, but not tapered, by €20 billion per month.

A potential void in Emerging Markets left by the US may present opportunity and is just one of many things European companies, with their history of trade in the region, will be quietly observing. Domestically oriented stocks should continue to bring positive returns but there are potentially openings in the international market on the horizon for those with strong balance sheets and experienced management.

Japan

The Bank of Japan has plenty of stimuli in place, which it continues to deliver, the latest being November 2016's surprise announcement to buy an unlimited amount of Japanese government bonds at fixed rates. This is perhaps a sign of concern over recent rises in yields across international markets following the anticipation of increasing growth and rising inflation following Donald Trump's election win. However, the impact of such stimulus is waning, leaving room for private investors to fund the likes of the 2020 Olympics and help maintain some momentum.

In December 2016, the Bank of Japan left the interest rate unchanged at minus 0.1%, as was widely anticipated by the market. Policymakers also decided to maintain its 10 year government bond yield target at around 0%. Rising yields, unlike elsewhere internationally, have not been a particular issue for Japan, however, this decision could be seen as confirmation of the Banks intent to take action to prevent any trend for rising yields developing.

There is room for the region to deliver growth near term, continuing to build on the significant amounts of corporate change that has taken place. It highlights once again that individual companies rather than entire sectors will be important to investment success.

Asia and Emerging Markets

If politics has been increasingly influential in markets in the last few years, this year, just one word could dominate: Trump. A new approach from the US could be very disruptive for emerging economies in particular. A protectionist stance from the US will see countries that have significant exposure to the US, notably Mexico and China, suffer. For how long will depend on the political drive and ambition of the respective nation. However, particularly in the case of China, political will is absolute and we would expect swift action to, at least, partially fill any void in the region left by the US.

Staying with the US sphere of influence, the prospect for further Fed rate rises, however well priced in, is still uncomfortable. Tighter credit conditions are expected in Emerging Markets across 2017 and although countries are in better shape, many remain vulnerable particularly given the levels of debt that have been racked up, higher inflation and political instability, which simply cannot be escaped at the present time.

In some countries household debt to GDP is in excess of 70% focusing central banks actions on financial stability. This debt is likely to push the focus on fiscal planning and may mean that the domestic consumer is more constrained in 2017.

The light relief and optimism for Brazil appears to be waning as its central bank cut interest rates by 0.75% to 13% with disinflationary pressures mounting. Unemployment is rising and GDP is expected to fall to 0.5% following September 2016's expectations of 1.4%. Brazil is broke, efforts have been made to fix it but the risks to the downside look once again to be growing. China will face questions internally and externally over its currency policy and private investment is likely to remain weak. Another important question for the region is whether or not countries are able to abide by the latest OPEC agreement. In theory, it should help sustain higher prices, which are helpful for the region but the track record for sticking to quotas is not great.

Political exchanges between Asia and Emerging Markets and the US are already changing, raising tensions. It is intriguing to think about potential outcomes and ramifications and means the next 12 to 18 months will be some of the more politically active we have seen for a while.

Fixed Interest

A waiting game is almost the norm now within fixed interest as markets and consumers wait for the cycle to turn. Rates rises have been permanently on the horizon since 2009 and, as is clear, timing them and understanding their impact has so far been difficult. We may now start to get more clarity in some areas of the world and think they are largely priced in. As a result we expect some impact but definitely not of Armageddon magnitude.

Following guidance from the Fed, markets rate rises in the US are currently 100% priced. We do not expect the number or scale of these to be large. The result of the forward guidance from the Fed means that, where possible, action has already taken place in fixed interest funds to manage the likes of interest rate sensitivity and, although some impact will be felt, it will be managed.

In the UK it is unlikely rates will be cut further. The expectation is for the status quo to be maintained in the near term. Elsewhere there is little room for rate rises so we expect duration management to centre around any impact from the US and then pull back slightly.

Liquidity presents the biggest concern, as it has done for a number of months now. The bond trade is crowded. Managers can do as much as they like with positioning and duration but if the trade collapses no fixed income portfolio will be immune. We continue with the underweight view and we continue with the use of funds with a strategic or multi-strategy remit, also highlighting short-duration while being mindful of the impacts of cost and charges on overall returns.

Property

Income remains the main attraction of property investment, although it is under pressure as the search for income drives prices up. Vacancy rates are historically low at present and will go some way in helping protect the income yield. Long leases and tenant quality are important to maintaining this going forward.

A weakened, though still positive outlook, will mean property investment is likely to be a little subdued but weak Sterling means that UK property is attractive to overseas buyers. London office space, particularly in the financial sector, looks set to come under scrutiny as the UK draws closer to leaving the European Union ("EU") and London's prospect as the main European financial centre fades. South East office space retains a high yield relative to the rest of the market while industrial/distribution warehouses across the country continue to do well reflecting more internet purchases as consumer spending habits evolve. Portfolio diversification is important at this juncture.

A note on property funds: the disposals made in the wake of the UK's leave vote have enabled most fund managers to crystallise gains while raising liquidity and most have unwound provisions that were put in place in the aftermath of the UK's leave vote. Opportunity will arise across 2017 as clarity begins to appear in relation to the UK/EU divorce.

Summary

We think government and central bank actions are broadly supportive of equities and continue to think that forced buyers of bonds will help maintain but not fully protect the bond market, meanwhile, although weakened, UK commercial property continues to deliver a diversifying income stream.

During the years following the financial crisis, a sensible (some may call it boring) and "exotic" asset free approach to asset allocation has stood us and our client portfolios in good stead. Individual funds may rise and fall but the shape of the overall asset allocation will continue to drive the majority of long term returns and offer an element of protection in terms of volatility in client portfolios. We continue to believe this to be the case, despite the challenges we have seen.

Our short term views

UK Equity Neutral
US Equity Overweight
European Equity Neutral
Far East (ex Japan) Equity Neutral
Japan Equity Neutral
Emerging Market Equity Neutral
All Fixed Interest Neutral
UK Commercial Property Neutral

 

If you have not reviewed your holdings recently, contact your Chase de Vere adviser. If you do not have a Chase de Vere adviser, please contact us on 0345 300 6256 so we can arrange for an adviser to contact you.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investing in shares should be regarded as a long-term investment and should fit in with your overall attitude to risk and financial circumstances.