Market outlook summer 2015 by Blayney Partnership

Market Outlook Summer 2015

“Human nature desires quick results, there is peculiar zest in making money quickly” - John Maynard Keynes, 1936

SHORT TERMISM - A CURSE FROM THE RECENT PAST

Time and again, history provides lessons that taking a short-term approach rarely results in beneficial outcomes.

control and requires their adviser to provide a service that their client is happy with. Our clients know this and we know our clients know this and so if Moore Stephens is to remain a successful growing business, we have to focus all our efforts into providing service that our clients truly value and of course are happy to pay for.

From a financial perspective, the excesses of the early part of this century by some parts of the financial services industry bear testament to this. Banks and other financial institutions largely made their money by selling products rather than by providing services. All their effort was focused on finding new customers to sell their plans to in order to make huge upfront commissions with little or no thought given to providing an ongoing service to their clients.

The downside of this approach is that providing excellent service is hard work, it takes time and requires attention to detail in every aspect of what we do. Last but not least, you have to be good at it and require skilled and highly trained employees. I believe that the reason the high street banks don’t offer this service is that it is incompatible with their short-term approach as outlined above and they aren’t yet ready to change. I think that our business model is the right one and I would hope that our clients agree with that view, certainly the growth of our business over the last 11 years suggests that they do.

Ten years ago the financial services industry was awash with advisers of many different hues. It was almost impossible to visit your local high street bank without being pounced upon and sold all manner of products from home insurance, to investments, to loans and payment protection insurance. High street banks weren’t alone in their selling zeal, the global investment banks were just as bad and possibly worse pushing their toxic mix of sub-prime loans packaged to create new ways to make money quickly for the sellers. As we know, that period of selling excess didn’t end well and we are still living with the consequences. Unfortunately, I don’t believe that these institutions are yet ready to change their spots. If they were, we should be able to see the evidence in those same organisations today. The alternative to selling products for short-term gain is to provide an ongoing service to your clients where you get paid as you go along, for as long as your client is happy with the service you provide. We have had this ‘pay as you go’ service in place since 2004. It is incredibly simple and has the advantage that it allows customers to ‘vote with their feet’ whenever they feel they aren’t getting value for money. Rather than paying huge advance commissions upfront for service that could be good, bad or indifferent, this approach puts the client in

Timescales are also important from an investment perspective. When investing on behalf of our clients we always try to take a medium to long-term view on where we believe returns can be made. Some other investors tend to be less sanguine and prefer to flit like humming birds from one sector to the next trying to ‘beat the markets’. The result of this flitting around can be heightened volatility in the markets and we may well be entering one of those periods at the moment. In recent years, incredibly low interest rates have resulted in huge inflows of cash into government bonds, both here in the UK, the US and in other western states. The demand for yield at any price has seen the value of these bonds soar and as a consequence, bond yields have dropped. In 2007 the yield on 10 year US Treasury stock was 5% and by 2012 it had dropped to 1.5%. However, at the time of writing bond yields appear to be headed in the other direction with the same 10 year US Treasury stock currently yielding 2.5%. Ultimately, interest rates have to get back to a more ‘normal’ range, which is likely to be significantly higher than they are now.

Nobody wants to be left holding an investment that is going to significantly fall in value, however gradual that fall is likely to be and so there are very many holders of government bonds nervously worrying that as the world economy shows signs of entrenched recovery, interest rates will rise and bond prices will begin their long descent. I am pleased to report that we don’t hold government bonds in our client’s portfolios at present since they don’t meet our criteria of being attractive for the medium to long term and this has been the case for quite some time. Oddly, even investment sectors that have good long term potential can be overlooked by many of those whose objective is shortterm gain and so it’s certainly possible that we will see short term falls in Asia and the Emerging Markets sectors whilst the markets re-balance towards the ‘normal’. An article in the Economist (Charge of the Lithium Brigade – 30th May 2015) caught my attention recently. The depth of research into developing new battery technology is quite incredible and it points to a very different future for energy than the carbon based present one. Elon Musk (founder of PayPal and Tesla) is the new darling of Social Media and the Tech world. His recently announced partnership with Japanese Industrial giants, Panasonic to build a $5 billion battery factory in Nevada underlines the point that storage of electricity, much of it generated by renewables is the key to making sustainable energy affordable and effective. These developments combined with new research into improving the efficiency of PV cells (solar panels) means that we are now in a world where renewable energy is part of the mainstream and not just the domain of tree hugging environmentalists. As ever, the rise of a new technology will have consequences for the technology it replaces. Back in July 2008, the price of Oil hit $147 a barrel, today it is $64 per barrel and I wonder if it will ever reach those dizzying heights again.

CHANGES AT A GLANCE

Fixed Interest

Absolute Return

Property

UK Equity

European Equity

Global Equity

Asia Pacific

Emerging Market Equity

After a period of relative stability in the markets, varying forces are starting to weigh heavy on investor sentiment. Companies are actually in good shape, with much improved corporate governance and a renewed commitment to reward investors. The dilemma is that for the first time in a while, external factors are causing markets to be nervy again and this has seen noticeable movements in assets such as fixed interest in recent times. On a case by case basis there seems little sound reason to trim back allocations, but prudence is probably the overriding theme of the changes we have made to allow us to remain invested wherever possible, but alter quite significantly some of our underlying weightings to provide what will hopefully turn out to be a buffer should markets continue to be unsettled in the coming months. Perhaps the most encouraging signs to emerge in recent months is a return of diverse returns. For too long all assets and sectors behaved in the same way, whilst we are not yet back to the days of true diversification in all asset classes, there is enough evidence, as shall be seen in this review, to suggest that developed markets in particular are moving in different ways. If market nervousness is a concern to us, then it may seem illogical that the biggest changes in the portfolios have come in the fixed interest sector, supposedly the lower risk part of portfolios. It should be illogical, but there are growing fears about the future of bond markets, at least in the near term. In our growth portfolios, we

have sold out of all the core fixed interest holdings. For the sake of maintaining an income we have retained some emerging market debt in our income portfolios and for ethical reasons, we have retained some fixed interest holdings in our ethical portfolios, but by and large our sentiment towards fixed interest is one of nervousness. There was nothing wrong with the funds we predominantly owned, either the Jupiter Strategic Bond or Threadneedle Emerging Market Bond funds. They remain leaders in their respective sectors, but we feel a shift has come in the future of fixed interest funds and how they will be managed in the future. Emerging Market Debt is highly likely to reappear across all portfolios again in the future as we consider this to be the area of fixed interest with the greatest longevity, but in the near term concerns over the US Dollar in particular create uncertainty. We have experienced quite large falls within the sector in the past in almost identical economic circumstances (Greek exit concerns and rising interest rate fears) and just sense that whilst the manager has taken action to smooth the fund against such extreme reactions in the future, for those not seeking an income yield specifically, it may be pertinent to take a break from the fund. The Jupiter Strategic Bond fund is now one of the largest in the sector. We originally bought it when it was much smaller and whilst the size hasnâ&#x20AC;&#x2122;t been an issue to date, we have started to see a slowdown in returns and fears over liquidity across bond markets as a whole. The fund is exceptionally low risk and so there was an argument to retain it simply for a nominal return with limited downside, however,

we believe there are better alternative investments at the present time. Liquidity (i.e. the ability for bond managers to buy and sell holdings) is becoming much tighter and this creates problems for traditional bond managers who have less control over the price they sell at and less quality issuance to buy on the reverse. There is no doubt that Greek exit fears have caused quite marked movements in bond prices in recent weeks, particularly amongst German Bunds and some managers who are desperate for yield and improved performance figures are buying significant amounts of periphery debt (i.e. Italian, Spanish, Portuguese debt), but that just highlights how unreliable the sector has become. We have introduced a new fixed interest fund to our lowest risk portfolios, the Blackrock Fixed Interest Global Opportunities (FIGO) fund and we consider this to be a model of how fixed interest funds will need to operate in the future. In essence the fund is run by three key managers, each responsible for a different arm of the fixed interest world. Behind them are a team of analysts and research facilities which continually feed into risk adjusted matrices. Risk adjusted matrices ensure that the fund continues to invest along strict investment lines, so that the risk being taken for the potential reward does not go out of balance. This governance and continual tweaking of the investment strategy creates incremental returns and is how we believe fixed interest funds will run in the future. Rather than core holdings of specific bonds or gilts, there will be combinations of a host of different ideas that retain the highest levels of liquidity at all times to counter what has become the biggest threat to traditional bond funds.

A word on inflation, index linked gilts or bonds would have been an obvious choice for the portfolio if we assume that inflation will inevitably rise over the coming months.

The vertical axis shows investment returns over three years against a horizontal axis showing the volatility of each sector. The chart compares the UK Equity Income sector (the red dot) versus the UK Index Linked Gilt sector (blue) and the Targeted Absolute Return sector (green). What we can conclude from this comparison is that the UK Index Linked Gilt sector has experienced almost as much volatility as the UK Equity Income sector (7.89 vs 7.79). The investment returns from the equity sector are significantly higher than the gilt Scatter Chart sector which Static one would expect, but given that Gilts are regarded as one of the safest investment assets it doesn’t seem right that

The chart below summarises our concerns about the recent behaviour of index linked gilts in particular.

the risk associated with them are virtually the same as equities over a three year view. In part, this distortion has been caused by a phenomenal 2014 where index linked gilts made double digit returns, so most of the performance shown on the chart was achieved in one year, in previous years returns had been flat if not slightly negative. Such a wild swing caught bond managers by surprise. Logic would suggest that index linked assets should perform well when inflation returns, but we would argue that based on current volatility levels, we can achieve far better investment returns for marginally more risk by inflation proofing portfolios with dividend paying equities. 13 June 2015

Pricing Spread: Bid-Bid / Currency: Pounds Sterling Pricing Spread: Bid-Bid ● Currency: Pounds Sterling

75.0

Mean Ann. Volatility of 5.89

70.0 65.0

55.0 50.0 Performance

Performance

60.0

45.0 40.0 35.0

Mean Performance of 31.91

30.0 25.0 20.0

B C

15.0 10.0 5.0

0.0

0.5

1.0

Key

1.5

2.0

2.5

3.0

3.5

4.0

Name A

UT UK Equity Income Retail TR in GB

UT UK Index - Linked Gilts Retail TR in GB

A - UT UK Equity Income Retail TR in GB C UT Targeted Absolute Return Retail TR in GB B - UT UK Index - Linked Gilts Retail TR in GB C - UT Targeted Absolute Return Retail TR in GB

4.5

5.0

5.5

6.0

6.5 Ann. Volatility

7.0

Annual Volatility

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

31/05/2012 - 31/05/2015 © FE 2015 Performance

Volatility 31/05/12 - 31/05/15 Annualised Data from FE 2015

61.00

7.89

18.98

Annualised Volatility: 7.89 Annualised 2.00 Volatility: 7.79 Annualised Volatility: 2.00

Performance: 61.00 15.75 Performance: 18.98 Performance: 15.75

7.79

Past performance is no guide to future returns. The value of units can go down as well as up. Please note that pension fund and life fund performance differs from unit trust/OEIC performance due to the underlying difference in the taxation treatment.

The Targeted Absolute Return sector has replaced much of the fixed interest element in portfolios, hence its inclusion in the chart previous. Selected absolute return funds combine a predictable investment return of typically around 5% per annum, with much lower levels of volatility than can be found in many alternative funds. The added advantage to absolute return funds in current market conditions is their liquidity, they are far better placed to manoeuvre the underlying assets at any given time than either a traditional equity or bond fund. We have included the Henderson UK Absolute Return, Henderson European Absolute Return, Threadneedle UK Absolute Alpha and Invesco Perpetual Global Targeted Return funds in our portfolios in varying proportions. The two Henderson funds used to be known as the Gartmore funds and we originally bought these funds when they first launched in 2009. We held them during the aftermath of the financial crisis, selling out when markets started to calm down. The consideration with absolute return funds perhaps more than with other sectors is that they can perform a role in particular market conditions, but when markets

are all moving in the same direction they can return virtually nothing as they are seeking to suppress some of the downside associated with markets whilst benefitting from some of the upside. If everything is moving up then there are very few anomalies or market mis-pricings to take advantage of and so these funds typically do not feature as permanent fixtures in portfolios, but we feel that these particular funds are proven performers in the type of investment conditions we anticipate in the coming months and hold an advantage over fixed interest. We have also sold down some of our property exposure, selling out of the Standard Life property funds we previously held. We have retained the L&G UK Property and the F&C UK Property funds as they combine both a sensible property portfolio, liquidity (a recurring theme in property as well as fixed interest) and diversification as the F&C fund is purchasing much smaller properties to L&G. The Standard Life funds had not performed poorly, but we are worried about the amount of money which continues to flow into property funds and how this may affect investors when returns revert to normal. By that I mean that property funds have produced double digit returns for the past 18-24 months. That is simply not normal. Property funds should have slight capital growth with a yield of around 5% thus giving an annual total return of maybe 6.5-7%. The

excessive returns for what are undoubtedly lower risk funds has seen a wall of money hit a limited number of funds. We expect returns to hold up for most of 2015, but then fall as 2016 progresses. It is the point at which returns start to fall that bothers us. Whilst we donâ&#x20AC;&#x2122;t anticipate a repeat of 2008/09 when property funds were hit by massive outflows and had to shut the doors to redemption requests, we are not convinced that we wonâ&#x20AC;&#x2122;t see some significant outflows from property funds. Property funds are still offering attractive yields and investors are crying out for such income, but we fear that as soon as the boom days are gone, too many redemption requests will distort market returns and will cause remaining investors problems. We remain comfortable with the management of the L&G fund for now and F&C do not market their fund to new investors. The nature of the F&C fund and the smaller assets it purchases mean that a group of investors are already in the fund and F&C seek further investment from these sources rather than market the fund to the masses who in turn cause problems for the management. They seek stable investors rather than easy money which could just as easily flow out as in. The F&C fund may not always seem the most exciting of property funds, but it is that cognisant management that we support for our clients.

As alluded to earlier, income is becoming harder to find. By moving away from a fixed interest focus, we have had to look for alternative ways to generate income and in so doing we have added some new funds to the portfolios, some of which have emanated from sectors traditionally unloved by investors. The UK Equity & Bond sector only comprises just over 20 funds. This is tiny compared to some sectors which contain hundreds. Traditionally, investors shy away from investing in these funds because they don’t fit a particular model, they are neither solely equity nor solely fixed interest, but we have selected two funds from this sector that meet our criteria of stable income, capital return and low volatility; Jupiter Monthly Income and Threadneedle Monthly Extra Income. Essentially these funds combine the fixed interest and equity prowess of the respective fund houses to produce income for investors on a monthly basis. Whilst the equity content may incur slightly more risk than pure fixed interest funds, as per our previous thesis, equity income assets are not proving to be significantly more risky than bonds at present. Both funds are relatively small at around £100m and £300m respectively which is tiny compared to fixed interest funds and allows them to focus on their investment mandate rather than worry about capacity or the scale of any purchases they make. In an age where multi manager and outsourced discretionary investment are becoming monopolistic in the investment fund space, we feel that we have an advantage in accessing these highly rated, yet relatively unknown funds. The performance of the Marlborough Multi Cap Income fund has heralded a shift in investment returns from larger company investing to smaller companies. This is usual in any economic cycle, but is most marked by the Marlborough fund which has around 40% of the assets invested in small or micro-cap stocks. These stocks have really boosted performance in recent months and it has been noticeable how larger company investment funds have continued to be successful, but less spectacular than small company assets. To this end, we have added the JO Hambro UK Equity Income fund to our income portfolios and the Miton UK Value Opportunities fund to our growth portfolios. The JO Hambro is not a small

fund and has traditionally been larger company in focus, but sensing a shift towards smaller companies, the managers rotated the portfolios towards smaller companies and exemplified a refreshing ability to actively rotate their fund to suit conditions rather than stick to a larger company focus. The Miton fund is one to watch for the future. There are a handful of really promising UK smaller company funds around at the moment with R&M and Franklin Templeton both possessing funds and management that we predict to be some of the best performers over the coming decade. We have selected the Miton fund based on an excellent track record and a different approach by the managers to that which we currently benefit from in our existing UK equity funds. Just under 75% of the portfolio is invested in smaller companies and yet the manager is seeking not just the natural growth which emanates from such companies, but also the mispricing which is likely to have happened due to a lack of research coverage on those companies. Research is omnipresent on FTSE 100 companies, but is much harder to find as the company size reduces, those managers with a specialisation in that area are therefore much better placed to take advantage of potential opportunities. Continuing the smaller company theme, we have included the Baillie Gifford Global Discovery fund in our higher risk growth portfolios. This fund is a global smaller company fund that has an excellent track record. Again it has gone slightly under the radar of many investors, but if we are moving towards smaller company investments in the market cycle, this fund should perform well. There is a slight American bias within the fund, but the manager isn’t geographically targeted, his preferences are for companies with a future-proofed advantage such as technology firms or companies that can automate processes to make them more efficient. The manager contains risk by spreading the portfolio across around 90 different holdings. This fund fits well with our search for growth allied to risk reduction. We have maintained our global equity income allocations and there has been no better performer than the Artemis Global Income fund, which has impressively maintained returns despite its growing assets under management. To tap into the fund manager’s expertise, we have included the Artemis Monthly Distribution fund in our lower risk portfolios to further boost income availability. The fund

combines Jacob De Tusch-Lec’s equity expertise with Artemis’ bond experience. There is less equity exposure than the Jupiter and Threadneedle monthly income funds mentioned earlier and there is little overlap with the Artemis Global Income fund in portfolios as there is less equity exposure in our lower risk portfolios. In terms of Asian Income, we have included the Henderson Asian Dividend fund in our income portfolios. The fund offers a yield currently in excess of 5% which is one of the highest available combined with capital growth. We have been unaffected by the manager changes at Newton on their Asian Income fund, as we have instead been allocating to the Liontrust Asian Income fund which has been a top performing fund over the past year. The Henderson fund will run alongside our Liontrust allocation to make Asia one of the strongest areas in our income strategies. We have maintained our European and American fund weightings. The threats to Europe are well documented, but the funds we own are highly diversified and as has been proven over recent months, perform quite differently in different market conditions which is precisely why we own them. There are funds out there with some stellar performance numbers associated with them, but when one looks under the surface, much of the performance can be attributed to high risk investment strategies based on the more vulnerable regions of Europe. The inclusion of the Henderson European Absolute Return fund should add another layer of diversification to our holdings. The threat of rising interest rates continues to haunt American assets, but we consider our chosen funds to understand the US markets as well as any managers and whilst there may be a little market noise when interest rates do rise, they will do so on the back of strong economic data and the fallout from falling oil prices has already happened, so we feel that there are still reasons to be hopeful about the US. We have been disappointed with the M&G Emerging Markets fund since its inclusion last year. Much of the poor performance can be attributed to poor stock selection which happened to coincide with a period when emerging markets rallied strongly. The manager has recovered some of the falls, but nonetheless it has affected our confidence in the fund and we have decided to switch out of it. In its stead, we have purchased the Henderson Emerging Market Opportunities fund.

Fidelity Emerging Markets has been one of the outstanding funds within the sector, but we need a fund to run alongside this and the Henderson fund has the potential to be consistent in the future. The fund has undergone a restructure since January 2015 as a new manager, Glen Finegan, joined Henderson from First State. He previously ran their Global Emerging Markets fund and the First State fund has been the pedigree fund in the sector for years. He sought an opportunity to build a new fund and whilst there is an element of the unknown as to how he will perform away from the First State team, to date his objective to combine greater consistency to returns alongside genuine growth opportunities has shown signs of turning around a fund which historically underwhelmed. In the higher risk portfolios we have introduced the Threadneedle Latin America, Invesco Perpetual Emerging Europe and the Blackrock Asia Special

Situations funds. These funds may well migrate across all portfolios in the future, but whilst there is a level of market uncertainty, they shall reside in the higher risk strategies for now. Blackrock introduced a new Asian team a couple of years ago and have been slowly building assets in their Asian franchises. The Special Situations fund has got off to a flying start and although we need to keep an eye on our overall China weighting, as with the new Blackrock FIGO fund, there is a clear focus on risk management within the Asian team, which is quite different to anything that certainly Blackrock have offered to retail investors before. The Latin America and Emerging Europe funds are perhaps the most contrarian additions to our strategies. The problems in Russia and Eastern Europe have been well documented and are the reason we left the fund last year, however, it is questionable how much further this fund Performance Line Chart can fall and intermittent rallies in Russian stock markets have indicated that there is

now the opportunity for a recovery in spite of the negative headlines. Latin America has become the forgotten region of the emerging world. It has been hard to find positive reasons to return to the region, but in very recent times, there have been signs that the situation now poses a recovery opportunity. With inflation set to climb as high as 8% this year and economic growth tipping into recession, a couple of positive factors are being seen, with the finance minister aiming for more fiscal discipline, inflation anticipated to decline gradually in 2016, and increased scope for very high interest rates to be reduced. Just under half the Threadneedle fund is invested Brazil with around 35% in Mexico. This is quite diverse for a Latin America fund. As the graph below shows, the fund and region are at their lowest point for the past three years and so we have started to rebuild our weighting in the region in the hope of long term recovery.

13 June Pricing Spread: Bid-Bid ● Data Frequency: Daily ● Currency: Pounds Sterling Pricing Spread: Bid-Bid / Data Frequency: Daily / Currency: Pounds Sterling

A - Threadneedle - Latin America Ret GBP in GB [-20.67%]

To finish off, we continue to avoid commodities. We came very close to allocating back into the sector on the back of the huge

falls we have seen in gold and energy, but most generalist natural resources fund managers are themselves struggling to find value in many assets, allocating predominantly to industrials that will benefit from increasing industrialisation

12/06/12 - 12/06/15 Data from FE 2015

and infrastructure spending that is expected to rise with lower energy prices. It is a sector that should perform well in an inflationary environment, but this is one asset class that has yet to show signs of its historic characteristics.

THE NEXT STEP

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