MSFS autumn 2014

Market Outlook Autumn 2014

“People will not look forward to posterity...

Lessons from our past could hold the key to our future economic prosperity.

As we approach the end of the summer of 2014, there is no doubt that economic conditions are improving with the UK economy expected to grow by 3% this year.

As a result the UK has now managed to get back to where we were before the pre-crisis peak in 2008.

As this news filters out to the general public and to investors, expectations for investment returns also rise. A not unreasonable expectation you might think, however the reality is that markets have already priced in the growth that we are now experiencing. The stock market returns we experienced during 2013 as we began to emerge from recession anticipated the growth we are now seeing in 2014.

So where do we go from here? Are the stock markets about to boom? Are we likely to see double digit returns this year? Whilst that is just about possible, it is probably unlikely.

Whilst I am by nature an optimist, I do struggle to see where our long-term growth can come from. The UK economy is very

dependent upon consumer spending and consumers have had a hard time over the last 5 years. Wages have only risen by about 0.7% per annum whereas inflation has been more like 3% per annum. As a result disposable income has been squeezed and for many mortgage holders, the Bank of England’s ultra low rate policy has rescued them from the defaults that would have occurred had interest rates followed their ‘normal’ trajectory. There is a view that there must be consequences resulting from the unprecedented manipulation of the markets by governments and central banks.

Recessions of the past have tended to be short and sharp, overvalued assets such as residential property and stock markets crash quickly and steeply and then within a year or two at most, a bounce back occurs and recovery sets in.

This last recession was quite different however and lasted for 5 years. With ultra low interest rates and money printing on a vast scale our economy didn’t suffer the normal sharp falls in asset prices, house prices moved sideways and stock markets didn’t crash. The overall effect was a prolonged and shallow recession, but of course the corollary to this is a prolonged and shallow recovery meaning that we could have 5 years of modest growth ahead of us. Investors may well have to get used to years of low returns from their investments

before markets return to normal behaviour as the effects of government intervention dissipate.

A well diversified portfolio is essential in this low return environment. Thankfully, we are not limited to western markets when it comes to investing for returns. Asia and the emerging markets offer an attractive alternative to investors at currently better values. China, whilst no longer achieving double digit growth, is still expected to grow at 7% this year, roughly double the return expected in the UK and USA. At the lower risk end of portfolio construction we are allocating further to property funds. This is not because we believe that commercial property (i.e. offices, retail outlets and industrial buildings) is likely to boom in the near future, it is because we believe it isn’t likely to fall in value and may also provide some modest growth. In a market where bond yields are likely to rise whilst their capital values fall, property funds can act as stable bond proxies, albeit ones which should be monitored closely for signs of overheating.

Recovery, albeit modest, would be welcomed by all in the west, but in recent years a rather worrying theory of “secular stagnation” has been developed by the US Economist, Larry Summers.

...who never look backward to their ancestors.”

- Edmund Burke

His theory suggests that the U.S. and Europe are suffering from more than just the aftermath of a major financial crisis.

It suggests that the Western economies might be stuck in an unusual and prolonged equilibrium, in which frustratingly slow economic growth is the norm. Policy measures such as central-bank stimulus may be ineffective in simultaneously delivering high growth, sustainable job creation, price stability and financial soundness. As Larry Summers puts it, if the macroeconomic goals are attained, “there is likely to be a price paid in terms of financial stability.” In other words, tinkering with the economy by printing money and putting rates down to very low levels will have undesired effects.

Given the enormous consequences for current and future generations, the economists suggest that serious thinking should be devoted to developing alternative policies. These involve capital spending initiatives such as investing in education and infrastructure -- ideas that have broad support among economists but which have been stymied by political dysfunction.

Regardless of your depth of economic knowledge and understanding of this particular theory, investment in education and infrastructure makes a lot of sense.

The council house building that took place from the 50’s to the 70’s not only created

jobs but added real value to the nation’s infrastructure. Not only would this kind of project solve the housing problem but it would create work and training for thousands including school leavers struggling to find worthwhile employment.

Of course a building programme would need to be paid for, but at the moment the government is able to borrow at incredibly low rates of interest. Is this kind of initiative likely to happen? We can but hope, but perhaps the long term benefits are too far in the future for our short term thinking politicians to consider seriously.

Liquidity has been the buzz word affecting fixed interest funds over recent times.

Whilst a great rotation out of the sector hasn’t materialised, fund managers are finding it increasingly difficult to trade. One manager, who we don’t invest in, quoted a six month timescale to fully exit one holding, simply because there is a lack of competition in the asset class. That is not to say that holdings are of lower quality, more that there isn’t much appetite to trade and so buyers can effectively name their price

with sellers beholden to that price unless they just don’t sell.

The Jupiter Strategic Bond fund continues to be one of the most consistent and best performing funds in the fixed interest universe. The manager has taken a cautious view of potential returns and has been flexible when it comes to altering duration (i.e. the age of the bond, typically 2 years or 10 years). The duration decisions have directly contributed to the performance of the fund, as he has reduced the downside risk and focused on sustainable returns.

Gilts showed signs of overheating, but that has reversed as 2014 has progressed and the Jupiter fund has not been afraid to increase weightings to Government debt in places such as Australia rather than rely on the increasingly illiquid high yield bond markets for future returns.

Emerging market debt has continued its recovery from the lows of June 2013.

Despite Argentina’s recent default, the sector has become one of the more favoured fixed interest sectors and flows have increased accordingly. The fallout from Argentina for investors is likely to be negligible as Argentina has traditionally been an area to be avoided by fund managers, due to past credit concerns.

We have retained our existing fixed interest funds, but haven’t altered the allocation as we consider the property sector to offer improved prospects for the coming months.

being that it is better to own more lower value properties than rely on a handful of multi million pound estates in the City.

The increased radius requires increased management, but assuming the fund house has the capability, there is opportunity to build a quality portfolio in this way. A good example would be the move towards online retailing and the need for swift distribution whereby managers seek to invest in properties which are logistically well positioned for delivery drivers and click & collect customers.

Property has become the in-vogue asset class of 2014, it is difficult to have many conversations with fund houses without property becoming the key focus. For a while commercial property has flattered to deceive with the promise of 4-5% yield returns being eroded by the costs of running a property portfolio.

We have increased our allocation to the L&G UK Property fund which has performed well and is competitively charged, whilst producing a realistic yield. The Standard Life Global Real Estate (formerly Select Property) fund has not performed as well. The L&G fund is UK centric, whereas Standard Life has a more global remit. The Standard Life Global Real Estate fund has recently tweaked its mandate to allow it to invest up to 80% in direct real estate assets.

This means that the fund does not have to own as much in the way of Real Estate Investment Trusts (REITs).

The tide seems to have turned and prospects for the sector appear to be more predictable than has been seen for quite some time. Whilst capital returns are unlikely to form the majority of a predicted 8-9% return for 2014-15, rental yields driven by imminent rent reviews are rising and the sweetspot for these returns is mooted to be the next two years.

London has inevitably been the focus of property discussions in the UK, and that applies as much to residential as it does to commercial, but fund managers have become more adept at looking further afield for opportunity. The consensus

REITs are effectively property shares and so have higher correlation to equity markets, albeit driven by the real estate sector. REITs can add positive returns, but they can also distort returns to investors in periods when stock markets are trading within a range, both positive and negative. By allowing the fund greater flexibility to own more direct real estate assets (bricks & mortar), the manager is able to better manage

the risk and potential returns without the unpredictability of the stock market becoming too big a factor.

The Global Real Estate fund sold many of its Polish distribution centres earlier in the year at inflated valuations. Proceeds from these sales and the sale of REITs is being used to purchase additional office space in Tokyo, where space is at a premium akin to London.

An interesting dynamic to monitor for this fund over coming months shall be that of the German market, where the residential market is starting to take off. Rental yields are growing at around 3% per annum versus record low borrowing rates and new supply is at a minimal level, so where funds invest in REITs, German exposure is likely to rise to take advantage of this imbalance in such a developed market.

A key change in sentiment in the property sector of late has been the attitude to holding cash. For a long time cash was seen as a necessary buffer to guard against future market falls and redemptions.

Of late, managers have been loath to hold too much cash for fear of dragging down returns. We wouldn’t advocate that property has lost all liquidity risk, but there does seem to be something of substance amongst all the talk.

We have decided to sell out of the Blackrock Gold & General fund.

This fund has been a staple of portfolios since we started. We have finally made the decision to sell based on longer term economic expectations. The gold fund has been one of the better performers for 2014 having recouped some of the losses of 2013, but global expectations for inflation have lowered as Japanese style deflationary fears displace inflation fears. Inflation is a key driver for gold returns. Whilst the perennial factors such as jewellery demand and central bank supplies remain, we no longer feel that these alone offer enough confidence for future returns, particularly when compared to the more predictable prospects for property as an example.

Returns from gold equities could prove us wrong spectacularly and that is the nature of the asset class, but it is no coincidence that the allocations of fund houses who offer a range of commodity solutions such as energy and agriculture, have their lowest weightings to gold.

We consider healthcare and renewable energy to offer a relatively unique opportunity over the coming year.

Renewable energy invariably results in gasps of “nice idea but too volatile” and perhaps this had some truth a few years ago. We have held the Jupiter Ecology fund in our ethical portfolios for quite some time and we have seen the fund mature during that

time. The typical holding period for stocks in the fund is 5 years, this is lengthy compared to many funds, but it is due to the nature of what it is investing in and the extended time for ideas to become mainstream. The technology involved in renewable energy sources is relatively nascent and so the ideas need to be allowed to run. The fund is run on the same strict investment criteria as any other fund, just because the universe is restricted to certain stocks doesn’t diminish the need to produce returns for investors.

For the first time in 2014 solar energy was cheaper than traditional energy sources and although it may take time for this outcome to be achieved year on year, the signs are that globally the market has developed.

The fund is not particularly volatile when compared to alternative global funds and as such we have included this in our traditional portfolios for the first time.

Healthcare as a theme seems to offer some specific opportunity at the present time.

The headline dominating Pfizer takeover story has settled down, but M&A activity remains high in the sector. Shire traded at highs earlier in the year and it is an area where intellectual capital is sought after quite fiercely. With an improvement in fortunes for the emerging world and an ageing population across many areas of the globe, the need for investment in healthcare becomes compelling. The Schroder Global Healthcare fund invests in some names you may recognise from the FTSE 100, but is focused just as much on suppliers as drug companies. An example of areas that the fund is looking to take

advantage would be in America as the fallout from Obamacare means for the first time that healthcare providers no longer have to run at a loss from treating uninsured patients for whom costs could never be reclaimed. Obamacare means that these entities can start to become more profitable. We have included the Schroder fund in our portfolios.

Two names to drop out of our portfolios are the Standard Life UK Smaller and Global Smaller Companies funds. The former has been a staple in our portfolios, however, performance has dropped away considerably of late. This could be temporary due to some negative returns from key stocks such as ASOS, but we feel that our other holdings are well positioned to pick up returns from these areas of the market in the future. Our allocations have been diverted to the likes of the Healthcare and Ecology funds, but we have also topped up our weighting to the Artemis Global Income fund. This fund has had a phenomenal run which shows little sign of abating. The fund’s manager, Jacob de Tusch-Lec, continues to shift the portfolio ahead of market consensus and has yet to be proven wrong. The portfolio contains unusually high weightings to the emerging world and undervalued alternative markets compared to its peers, but the returns continue to be staggering.

We have consolidated our emerging market and Asian holdings.

Most notably we have sold out of the underperforming Neptune Greater China Income fund, moving the allocation to the Threadneedle China Opportunities fund which we already own and have switched our Neptune Latin American holding into the M&G Emerging Market fund. The M&G fund performs best in ‘value’ conditions and it is arguable that the emerging world is now entering that phase of the recovery cycle. The M&G fund compliments the Fidelity Emerging Markets fund which has been one of the best funds in the sector.

In our income portfolios we have included the Standard Life Global Emerging Markets Income fund. Standard Life have not traditionally been strong in either Asia or Emerging Markets, but they have started to bring some of the expertise they have in global funds into specific funds for UK investors.

The Global Emerging Markets Income fund has been running since 2012 and whilst it launched at a relatively fortuitous time, the structure of the fund does indicate that it will work through most market conditions.

The fund manager sees recent sell offs in emerging markets as a buying opportunity for increasingly undervalued stocks. The fund is able to access newer markets such as the frontier markets of Georgia, Nigeria and Saudi Arabia. These are regions that we have accessed via region specific funds in the past, but a move towards the Standard Life fund has in part been made, because it takes a flexible approach and is willing and able to invest in future growth markets, rather than stick to traditional emerging economies. To our mind this gives the fund an edge over some of its peers, as there are many markets where they are less mature, but still warrant investment.

Unlike some newer fund launches in the sector, Standard Life do meet all the companies within which they invest and use their overseas structure to gain on the ground information about companies and stocks. The market has developed as there are now more dividend paying countries in the emerging world than in developed markets and typically dividends represent one third of returns available from emerging market stocks. An example of a stock the manager has bought is Chipbond in Taiwan who specialise in the chips for tablet technology. As the market grows and the demand for more and more icons grows, Chipbond are a market leader in producing chips to meet changing consumer and developer needs.

We have sold the Invesco Perpetual Emerging Europe Fund. We retained this fund despite the escalating troubles in the Ukraine and some of the losses were recouped, however, the troubles have shown little sign of being permanently resolved and increasingly we are seeing economic sanctions being resorted to.

Valuations in Eastern Europe remain attractive from an investor perspective, but political risk needs to reduce for longer term investor confidence to return. We had considered investing in India specifically.

Modi’s election could singularly be the biggest catalyst for development in the country, but the market rallied extensively prior to his election and there is always the danger with India of timing the market just as it falls from a peak.

With that in mind, we shall maintain our Indian exposure through the Schroder Small Cap Discovery fund and the more generalist emerging market funds. The Invesco Pacific fund has been retained as it continues to provide wide coverage across the whole of the Asian region. Some new funds are on the horizon with Blackrock bedding in a new Asian fund management team and Baring’s ASEAN fund now becoming more widely available, but for the timebeing we

have retained the Invesco fund. We have introduced the Baillie Gifford Pacific Fund alongside the Invesco version. The Baillie Gifford fund has quietly been gathering momentum and assets. It’s geographical split mirrors our view of the Pacific region and we are slowly building a position in the fund as we consider it to offer a refreshing view of the region.

Baillie Gifford take an unusual view to due diligence, staying with ordinary family’s in South Korea for example, as a way of better understanding consumption and future market trends. The fund typically takes a five year view on stocks and as such has a relatively high weighting towards technology, as the changing demographics in the likes of India and China suggest that these countries shall provide the stimulus for development and consumption in the future.

In essence, these nations have missed out a technological stage, instead of moving to broadband, they have gone straight to tablet technology and with the ever increasing numbers of people using this technology and developing it, investment in the sector seems less of a concern than was seen with the nascent tech boom at the start of the 21st century.

Alibaba, the Chinese internet stock which has recently staged an IPO, was trading at a value higher than the combined value of Amazon and Ebay by the end of the first day post IPO. We have seen such hype before with the likes of Facebook and Twitter, but Alibaba is an online retailer, with tangible products being traded, unlike social media and so the IPO’s success gives an indication of the support for both technology and the Chinese middle class. Time will tell how the shares perform once the initial hysteria is out of the way, but initial reports are not suggesting they are overvalued.

Such cutting edge technology is not the only focus for Baillie Gifford, as they own more traditional technology stocks such as Taiwan Semiconductor, which still has the monopoly in its sector and which is a cash cow year on year. The fund is small, but growing, and whilst they do take a longer term view, they are not afraid to hold onto stocks which do well and will sell out of stocks which for whatever reason start to underperform. The fund is principally run on a stock by stock basis rather than based on global economic conditions, but one area where it will take a view regardless of stock quality is with regard to political risk.

Thailand being a good example, where the political risk is considered to have too much impact on stock prices that even though a company may have a sound investment thesis, a political coup could wipe the value and so until such areas settle down, the managers will be nervous about increasing allocation to the country.

The Threadneedle American Extended Alpha fund shall be reduced marginally, but we will retain this ongoing. A lull in performance coincided with the change of management and long term market predictions stumbling. In the short term, however, the fund has picked up its pace and it looks more likely that it will revert to producing the returns we have been accustomed to.

The former Threadneedle US team have arrived at Artemis and are starting to promote their venture there, so inevitably some comparisons will be drawn through the rest of the year and beyond. In the income portfolios we have replaced the Neptune US Income fund with the Fidelity US Index fund. This is unusual for us given our weightings to actively managed funds, however, income in the US is hard to come by and the ratio of charges to performance to yield simply do not stack up for income biased actively managed funds. In addition the Neptune manager has left the fund which has led us to review the position more closely.To follow on from this, we have rebalanced our passive portfolios into many of the Fidelity Index funds away from L&G primarily on the basis of charges. The Fidelity funds do not have the speciality of the L&G range and so some shall be retained, but in many other respects they are very similar. The Fidelity funds are not trying to do anything clever behind the scenes, which is why we prefer them and L&G to their peers and are simply able to offer index exposure at an extremely low cost.

In Europe, we have maintained our exposure to Threadneedle, Barings and SVM. The Baring German fund has outperformed wider Europe through its bias to mid and small cap holdings. It does have exposure to the emerging world for exports, but this is a positive overall given that the emerging world does appear to be recovering. There are some fundamental reforms going through in German policy on the minimum wage for example, but unemployment ratios remain some of the most competitive in the world and so business owners, or at least the ones owned in the German fund, do not anticipate this causing any significant issue. Within our

income portfolios, we have introduced the Schroder European Alpha Income fund.

This fund is slightly more adventurous in its approach than the Blackrock European Income fund we already own, however, it is managed by a young manager who has taken over the fund with some encouraging strategies and performance and there overlap between the two funds is not extensive. The Income portfolios have proven a happy hunting ground for funds which subsequently enter our traditional portfolios, and if the manager continues with his stock picking successes, this may well prove another one to watch.

To reflect our support of the Schroder European manager, we have also introduced his Alpha fund into our traditional portfolios as we anticipate him turning this fund around from a period of underperformance under the previous manager. James Sym took over the Alpha fund in June 2014.

The previous manager had experienced a rough period of performance and almost every decision worked against him. Mr Sym has already rebalanced the portfolio in line with his income fund, so there is much in the way of correlation in stock ideas and geographical bias. Clearly the Alpha fund does not have the income requirement and so one would expect the Alpha fund to outperform the income fund over time.

The Schroder European funds are different in style to our existing European funds in that they follow a market cycle investment approach. We are not always supportive of this style in all funds, as some developed markets offer less in the way of obvious market cycle changes as it can often be sector specific, however, in Europe we feel that this approach may prove to be successful. Mr Sym has provided research which shows that despite the rhetoric

which surrounds the European market, the reality of how the market has behaved has been almost textbook. With that in mind, “normal” market returns are predicted.

At this stage of the cycle, Mr Sym is seeking Recovery type stocks as these are the real growth plays which have been overshadowed in the market lurches that have happened at periods during the past six years. Wienerberger is a prime example.

This is an Austrian brick manufacturer who are the market leader. They trade at a massively undervalued price/earnings ratio of 3.9x, but are only operating at 60% capacity with little need for expenditure in the business in the short term as the restructuring post Eurozone crisis has all taken place. They are positioned to take advantage of improving construction markets in Germany and the UK. Scania is another household name, which remains Europe’s fastest growing, highest returning truck manufacturer. They have a stronghold in certain European markets and as economic factors improve, orders are likely to increase. If we believe that Europe is still in the early days of recovery, then this type of fund which is more nimble and seeking growth opportunities, should work well alongside the steadier Threadneedle and Baring funds.

Overall, our European weighting is higher than it has been for some time. European earnings forecasts remain over 30% below their previous peak, compared to US earnings which are 13% above their previous peak. Mr Sym explains that history often underestimates earnings rebounds and typically the market would be trading under 10x earnings with cyclicals under 5x.

With the stock examples given above, we can see that there are recovery stocks with sound investment cases to be made.

CHANGES AT A GLANCE

Fixed Interest

Property

UK Equities

US Equities

European Equities

Global Equities

Emerging Markets

Asia

Commodities

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