Investment Newsletter October 2015
Phantasy Stock Markets Neal Foundly Investment Analyst
Such spirits could be operating in the stock markets.
Despite this, the Index went up 75% in this time. In other words, profit expectations are unchanged over the last 5 years and yet the global stock market rose at an annual rate of around 10%.
Any finance textbook will tell you that stock markets rise as the expectations for future profits rise. As economies recovered from the credit crisis in 2009, this is indeed what happened.
Why has the stock market continued to go up when profit expectations have flat-lined? What invisible forces are at work here?
Halloween is a time when spectres reveal themselves and shadowy forces menace.
By the end of 2010, within a couple of years into the recovery from one of the worst recessions in a century, the forecast post-tax profits for the MSCI World Index (an index of the largest companies in all the major markets around the globe) were 28p per share. A year later, at the end of 2011, the forecast earnings were 27p per share. At the end of 2012 they were still 27p and this has continued each year up to today when the forecast earnings are still around 27p. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter October 2015
Quality Street
It is perfectly reasonable for stock markets to rise in the face of flat profits growth if there is a perception that the risks associated with the earnings have fallen. For example, during the credit crisis it became apparent that much of the growth was heavily debt-fuelled but as economies recovered and most companies reduced debt, this has reduced the likelihood of defaults and liquidity crises – the ‘quality’ of the earnings are perceived to have risen. Equally, equity investors tend to be optimistic creatures who believe that profits will go up over time – maybe not next year, but surely the year after..? Both of these are good reasons why stock markets rise in economies devoid of profit growth. The process is generally called ‘rating expansion’ which means that because of these factors, investors are willing to pay higher valuations for shares.
Boo!
The problem with paying higher and higher valuations for shares is that this cannot continue indefinitely. Over time, the higher the valuations investors pay for investments generally the lower the returns will be. Over the last five years there has been a 75% rating expansion, i.e. investors were willing to pay 75% more for the same level of expected profits as they did 60 months previously. This is partly because stocks were pretty cheap to start with but this eventually stretched investors’ patience and valuations became too rich for some.
generates around 40% of the growth in the world’s nominal GDP and many of the emerging markets that trade with China contribute much of the remainder. The combined effect of weak commodity prices, rising indebtedness and weaker investment growth meant that the Asian profit growth engine stalled. Clearly, equity markets needed to adjust for this change in outlook and fell accordingly. However, in their haste, a number of markets became oversold and provided investors with new opportunities, as we will outline later.
At some point investors were going to be spooked. In August we saw some of this horror show unravel as one of the largest positive contributors to global profits growth, China, produced economic numbers that implied that future growth would be much lower. China
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter October 2015
Trick or treat?
The problem of identifying why profit growth has been so anaemic has vexed economists and analysts in recent years. Demographics, structural imbalances and – appropriate for this time of year – the misallocation of capital to the plethora of ‘zombie’ firms that would ordinarily go bust but are being kept afloat by the extraordinarily low interest rates, are some of the explanations put forward to argue why profits are static.
efficiency. At the recent International Monetary Fund meeting in Lima, the conference implored countries to raise infrastructure spend if they can afford it, and in the UK George Osbourne has appointed Lord Adonis as the head of the new National Infrastructure Commission. Time will tell if there is genuine commitment and money behind such announcements.
Politicians have started to talk about lifting infrastructure spending to improve economic
Portfolio Changes
Against this background, the recent market turbulence has been understandable. Now is not the time to cower away, however. We took advantage of the significant falls in the UK stock market in August to raise the equity holdings in clients’ portfolios. This ‘volatility trade’ in a FTSE 100 tracker fund at around 6,000, in the face of market fears, has paid off and with the recent rally in the markets we have sold the fund at around 6% higher level than we bought it. For the moment, the proceeds from this sale will be held in cash, ready to put to work if we see further significant falls. The volatility in the markets has not been confined to the equity markets. The bond markets initially did not react much to the concerns about Chinese growth back in August. However the difference, or ‘spread’, in the income yield between corporate bonds and those issued by governments has widened significantly over the last two months. To take advantage of this opportunity, we have switched out of an existing bond fund holding that had a low yield
and large cash holdings, into a fund that is focused on slightly more risky corporate bonds with much higher income yields. Given the recent elevated levels of yield in the corporate debt market, the marginal increase in risk is more than compensated with higher income. Elsewhere in the models, we have a number of structured products designed to generate nearly double-digit returns even if equity markets start to flatline (or fall a fair way). There is no hocus-pocus involved – just the product of our caution on the elevated levels of the markets earlier in the year, so that going forward we can be assured of the thrills in the markets with less of the spills. If you want to understand more on how these products work, please take a look at the new edition of Equinox which will posted out over the next couple of weeks. Looking ahead, we continue to hope for higher markets but plan for more weakness and volatility. The performance of the Equilibrium models through the recent volatility has shown that this has been the right approach so far and given the uncertain outlook, is a plan to stick with.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Market Views October 2015
General Economic Overview The picture remains mixed in the global economy, with the UK and US remaining the leaders although looking slightly weaker than previously. Meanwhile, Europe has picked up nicely but we are continuing to see slowing growth in emerging markets, particularly those who are more exposed to commodities. Inflation is likely to remain low for some time and we think interest rate increases are still some way off. When they do go up they are likely to do so very slowly. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets After the recent rally in markets we have dropped our score back down and have reduced equity exposure. We have more exposure than usual to Japan and smaller companies in the UK which remain our preferred equity sectors.
-1
Fixed Interest Our score has increased to a -1 after a poor run for corporate bonds relative to gilts, which has led to more attractive valuations. We believe rate increases are unlikely until next year at least, providing more support for bonds.
-1
Commercial Property Commercial property returns have slowed after a very strong 2014 and we have reduced weights recently. However, it continues to provide attractive diversification to equities and bonds.
-1
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and neutral property. We are roughly neutral equity and also have with additional holdings in defined returns and alternative equity.
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.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.