Tune out the noise

  • Written by 
  • 17/12/2015

We still see further mileage in this current economic cycle, supporting our view that portfolios should continue to lean towards equities and away from the expensive bond market. Below we explore some of the factors to think about as we look into the New Year.

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The turn of the year tends to be a popular time to make changes – gyms briefly throb with repentant gluttons and smoking areas empty. The world of investment advice follows a similar rhythm. New Year outlook documents generally describe the five or ten big new ideas for the year ahead. For our part, even though we see the New Year as an opportunity to share our views, we are not currently looking to make any major changes. We still see further mileage in this economic cycle, supporting our view that portfolios should continue to lean towards equities and away from the expensive bond market.

As always, there will be plenty for investors to worry about in the year ahead – from the ripples from China’s ongoing economic slowdown to the path of US monetary policy, as well as the usual host of unknowns. We may also find that the perennial prophets of doom gain an ever wider audience as the business cycle continues to age beyond the post-war average. Here it is worth remembering that sentiment can do damage on its own – if enough investors believe something about a particular region or asset class and they act on those beliefs, then in the short to medium term that asset class or region will indeed underperform. Nonetheless, we believe that the constraints on continuing global economic growth are still less acute than widely perceived. In fact, if past relationships between oil prices and G7 real GDP hold true, an acceleration in output growth is on the cards (Figure 1).

Of course, we remain on the lookout for the signs of economic hubris that traditionally characterise the closing stages of an economic cycle. However, we still see few signs of private sector excess. If anything, there remains a backlog of opportunities still to be made good after the worst decade of US growth in half a century (Figure 2).

Some things to consider…

Inflation and interest rates – One of the more plausible risks to a peaceful 2016 for investors is the return of more inflation than currently expected. Admittedly, there is scant sign of inflation around the world right now, in fact quite the opposite. However, with wage growth finally showing some signs of life in the developed world, the effects of declining oil prices on inflation indices starting to wane, and bank lending picking up more briskly, the inflation numbers should pick up. Admittedly, a little inflation is unlikely to deter central bankers in the US, or the UK, from raising base rates at no more than a glacial pace over the coming years, as promised. However, it is worth remembering that most of the time big turning points in interest rates are driven by economic developments and their accumulated effects on money and bond markets, not by central banks. As businesses and consumers spend a higher proportion of their income, lower savings ratios can begin to squeeze money rates and bond yields higher.

Central banks preside over this, and effectively rubber-stamp the process with their own policy rates, but they are not usually the prime movers of it. With real yields already low to negative, the return of more inflation than currently forecast, especially if it’s driven by higher wages, may well see the bond market start to reappraise its current extremely benign view of the path of US and UK interest rates. The world economy can handle higher interest rates across the curve, as can equity valuations (Developed Equities update – In Focus, 17th July 2015), but clearly this would herald a more difficult time for fixed income investors.

Emerging Markets Equities – Emerging Markets Equities have been one of the major disappointments of the last several years for global investors. We remain tactically underweight the asset class, but maintain a more constructive longer-term view, partly on the back of our well-worn demographic argument (Figure 3). Tactically, we see more selective opportunities, most notably in the MSCI China index. Prospective valuations in the dominant China banks segment are consistent with a rise in Chinese non-performing loans that would look extreme if the Chinese economy does not collapse imminently (Buying China, Compass, Q4 2015).

While overcapacity in certain segments of the emerging equity markets (particularly those related to commodities) is likely to continue to dog returns on equity, in particular asset turnover (Figure 4), we see scope for a pick-up in global trade, catalysed by a still buoyant US private sector. This should lead to stronger returns from other more trade sensitive areas such as Korea and Taiwan. (Figure 5).

Corporate profitability and prospective earnings growth – Corporate profits have the most obvious opportunity to recover further in Continental Europe, a keystone of our overweight recommendation on the region’s equity markets. However, those calling time on the US corporate profits cycle may again be too early in our view. As the double hit of commodity price declines and the dollar’s dramatic 2014 ascent wash out of the corporate earnings data in the coming quarters, the underlying picture for corporate profitability should look less worrying. In any case, focusing on more holistic measures of corporate profitability, such as return on equity, the current cyclical position for US equities does not look particularly elevated (Figure 6). Valuations are unlikely to be the key determinant of returns from here in the developed world. However, with profitability and valuations for the developed world quoted corporate sector holding firm, investors should be well compensated by banking the proceeds of earnings (dividend) growth alongside whatever dividend the sector chooses to pay.

Politics – From a political perspective, much of the last several years has been characterised by the rise of the more extreme ends of the political spectrum in the developed world. Particularly apparent in Europe – from the rise of a comedian in Italy to the success of sister parties, Syriza and Podemos, in Greece and Spain – this dissatisfaction with the political status quo seems to have caught on more recently in the UK and the US. Unsurprisingly, many commentators have tried to lump all of these trends into the same bucket – widespread economic hardship is leading to an uprising of the disenfranchised masses, a revolt against capitalism and the political systems that have traditionally nurtured it.

We urge caution against pat analysis linking political and economic trends across a range of very different socio-economic backdrops. As we head into a year which will be characterised by a lot of noise around the impending US elections, we would also do well to remember that equity markets have not differentiated meaningfully between Democrats and Republicans over time (Figure 7). Similarly, as the ‘Brexit’ debate heats up, it will be important for investors to remember that while a decision on Britain’s membership of the euro may have important social, political and economic ramifications for the UK, it is unlikely to be a decisive factor for its capital markets – UK markets tend to dance more to the tune of factors born outside of the UK and even of Europe. Even so, for those nervous of an apparently growing potential for less benign political outcomes around the world, we advise sticking with an investment portfolio that is well-diversified across geographies and asset classes.

Investment conclusion

Of course bursting bubbles are not the only source of capital markets volatility, or indeed recessions. However, accurately predicting (and trying to trade around) periods of stomach churning volatility is fraught with difficulty. While few would argue that Chinese economic turbulence, or indeed chronic political dysfunction in Greece, came out of nowhere this year, even fewer would have been able to successfully pinpoint the moment that these were to become the concern of global capital markets. Meanwhile, those who foresaw the cycle’s end in these two diverse crises likely missed out on subsequent profitable opportunities within equity markets.

Looking into 2016, there may well be more of the same. As noted above, there is sufficient evidence for us to believe that there is room for this business cycle to continue chugging along without alarming consequences. As a result we make no major changes yet to the broad outline of our strategic and tactical asset allocation, or to our perennial conviction that investors are best served by getting invested and getting diversified, and the sooner the better.