Moore Stephens - Market Outlook March 2014

Market Outlook March 2014

- Noam Chomsky

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Optimism is a strategy for making a better future.

Because unless you believe that the future can be better, you are unlikely to step up and take responsibility for making it so.

INTRODUCTION

2013 was a very good year for investors. Across the 12 months to 31st December, double digit returns have been the norm, but now that we are well into 2014, markets have been a little jittery and have fallen back a bit. In this issue of Market Outlook we will look at how 2014 is shaping up and what investors can expect going forward.

A significant theme that has been driving markets over the last few years is Quantitative Easing, or QE as it is sometimes referred to. In simple terms QE involves Central Banks such as the Bank of England or the US Federal Reserve printing money and then pumping it into the markets. There are various arguments both for and against QE; those in favour say the recession would have been far deeper and more severe without it whilst those against say that printing money simply makes all the existing money worth less and will eventually result in rampant inflation. Whichever view you take, there is no doubt that a mixture of QE and ultra low interest rates have had a significant effect on investor behaviour. Faced with the prospect of seeing their capital devalue in real terms against inflation, many traditionally risk averse members of the public have been forced out of their comfort zones and into the stock markets in search of reasonable returns.

Recently however, the US Federal Reserve announced that they have begun to ‘taper’ their QE programme before eventually stopping it completely. Markets have taken the view that if QE is to be withdrawn, then a rise in interest rates cannot be far away, but how realistic is this scenario? Could we

soon be back to the sort of returns that were being achieved back in 2008 when it was possible to achieve 5% per annum on a 1 year fixed term deposit?

Our view is that interest rates are likely to stay low for the foreseeable future, which means at least the next 18 months. We believe that there is plenty of evidence to back up this theory. Back in August last year the new Governor of the Bank of England announced that interest rates would not rise until unemployment dropped to 7%.

More recently the UK has made significant progress in its recovery from the recession and thanks to the new economic growth, unemployment has fallen to 7.1%. But when reminded of his statement from last year the Governor was quick to change tack and abandon his previous pledge. Why should this be. Surely if the economy is on the mend, there is no reason to maintain the low interest rate environment that was previously necessary.

We believe that the economic recovery is not yet strong enough to sustain itself without the benefit of very low interest rates. This is mainly because our recovery is not due to the UK becoming better at exporting goods and services around the world, it is because this recovery is consumer led.

One of the major benefits that the current low interest rate strategy has brought has been very low mortgage rates and UK consumers have managed to get by over the last few years because their repayments have stayed low. Since 2008, wages have only increased by around 0.7% per annum on average whilst inflation has been closer to 3% per annum. Cumulatively we have seen prices rise by around 15% over the last 5 years whilst wages have only risen by around 3.5% over the period. It is the very low rates that mortgage payers have gotten used to and are now dependent upon that have kept them afloat. If mortgage rates were to go back to 2008 levels, many individuals would

find their mortgages unaffordable and there would be a fresh round of defaults and bankruptcies putting pressure back on the banks at a time when they are beginning to recover.

This means that interest rates are almost guaranteed to remain low for the next couple of years at least and even when rates do start to go up, they will most likely be modest movements, perhaps increments of 0.25% at a time.

The future for interest rates has a huge significance for stock markets and the bank base rate at 0.5% effectively creates a solid floor under them. Stocks & Shares paying dividends of 4% per annum look very attractive to someone who is struggling to earn 1% from a deposit account. This demand for investment yield means that as long as interest rates stay low, the stock markets are likely to hold their current value, despite valuations being at the top end of the range historically.

At the time of writing US and UK shares are trading at almost 16 times earnings. Looking back over the last 50 years, shares being priced at these ‘expensive’ levels have often presaged a fall in the markets. This time however we believe that things are different.

In the past when markets did fall, interest rates were much higher than they are today and so the artificially low rates of today are the game changer that makes the difference.

Markets retaining their current values is all very well but where will future growth come from? The answer has to be from the increasing profits made by companies as economic recovery takes hold. The next few months should provide the answers as the earnings season unfolds. Flat profits will mean that the FTSE 100 is likely to move sideways across the year, but if earnings and profits grow then the index is likely to do the same.

FIXED INTEREST

The fixed interest sector feels like it is facing many headwinds at the moment.

Bond managers at the turn of the year were fretting over liquidity drying up in the bond market and were trading their portfolios into short duration (i.e. bonds which mature in 1-2 years time as opposed to 10-15 years) higher grade bonds. Their fear was that if sentiment towards bond markets turns quickly in favour of equities, there would be insufficient liquidity to meet redemptions.

In response, Ariel Bezalel who runs the Jupiter Strategic Bond fund, increased the investment flexibility available to him to increase liquidity and protect remaining investors should sentiment turn.

In terms of strategy, Jupiter continue to hold the view that European high yield bonds present some of the most compelling opportunities available for investors in fixed income, as has been proven by the Invesco High Yield Bond fund (formerly the European

High Yield Bond fund). The region is enjoying low default rates, companies continue to focus on repairing balance sheets, the economic backdrop is stabilising and interest rates are likely to remain low for a prolonged period. These conditions contrast with those in the US where companies are more confident and therefore more willing to take on leverage.

The Threadneedle Emerging Market Bond fund fell rapidly in the middle of 2013, as did all emerging market debt funds. As the Federal Reserve introduced the idea of QE tapering, emerging market debt and currencies started to revalue in anticipation of normalising US interest rates. Should this continue, the threat of default is not deemed to be likely, but the necessity to be more selective about the debt and currencies owned will be key to the market reasserting itself. As far as fixed interest goes, we continue to regard emerging market debt as the long-term asset class to own and the manager remains optimistic about returns for 2014.

PROPERTY

The outlook for UK commercial property is extremely positive at the moment. It is important to differentiate between concerns over a bubble in the residential market on the back of ‘help to buy’ and the commercial market.

Clearly interest rates will have some impact upon future prospects for the market, but we have seen through the L&G UK Property fund in particular, yield and capital returns starting to come through. For a long time, returns were simply the yield minus costs, but improving sentiment is finally coming through in returns to investors. We haven’t increased allocation, aside from some of the lower risk strategies where we have increased the F&C UK Property allocation slightly. We don’t wish to pile into a sector, which is still effectively an illiquid asset class.

The Standard Life UK Property fund has performed well although Select Property has lagged. The international influence has had some bearing on this, but if we think that the UK is actually one of the better placed European economies, growth from the wider community should follow suit. The fund has suffered a little from its Australian exposure, but is taking the opportunity to reinvest profits into recovering economies, or those expected to benefit from reflation such as Japan. In Europe they are moving from Eastern European holdings such as Polish logistical property to dominant office and core retail property in Western and Northern Europe.

We have added the Schroder Strategic Bond and Old Mutual Monthly Income fund to lower risk portfolios. The former is designed to produce stable single digit returns month on month. It is a traditional, slightly boring for want of a better word, bond fund. The latter is more interesting as its primary aim is to produce a monthly income for investors.

This is tricky as the portfolio has to comprise bonds that will mature and pay out at different dates. The upside is that there is plenty of diversification and the manager is not afraid to look beyond the traditional market to find opportunities. Alongside household names such as Barclays, there are holdings in New Look, the fashion retailer. The bonds look attractive, as the firm has recently announced strong online trading with a successful overseas expansion program in force.

UK EQUITY

2013 became the year of the “star” fund manager departure.

Some key protagonists announced they were leaving either for pastures new or for retirement. Neil Woodford leaving Invesco Perpetual was perhaps the biggest announcement of them all, in that he wasn’t leaving the industry, but leaving to set up a new venture. A concern for us when owning the fund was not so much the billions of pounds he ran, but his motivation to keep doing it year on year after the acclaim he had achieved through his career.

The Neil Woodford effect caused a shake up in UK Equity Income funds across the board as rival managers touted quite aggressively for business. There was an initial outflow from the High Income and Income funds, although that stemmed a little over the following weeks. In turn, alternative funds have seen significant inflows of assets that they couldn’t have anticipated.

Mark Barnett, who has run a number of successful funds at Invesco for years, has replaced Neil Woodford as manager of the Income mandates. The unknown challenge for Mr Barnett is maintaining his existing mandates, whilst trying to manage the multi billion pound funds Mr Woodford has left behind. We have decided to sell out of the Invesco High Income fund whilst the situation unfolds.

We have bought the Schroder Income fund in its stead. Although this is run by the team who manage the Schroder Recovery fund, there are differences between the stocks held and the outcome they are looking for. In Recovery they seek growth returns, in Income they seek yield, but the key to both funds is the focus on valuation over sentiment, which means that the composition of stocks will look very different to Neil Woodford’s funds, but at this point in the UK economic cycle, the Schroder fund looks better positioned to return both yield and capital growth to investors.

Unicorn seek to divert attention and assets into some of these other, less renowned funds, as concerns over the size of UK Income abound.

In addition, the Unicorn UK Income fund has created something of a dilemma of late.

We bought the fund when it held less than £50 million, today it stands at over £520 million. That phenomenal rise has come in under two years. The fund has been one of the top performers in our portfolios as well as the wider universe. We have switched assets out of this fund and diverted them

The Unicorn fund is concentrated on under 50 stocks from the smallest realms of the UK equity market. It is simply not possible to invest huge amounts of money into these type of firms when trying to limit the number of stocks held. The Marlborough fund takes a different approach. The fund holds around 120 stocks at present, with a maximum investment of around 2% into any

into the Marlborough Multi Cap Income fund. This decision would have come sooner rather than later, as Unicorn have spent the last few months stating that the fund is likely to soft close as it reaches £750 million. Based on past performance and future inflows, this could be breached in the next few months. There have also been subtle changes at Unicorn, as a co-manager has been appointed to run the fund, whilst John Maclure who built UK Income focuses more of his energy on other of Unicorn’s less popular funds. The cynic in me suspects that

one company. 10% of the fund is typically invested into FTSE 100 companies to aid liquidity and the whole approach is designed to reduce the risk of one particular stock underperforming. This strategy offers similar returns to Unicorn, but with a potentially longer shelf life as they are confident that their diverse approach can be scaled up with consistent inflows of assets.

the market so that the fund can benefit from both outcomes. The latter aspect has been taken over by the Threadneedle Global Extended Alpha fund manager, who already shares many of the stock ideas as the American version of the fund and who has been extremely successful in his own right.

On the income side of things, we maintain the Neptune US Income fund. This hasn’t been a strong performer from a growth perspective, although the yield is higher than alternative funds. Interestingly, there seems to be a view that as the US market enters a different phase, the stock ideas held within the fund should start to produce the capital as well as yield returns for investors.

The Marlborough fund to date is not a sacrifice of performance. We cannot predict the future, but in essence there are many parallels between the two. Giles Hargreaves has been one of the UK’s most successful smaller companies investors over decades and he is imparting that knowledge into the multi-cap fund, alongside his co-manager who looks after the larger cap, FTSE stocks.

US

Just as we started to write this brochure, Threadneedle announced the departures of Cormac Weldon and Stephen Moore to Artemis.

This was a surprise as Mr Weldon has been at Threadneedle for 17 years. On the positive side, some of the key analysts and designers of this fund have stayed with Threadneedle.

We have a high weighting to this fund and are maintaining this for the forthcoming months.

There are two aspects to the fund: the stock-picking aspect, much the same as any other fund; and the market analysis which ordains which stocks or sectors are deemed to bring positive and negative returns in

The former is generally a team effort and with the original analysts still involved, the transition should hopefully be a smooth one, particularly when there are few alternatives that we are confident about. In unprecedented market conditions such as we may again see in 2014 with the reduction in QE, it seems wise to maintain a fund that can protect against potential lurches in the market.

EUROPE

The European market has produced very diverse returns. Funds such as Invesco Perpetual’s version have outperformed rivals based on improved returns from more of the Southern, periphery states.

Funds such as Threadneedle European Select appear to be lagging in comparison. We will maintain the Threadneedle fund as our core European holding understanding that it is a “get rich slow” type of fund. There are many pockets of the globe where it is possible to attain short term gains, but these returns are equally unpredictable and as tapering slows in the US, consistent returns from Europe are more appealing for our portfolios.

We have increased the overall European weighting as we have reintroduced the Baring German Growth fund. We previously held this fund in some of the darkest days of the Eurozone crisis, but feel that a return to the fund at the moment is a sensible move.

Germany has come through the elections of 2013, and exports continue to rise to Eastern Europe and China, which places it in a strong position to benefit from upturns in performance from both regions.

Recent reports from Ernst & Young show the Chinese to have made 25 acquisitions in Germany and the UK through 2013, with China being the second largest nonEuropean investor in Germany after the US. The Chinese are particularly interested in Germany for machine manufacturers and automotive suppliers. German valuations remain low when compared to historic levels

and this fund should offer growth potential, albeit through a highly developed market, to boost alpha from our European weighting.

On the income side, we have switched from the Standard Life European Equity Income fund into the Blackrock Continental European Income fund. The Blackrock fund launched a couple of years ago at a point when the European market hit a rough patch, but since then it has consistently produced yield and capital returns. The Standard Life fund has picked up in the very recent past, but aside from that it has lagged its peers. Having met both managers, we have more confidence in Andreas Zoellinger’s interpretation of European politics and markets movements.

GLOBAL

On the global side, we have sold out of the First State Global Listed Infrastructure fund and diverted the holding into the Artemis Global Income, Schroder Income and Marlborough Multi Cap Income funds.

First State has been a true steady Eddie fund.

In many respects, we came to regard it as a proxy for lower risk assets such as property and fixed interest. Over time though, it has become more correlated to other funds we own, in particular the Artemis Global Income fund which has purchased more infrastructure stocks over the years, but with higher yields and capital returns.

If anything, the theme we are looking at through all the changes we have made is that funds such as First State have served a purpose whilst markets have been so unpredictable, but as market data improves, and the initial fear of QE reduction passes, we would expect growth in good quality stocks to return and being too defensive may hurt performance overall.

On the socially responsible side of things, there seems to be greater optimism about prospects for renewable energy and SMART technology. Historically, emission targets were interpreted by individual Governments to the extent that most major economies have made strides in this area, but with little coherent strategy. The advent of SMART technology could hasten what is being regarded as potentially the second electrification of the developed world, whereby SMART technology evaluates energy usage in homes and immediately cuts off technology which is using energy, but which shouldn’t be.

Given the inexorable thirst in modern society for a gadget to do all the thinking, the advent of this technology into the mainstream could have an emphatic impact upon our understanding of energy usage, future energy prices and investment opportunities within sectors developing this technology.

ASIA

Our Asian exposure has changed quite significantly.

For a long time the Newton Asian Income fund has been a core holding across most portfolios. We are concerned on two levels though. First the size of the fund (£4.4bn) cannot continue to rise without it closing to new monies and secondly the manager made some poor stock selections last year, which dragged down performance from previously high levels.

The manager has been slightly suspicious of Far Eastern economies such as China’s, but New Zealand holdings that were preferred were caught out when the New Zealand Government reneged on an agreement with “Chorus” on pricing for its copper broadband service. As a result all the New Zealand holdings in the fund tumbled in November leading to a loss for the month of 6.44%. Perhaps the manager couldn’t be held responsible for this action as it did seem to be a hasty u-turn by the Government, but with a weighting of 50% to Chorus, such positions can really harm performance.

In the income portfolios we have replaced Newton with Liontrust Asia Income. Liontrust traditionally were a fund house dominated

by UK Equity expertise. Following the loss of some key managers a couple of years ago, they have reinvented themselves, with a focus on income producing funds in Asia and the rest of the world. The Asian fund has started to pick up traction since launch in March 2012, with a fund size of £18m, albeit tiny relative to Newton.

The managers are underweight Australia, which is a key contrast to Newton, as they feel that the market is overvalued, interest rate cuts have failed so far to stimulate consumption and the market appears to be holding more bond proxies than many others, which is not good news because in a QE tapering environment, growth stocks not cash rich bond proxies are more likely to outperform. The fund currently favours China, Hong Kong and Singapore.

Another key shift in Asia is a move towards growth funds away from more defensive plays. In the growth portfolios, we have introduced the Invesco Perpetual Pacific fund. This is a pan Asian fund which includes exposure to Japan. As many readers will know, we are not supporters of the Japanese economy. Those who timed the market right in 2013 would have been extremely successful, although after a spectacular

rise, the market somewhat flattened out as the initial excitement of Abe-nomics lost its shine. Where 2014 may be different for Japan is that their companies have become more competitive, with a greater focus on investors. Historically, deflationary fears, the ageing population and complacency at being the World’s second largest Superpower left little long term optimism for investment into Japanese companies. Things do appear slightly different this time. Chasing shortterm gains is not the answer, but Japan has an opportunity to bring growth to the region as a whole rather than be so inward looking. If the next round of Abe’s QE takes hold and economic relations between Japan, Korea and China are maintained, a period of renewed prosperity may return to the region.

Aside from Abe-nomics, Simon Somerville, manager of Jupiter Japan Income feels positive outcomes can be drawn from the announcement that Tokyo will host the 2020 Olympic Games. He feels that the social impact is likely to be much more positive than the economic impact. Winning the Olympic bid will improve confidence among the Japanese and the feel good factor should make Prime Minister Abe even more popular. This increased sense of confidence and purpose among Japanese people should also mean that Abe’s and Bank of Japan Governor Kuroda’s pro-growth policies will become much more effective. The Olympic bid decision will, in his view, also give increased force to Abe’s “third arrow” reform policy and further drive his initiatives for PFI (private finance initiative) and PPP (public private partnership) funding.

We have also tweaked our Chinese funds.

We have reduced the Neptune Greater China Income fund and added in the Threadneedle China Opportunities fund. The income fund is a long term holding, but we feel that China may be a surprise performer in 2014.

Some Chinese returns in 2013 were acceptable if not amazing, but contrary to the fears of many, we think that China is actually adapting in the eyes of the world to a more sensible economic policy. It is easy to judge, but politics aside, would the US or UK avoid constant criticism if they were being built in today’s society with never-ending media speculation? Yes, the headlines will say Chinese growth figures reduce, but the reality is that these are still way ahead of the Western world. Consumption in China remains a long-term growth story and the Threadneedle fund with its bias towards small to mid cap stocks should contrast with the defensive nature of the Neptune fund.

EMERGING MARKETS

Emerging market funds underperformed in 2013.

The Somerset Emerging Market Dividend Growth fund was held to withstand some of the falls and to a degree it did that, but we feel that whilst this remains a core fund for the income portfolios, our growth portfolios need a different approach to try to take advantage of the low valuations across the emerging world.

This isn’t the first time we have referred to the emerging world looking cheap and it has been a consequence of the general economic uncertainty that market valuations have meant very little in recent times, when once they were a key indicator. QE reduction may hurt the emerging world further in the short term, but it may also be a catalyst for

growth to return to the region.

The Fidelity Emerging Markets fund has a natural bias to those areas of the emerging world we continue to favour, such as Africa, emerging Europe and Latin America. The fund is leading the charge of the next phase of emerging market funds behind the mega-funds of First State and Aberdeen. Its long-term track record is encouraging and by allocating to Fidelity, we will reduce our weightings slightly to the Neptune Latin America and Invesco Emerging Europe fund.

The former has a high weighting to Mexico, which we favour, but as with many Latin American funds, 2013 was a poor year. It may well be that as signs improve we increase our weighting again in the future.

are few viable alternatives in the region and the fund’s consistent focus on Turkey as well as Russia is a positive in our view and so again, we will run it alongside Fidelity.

We have sold the Neptune Africa fund.

It was a small allocation in portfolios and had proven resilient compared to other Emerging Market funds, but given the bias of Fidelity towards the region, we felt we could consolidate the allocation, particularly as we approach a period of tension for Africa with elections forthcoming most notably in South Africa.

The Invesco fund saw a change of management in the Autumn of 2013. There

COMMODITIES

Blackrock Gold & General stands out in performance reports for all the wrong reasons at the moment, as it has produced negative returns for quite some time.

Our decision to previously reduce the weighting and sell out of our other commodity funds was beneficial to performance, as commodities across the board have fallen. Despite the growth of fracking and continued emerging market industrialization, commodity prices have

continued to fall. However, we have decided to increase marginally our allocation to the Blackrock Gold & General fund at this time.

There appears to be no magic bullet, which will resuscitate commodity prices, but if we believe in long-term growth opportunities in the emerging world, allied to their knock on effect in developed markets such as Germany, plus the threat of inflation in a post QE world, then it would seem that the price of gold and gold equities could rally.

Valuations sunk lower than they have been since August 2010 towards the end of last Summer only to rebound a little in the Autumn. However, this was wiped out on

18 December when the Fed announced it would reduce the level of its ongoing QE programme.

The gold price then fell over $40 in two days, bottoming at $1,188/oz the day after the statement. It recovered somewhat soon after, closing the month at $1,206/ oz. Current prices are putting pressure on gold producers and it may be that instead of increasing or maintaining production, an increase in M&A activity will return to the sector, which may be positive for equity prices, even if the price of physical gold takes longer to recover.

CHANGES AT A GLANCE

Allocation Increased No Change

Table Fixed interest

US Equities

Emerging Markets

Property

Euro equities

Asia

UK Equities

Global equities

Commodities

Allocation Decreased

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THIS DOCUMENT IS PROVIDED FOR INFORMATION PURPOSES ONLY AND DOES NOT CONSTITUTE ANY FORM OF FINANCIAL OR INVESTMENT ADVICE. PAST PERFORMANCE IS NOT A GUIDE TO FUTURE INVESTMENT PERFORMANCE. THE VALUE OF YOUR INVESTMENTS AS WELL AS ANY INCOME DERIVED FROM THEM CAN FALL AS WELL AS RISE AND YOU COULD GET BACK LESS THAN THE AMOUNT INVESTED. WE BELIEVE THE INFORMATION IN THIS BROCHURE TO BE CORRECT AT THE TIME OF GOING TO PRESS AND IS BASED ON OUR CURRENT UNDERSTANDING OF LEGISLATION AND TAX ALLOWANCES WHICH MAY CHANGE IN THE FUTURE. AS SUCH CHANGES CAN’T BE FORESEEN WE CANNOT ACCEPT RESPONSIBILITY FOR ANY LOSS ACCESSIONED TO ANY PERSON AS A RESULT OF ACTION OR REFRAINING FROM ACTION OF ANY ITEM HEREIN. PRINTED AND PUBLISHED BY MOORE STEPHENS FINANCIAL SERVICES (EAST MIDLANDS) LIMITED. AUTHORISED AND REGULATED BY THE FINANCIAL CONDUCT AUTHORITY. JANUARY 2014