2. 2
The move has been more muted in Europe given a weaker growth outlook
and outside Germany yields have generally fallen in Portugal, Spain, Italy
and Greece as perceived risks recede. It is worth noting that the gap relative
to benchmark German Bunds is still far too wide for a single currency zone;
nearly 3% in Italy and nearly 3.5% in Spain. If you move all the way out to 30-
year bonds the yield shift for all concerned has been less pronounced because
the 30-year yield is more influenced by long-run inflation expectations and
these remain relatively subdued.
This move up in bond yields has certainly presented challenges for investors
who have grown accustomed to abnormally generous returns during recent
years; though returns have been far from disastrous with the entire Gilt market
delivering around -3% in 2013. As we anticipated, corporate bonds have
proven a more rewarding area, generating low single digit returns thanks to
falling credit spreads. The biggest beneficiaries have been high yield bonds
where the typically shorter maturities limit the negative impact of rising yields
whilst, with the widest credit spreads, they also have the most scope to benefit
from a narrowing of the spread. In aggregate the result is mid-single digit
returns. The fixed income market may not have been quite as exciting as the
stock market in 2013 but in a low interest rate, low inflation environment we
believe that opportunities for attractive risk-adjusted returns remain.
This report is primarily focused on the future rather than simply outlining what
has happened and we hope that the content is both of interest and thought
provoking. In a nutshell, we foresee 2014 unfolding as something of a repeat
of 2013 with positive investor sentiment and a belated move by some over-
cautious investors into the stock market set to lead to another year of positive
returns. However, we remain mindful of the potential for this pleasant, and very
consensual, scenario to be thrown off course. The disruption is most likely to
come from the prospects for growth in the US and how the Federal Reserve
times further cuts to its program of quantitative easing. The initial decision to
taper has been taken well by investors but we are a long way from a normal
policy environment and the timing of future moves is crucial.
In our view there remain a number of issues that are temporarily off investors’
radars but remain potential sources of market turmoil and we discuss some
of these later in the report. The overwhelming proportion of investment
commentary tends to be positive in nature and whilst we think there are good
grounds to expect 2014 and beyond will be a good period for investors, we
nonetheless remain watchful of the risks. This may mean sacrificing some
of the upside by holding investments that have the potential to rise in falling
markets but which may fall in rising markets. Portfolio construction is first and
foremost about balance and we really do not want everything going up at the
same time since it is then highly likely that all will fall in tandem.
Toni Meadows,
Chief Investment Officer
January 2014
3. 3
Growth
The global economy
In this report a year ago we included a number of charts that illustrated economists’
expectations for GDP growth in the US, Eurozone and UK. These charts showed the best,
worst and mid-point of the various forecasts. Given the sense that stock markets have risen
thanks to improving economic data we thought it would be worth revisiting to see how 2013
has played out relative to expectations at the start of the year, changes for 2014 expectations
and for the first time we can look at early forecasts for 2015.
Expectations for the US economy have barely changed, though 2013 has nudged down
because of the disruption caused by the Federal Government shutdown in October and the
Budget impasse. Expectations for 2014 have barely moved and early 2015 forecasts are
for more of the same with mid-point expectations of around 3% for both years. The housing
market remains a key source of potential future strength of the US economy so the substantial
rise in mortgage rates during the summer was unhelpful. The shale revolution is reducing
energy costs for US industry and encouraging a reversal of the ‘offshoring’ that saw jobs move
from the US to Asia. The unemployment rate has fallen sharply but this has been driven by an
abnormally large number of people simply withdrawing from the labour force.
2013 has been another year of postponed hopes for Eurozone recovery with a small
contraction now expected for the second year running, compared with a majority who
expected zero or better at the start of the year. This has had a knock-on effect on 2014 where
the mid-point is relatively unchanged at 1% but the most positive and negative expectations
have converged towards 1%. 2015 is expected to be a modest incremental improvement
once again.
Our concerns around the health of the Eurozone remain and we think that 2013 has achieved
little more than a temporary papering over of the cracks. In its attempts to circumvent their
mandate, the European Central Bank has increased the intertwining of risks between the
region’s oversized banking system and weak government finances still further and if anything
they have deterred banks from truly addressing the distressed assets on their balance sheets.
In an ECB press conference back in April 2013, President Mario Draghi insisted that there is
‘no Plan B’ and appears to think that political will alone is sufficient to keep the Euro project
on track; we disagree. There is a limit to how much people in southern Europe will withstand
endless austerity and the recent deterioration in economic data in Germany suggests that
the ‘recovery next year’, which has been expected for the last three years, may be yet
further delayed.
Closer to home, the UK economy has been the clear standout globally relative to expectations
in terms of positive news flow of late and George Osborne’s stock is very much on the rise.
This is quite a turnaround from March when the IMF savaged the government’s management
of the economy and raised the spectre of renewed recession. The controversial ‘Help to Buy’
program intended to boost the housing market has certainly achieved its first goal of boosting
house prices and generating a greater sense of optimism. The key target however is to
stimulate new house building, something that is very much needed from a supply point of view,
would help to keep a lid on house prices and would also be very valuable in terms of its impact
on the broader economy. The jury is still out on this but the house builders are certainly making
all the right noises. There remain concerns about the sustainability of this improved headline
economic performance as it has all the hallmarks of a typical UK debt-fuelled consumption
boom. Certainly, the very modest progress the coalition has made in repairing the public
finances appears to have had little impact on the structural element of the budget deficit;
this means that the UK is in aggregate still living well beyond its means.
4. 4
Japan has almost been ignored by Western investors for the last 20 years and the decline
of Asia Pacific funds in favour of Asia ex-Japan funds tells its own story. Unfavourable
demographics will always make Japan look worse at a headline GDP growth level and on a per
capita basis it looks somewhat better. However, there is no disguising the long-lasting anaemic
growth, embedded deflation and structural problems that have laid the economy low for too
long. The newly-aligned government, central bank and populace may finally have the solution
to these problems with inflation targeting by the Bank of Japan possibly proving to be the less
heralded but most potent element of a comprehensive package of measures. To the extent
that the desired pick up in core inflation is seen, this will likely mask progress when looked at
from a real GDP point of view but the Japanese may finally be on the cusp of breaking out of a
negative feedback loop and starting to benefit from a virtuous cycle that once again makes the
world sit up and pay attention to Japan.
With better news within most developed economies it is noteworthy that the outlook in
emerging economies has become distinctly more overcast. Of course there are many local
and regional differences between these countries and it is dangerous to generalise but as they
may have benefited from an over-consuming West, so too may they suffer from attempts to
reverse these imbalances. A number of large emerging economies have also gone through the
period of greatest growth in per capita GDP and will now face greater challenges with the ‘easy
wins’ out of the way. Whilst the West frets about how to deal with low growth, low interest rates
and low inflation, many emerging economies such as Brazil and India are grappling with high
interest rates and high inflation in the face of slowing growth. Conventionally they would look to
lower rates to stimulate the economy but high inflation and a need to support a currency that
has been fading fast distinctly complicates matters.
China is always the ‘elephant in the room’ when it comes to emerging economies and is
also facing challenges as it transitions to necessarily slower growth that, given the size of the
economy today, is more or less a mathematical certainty. The communiqué from the recent
‘Third Plenum’ in China suggests that the leadership grasps many of the issues but of course
successfully tackling them is far more difficult. The best of the planned reforms is probably
a commitment to a more market-driven approach to resource allocation that acknowledges
the decreasing suitability of total central-planning as the economy becomes more services-
orientated. On the downside there remain the issues lurking that many fear will sooner
rather than later lead to a major downturn that would have repercussions globally, namely
unrecognised bad debts in the banking system and the shadowy ‘local government
financing vehicles’.
We have consistently said that we expect interest rates in the West to stay ‘low for longer’;
nothing has occurred to change our minds on this. The general consensus amongst investors
is that interest rates will in due course move back up to their historical ‘norm’. This is a view
that is then used in turn to justify a negative stance on bonds and a positive stance on equities.
Whilst we do not discount the validity of this view, the implications of it being wrong are
sufficiently serious that we feel we must at least question it.
It is perhaps not surprising that the reference point for this return to normality is what happened
for the several decades prior to the global financial crisis. It behoves us to ask, was that
period ‘normal’? It represents an era of steady increases in financial leverage, faster economic
growth, consistent improvements in living standards and superior investment returns.
It is understandable that people would like to see a return to such a period but is that
expectation realistic?
As we touch on later in this report, this period of time coincided with perfect demographics
by way of the post-WWII generation of ‘baby boomers’ who were at the peak of their earnings
power, discretionary consumption and inclination to invest in the stock market. The parallel
period in Japan ended in 1989, the year the Nikkei 225 almost hit 40,000. Nearly 25 years on it
is less than half of that. Demographic trends should represent a headwind for most advanced
economies over the next 20 years which would suggest the potential for the opposite to
happen, namely lower growth and lower inflation that needs lower interest rates. Could the
West be the new Japan just as Japan finally appears to be emerging from its slumber?
Interest rates
and inflation
5. 5
The implication of all this would be that bonds could be an attractive investment at these
levels after all and that equities might endure a multi-year move to lower valuations that would
likely result in poor returns. It is worth noting that this is certainly not our core expectation but
we believe it is a credible possibility. We are not alone in considering this and indeed Larry
Summers, President Obama’s first choice to replace Ben Bernanke, raised this very issue in
a recent speech. He suggested that the US might be entering a period where negative real
interest rates of say -2% might be warranted, a reversal of recent decades when they have
typically been in the region of +2%. Perhaps the biggest danger if this comes to pass is the
potential for policy mistakes by central bankers who act as if nothing has changed. This could
very easily lead to the kind of ‘lost decade’ that Japan has seen; we hope that we are wrong.
Another challenge for central bankers, if they needed anything else to worry about, is that they
have to tread a fine line between policy changes and how markets perceive them. Chief in this
respect is the intrinsic link in the mind of investors between quantitative easing and interest
rates such that they interpret any move to reduce QE as a harbinger of higher interest rates.
We think the Fed was taken aback by the significance of the increase in long-term interest
rates that happened during summer 2013 which served to rapidly cool the US housing market
recovery. This may cause the Fed to pursue a non-linear approach to data where they ignore
large amounts of good data and then respond to one piece of relatively arbitrary data. This
raises the spectre that a comfortable, low volatility environment could suddenly change very
unexpectedly.
All in all we would be surprised to see any interest rate rises before 2015 at the very earliest
but central bankers will very much have their work cut out in 2014 trying to talk down interest
rate rises.
The real headline grabber in 2013 was, as we suspected it might be, Japanese Yen weakness.
Although never the stated intention of the Japanese attempts to revitalise the economy, it was
always a highly-likely and, for their purposes, welcome side effect. This weakness has restored
international competitiveness to where it was just prior to the financial crisis, according to
calculations by the Bank for International Settlements. A weaker Yen is clearly favourable on
balance for multinational Japanese firms who must be grateful not to be swimming against the
tide for once, but who loses? We see the most affected as being North Asian countries such
as Taiwan and South Korea, somewhat less so China which is still further down the ‘food chain’
technically. It is a double-edged sword though since a resurgent Japan should be good in
aggregate for the world with the Japanese consumer having prodigious spending power if they
finally choose to deploy it.
2013 proved pretty much a non-event for the US Dollar, Sterling and Euro and it was emerging
markets where we saw material currency weakness. With domestic clouds building in many
cases, international investors became more disinterested as the opportunity set in developed
markets appeared to expand. A number of countries found themselves raising interest rates
to support the currency rather than cutting them to boost the economy. Indeed we have heard
it suggested that what distinguishes a developed economy from a developing economy is
that the former can cut interest rates in times of turmoil whereas the latter has to raise them.
Emerging markets could certainly be a contrarian call for 2014 given recent investor apathy but
a strengthening US economy and possibly tighter monetary policy in some shape or form has
rarely been an auspicious combination for them; we may yet see further currency weakness.
Given the scale of what the Japanese are doing we can certainly see further Yen weakness,
albeit less dramatically, remaining in place. Of the ‘Big three’ it very much depends on the
path of monetary policy. If 2014 is more of the same from 2013 then the Euro may continue
to modestly strengthen as the currency where the central bank is doing the least to increase
supply although paradoxically the region could certainly do with a weaker currency. If the Bank
of England or the Federal Reserve wind down QE then look for those currencies to strengthen.
Exchange rates
6. 6
Growth, inflation, interest rates and exchange rates - are the vital issues occupying investors
but their future path remains quite uncertain and the outcomes are highly interlinked with each
other. We see the most likely scenario as being one where growth is not great but better than it
has been, inflation remains subdued, central banks keep interest rates at ultra-low levels and
not much happens in terms of major exchange rates. We term this the ‘goldilocks scenario’
for investors as it suggests a continuation of recent positive asset price trends. We have
highlighted a number of areas that could trigger the onset of adverse market conditions but
something related to the Federal Reserve probably ought to top the list.
Microeconomy
It is perhaps too easily forgotten by investors but companies cannot conjure revenue growth
and profits out of thin air. In aggregate, companies can usually grow earnings a couple of
percent ahead of nominal GDP growth; in the current environment that would be not too far
north of 5%. However, year after year post the financial crisis analysts keep pencilling in 10%+
earnings growth and year after year they spend most of the year taking a red pen to forecasts.
Last year, revenue growth was rarely in evidence and profits growth has largely come from
cost cutting and a lower cost of debt. The latter in particular has helped drive corporate profit
margins to historic highs and there are those who see these as unsustainably high with a
slump in corporate profits to come.
In spite of some of our concerns at the macroeconomy level, we are less concerned about this
based in part on our expectation that interest rates will remain very low. This implies that whilst
there will be little in the way of incremental additional benefit, the entrenched benefit should
not erode either anytime soon. Another factor is the steady decline in labour intensity of many
businesses owing to advances in technology, communications, automation, robotics etc.
that is allowing companies to produce more with fewer people. This appears to be a long-run
structural factor that is weighing on employment and may be one reason that wage inflationary
pressures will remain muted. Thus, labour intensive businesses that are willing and able to
adopt such advances could see meaningful improvements in margins.
If we give companies the benefit of the doubt and assume that they can maintain these
margins there is still the problem of the lack of revenue growth resulting from a low growth
environment. Put that together with ready access to cheap debt and substantial cash
balances and the answer appears simple: buy rivals and rationalise cost bases (another
downward pressure on employment). We have seen a notable increase in fund raisings by new
companies e.g. Twitter, Royal Mail, though the amounts raised are comparatively modest. In
2014 we may see more new listings but also more corporate activity. Maybe we are not ready
for massive corporate mergers but the small- and mid-cap segment of the market looks ripe to
be picked off by bigger rivals. We believe this could help drive further outperformance by such
stocks, relative to the market as a whole. Additionally, it is smaller companies that generally
have the best ability to outgrow the broader sector/economy since a new product, contract etc,
will tend to have an incrementally greater impact.
In the face of modest or little positive earnings momentum, investor sentiment will be essential
to keeping markets moving higher. If the earnings part of the P/E ratio isn’t doing very much
then it is the multiple of those earnings that investors are willing to pay that will be the key
driver. Stock markets have already rerated higher, though valuations are quite disparate across
sectors. We look at this below in terms of potential opportunities.
With sufficient encouragement, there is certainly no reason why stock markets cannot continue
higher but equally it is important to recognise that the foundations for the rally are not that
solid and the risk/reward balance is considerably less favourable than it was. This means that
investor sentiment, never the most reliable of bedfellows, is perhaps even more crucial than
ever as we start 2014.
Summary
7. 7
We do not believe that we are alone in suspecting that quantitative easing has had more
impact in suppressing bond yields and lifting stock markets than on the real economy. It is
however the hope of many, including Ben Bernanke, that via the portfolio balance channel,
some of the benefits of this will ultimately find their way into the economy through increased
employment, higher wages, business investment etc. It is fair to say that there is little sign of
this as yet in the conventional sense though some are starting to suggest that businesses
are now investing in a more intangible fashion. As an example, this might be working on a
digital marketing strategy, improving website functionality or investing in software to boost
productivity as opposed to a more traditional route of buying property or equipment.
As 2014 progresses we are likely to hear more about central banks reducing quantitative
easing and whilst in effect they will still be providing some stimulus, there is the potential that
investors will focus on the direction of change, also known as the second derivative. In this
respect, markets can behave very differently to how central banks think they should since
central bankers tend to focus on absolutes. As an example, the Eurozone still looks pretty
shaky but many investors think it is now less shaky. Alternatively, there may still be QE in 12
months but there is likely to be less QE. A wind down in quantitative easing is only likely if
economic data continues to strengthen so in that sense such a move by central bankers
should be seen as a positive sign but investor sentiment is unpredictable at the best of times
and it is possible that we might end up with a ‘good news is bad news’ mindset. For the
moment, sentiment is positive and the path of least resistance appears to be up.
This is the most classical example of style investing and we have seen the value style
underperform in developed markets since the early warning signs of the pending global
financial crisis in 2007. The blue line in the chart below tracks the returns of the SP 500 Value
Index since 1995 whilst the red line tracks the performance of the SP 500 Growth Index. It
can be readily seen that the relative performance moves in phases with growth outperforming
strongly during the late 1990s as the tech bubble built up before underperforming in both the
subsequent market downturn and upturn. Finally, growth has then outperformed on the way
down in 2008 and during the rally since. Similar patterns would be seen in Europe though
curiously the opposite has been seen in Asia.
SP 500 Value vs. SP 500 Growth (1995-present)
Source: Bloomberg LP
Value vs. Growth
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
350
300
250
200
150
100
50
SP 500 Value
SP 500 Growth
Total Return
Past performance
is no guarantee of
future performance,
you may get back
less than you
invested
8. 8
The way that we rationalise this is to think of it in terms of risk appetite and the level of
macroeconomic uncertainty. Whilst we acknowledge the rather sweeping nature of the
statement, value stocks tend by their nature to be more cyclically entwined with the broader
economic backdrop and growth stocks can have more individual or structural growth stories.
Thus, our explanation of recent outperformance by growth stocks would be framed in terms
of difficult economic conditions and elevated levels of uncertainty. This has drawn investors
towards more dependable growth stocks and has given rise to what have become known as
‘expensive defensives’. This attraction appears to have waned and we think such stocks could
come under further relative pressure given elevated valuations. Instead, rising risk appetite is
drawing investors towards the type of companies that have become cheap and unpopular but
now have better prospects in a stabilising/improving economic environment. One final way to
look at it is that when growth is very scarce, those companies that exhibit it are likely to attract
something of a scarcity premium, a premium that ought to subside if growth becomes
more widespread.
As things seem a little more stable in developed western economies, the opposite appears
to be happening within the broader emerging markets space. We have seen one or more of
slowing growth, increased local geopolitical risks, elevated inflation, weakening currencies,
international investor outflows in most major markets. This would suggest to us that the long
entrenched outperformance of the value style may reverse in favour of the kind of defensive
growth stocks currently falling out of favour in Europe and the US. The overall narrative of this
would suggest that developed and developing economies are more rivals than friends and that
at any one time one group are winners and the other losers.
It is often said to be a ‘stock picker’s market’ but what exactly does that mean? Those ‘active’
fund managers that build portfolios that look very different to their benchmarks have something
of a vested interest in arguing that this is the case. The implication is that fund managers
can add value for clients by owning one stock instead of another. Clearly this is easier said
than done because when one person buys a stock, someone else is selling it. This is the sort
of argument used against active management on the grounds that it is a ‘zero sum game’
before costs. However, what this ignores is that you don’t own everybody’s portfolio. Research
suggests that portfolios built with genuinely differentiated stock selection and that lack major
sector bets have the best chance of outperforming consistently. If we take this one step further
it must surely be possible that some market conditions suit such types of managers (and we
would consider ourselves to be in this group) more than other market conditions. So, what are
those conditions?
Somewhat erroneously in our view people often talk about correlations between pairs of
stocks being high or low and it is the latter case that is thought to favour stockpickers. In fact
we believe low intra-stock correlation is not the holy grail but rather it is a case of dispersion
of returns; the greater the differentiation in returns both within and across sectors, the more
room there is to beat a benchmark by holding different positions. It is in such a market that we
believe we find ourselves currently though there is no guarantee of how long such conditions
will last.
In conclusion, the fundamental justification for equities continuing to move higher does not
look rock solid but a combination of central bank stimulus, sufficient growth and investor
sentiment should be enough to keep things moving forward in 2014. It is important that
investors keep their expectations under control and a high single digit return for the FTSE
All Share Index in 2014 should be considered a good outcome in our view.
Stock picking
opportunities
Summary
9. 9
Attractive investment themes
We have talked about this before. Whatever the merits of quantitative easing we think it is pretty
clear that it has distorted some traditional relationships between assets and whilst the price of
some assets may have risen too far, too fast, others have been somewhat left behind. In our
view the assets that have been left behind are those that are more challenging from a liquidity
perspective and this essentially encompasses private assets such as commercial property as
well as publicly-traded assets such as small cap stocks or frontier markets that most resemble
private assets. Another common theme is the retrenchment of banks from many of these areas
and the knock-on effect that this has had on the availability of debt finance. By limiting supply
of funding we believe that this may have slowed the normal process that would see such
abnormal profits arbitraged away.
However, the market is already adapting and a flurry of private debt funds are now listed in
London with the vehicles seeking to step into the shoes being vacated by banks. Another
factor in slowing the elimination of the arbitrage is the specialist nature of these markets i.e. the
limited number of market participants that are able to make such investments. We are happy
with the ways that we can access these different areas for clients and think that if 2014 sees
more muted progress at the top benchmark level then some of these investments can really
start to do well.
When we wrote this report a year ago, the Japanese stock market had just started moving
higher and the Yen lower and we were in the early days of positive sentiment towards Japan’s
Prime Minister Shinzo Abe and his so-called ‘Abenomics’. We suggested that if Mr Abe was
successful in his goals then the Japanese stock market had ‘explosive upside potential’
with additional advice that it was logical to hedge the currency exposure since a rising stock
market and a falling Yen were likely to go hand in hand with each other. Some 12 months on
and Japan has been the best performing major stock market by a substantial margin though
without the currency hedge around half of the return would have been lost in translation!
There have been so many false dawns for Japan over the last 20 years that there is an almost
structural pessimism about any good news; so is it different this time?
Later on in this report we look at some of the dynamics around fighting deflation, quantitative
easing, forward guidance and inflation targeting. These are relatively new issues in the West
but have been of paramount interest in Japan for many years. Our optimism on Japan revolves
around a sense that they appear to have finally aligned the public, the government and the
Bank of Japan. We see no reason why quantitative easing should be any more successful at
boosting the real economy than it has in the US though it is likely to have a similarly positive
impact on asset prices and in weakening the Yen. The government is following this up with
fiscal policy changes but if renowed economist Paul Krugman and others are right it could
actually be the Bank of Japan’s decision to publicly target a 2% inflation rate that may make
the most difference. Ultra-low interest rates have been in place for many years but because
of deflation do not provide any positive stimulus to the economy.
However, a commitment to higher inflation whilst maintaining ultra-low interest rates for
a period of time should act as a boost for aggregate demand since it can give Japan
meaningfully negative real interest rates for the first time since the mid-to-late nineties. It has
been noted by various academics that the willingness to maintain low interest rates in the
face of rising inflation and strengthening growth is not really in central bankers’ DNA, which
creates something of a credibility issue. If forward guidance is to have the desired impact on
aggregate demand then companies and consumers need to believe what they say. In the
1930’s the US was the first out of the Great Depression arguably because politicians found the
will to do what central bankers couldn’t and it is notable that the abrupt volte-face in Japan has
been achieved by a new government that has installed ‘friendly faces’ at the Bank of Japan. In
this regard Japan appears to now have an advantage over others in terms of a clear electoral
mandate to pursue something of a ‘shock and awe’ strategy.
Private and
quasi-private assets
Japan
10. 10
If this is seen as being key in Japan then it obviously begs the question as to whether the
Federal Reserve and the Bank of England will be able to resist the clamour to tighten policy
as data improves and unemployment drops. They certainly appear to have less clear political
signals with something of a ‘lame duck’ second-term US president and a coalition in its
closing stages here in the UK. The best hope in the US is arguably Janet Yellen who is taking
over from Ben Bernanke as chairman of the Federal Reserve. She is well thought of and has
persistently argued that the official Fed forecasts were too positive and she has been proven
right. She is also thought of as being very much in the pro-QE camp and various speeches
mentioning ‘optimal control’ suggest that she favours maintaining QE for longer and then
stopping it relatively suddenly if required. The key question is whether as a new chairman
Ms Yellen can wield sufficient influence to head off what is likely to start sounding like an
increasingly hawkish (anti-QE) Fed, though stepping up from the deputy role rather than being
a newcomer probably helps. In the UK, Mark Carney is busily trying to shake up the austere
Bank of England and his enthusiasm for QE, forward guidance and keeping rates ‘low for
longer’ is certainly not shared by all.
There remain many unknowns in Japan but we feel that forces are sufficiently aligned to give
the economy a fighting chance of breaking free of deflation. The stock market rally thus far has
been driven by foreign investors and it needs domestic investors to take up the baton if it is
to keep moving further. Corporate Japan is in good health thanks to the weaker Yen and there
is clear political pressure to share some of the fruits of this with their workforce following the
conclusion of their fiscal year at the end of March. Base wage rises are likely to be very limited
as companies seek to keep tight control of their costs. However all is not lost as Japan has a
rather unique seasonal bonus system where the bonus can not only be significant in size (1-3
months salary) but is also set in reference to the underlying performance of the business. With
large Japanese exporters reporting record profits in many cases it is potentially in this seasonal
bonus where workers will benefit. This has the potential to have a knock-on effect on consumer
spending and confidence and could give further impetus to the needed structural reforms.
It is emotionally challenging to buy something that has gone up so much in so short a time but
this really reflects Japan’s belated recovery from the financial crisis. Before the Abenomics-
fuelled rally started the Nikkei 225 was virtually where it was at the end of 2008 whereas the
SP 500 was some 60% higher over the same period. It is certainly not worth getting carried
away with but 2014 could very easily prove to be another strong year for the stock market
with the Bank of Japan’s efforts at QE being double that of the Federal Reserve. In a portfolio
context, Japan appears to differentiate an international equity portfolio to a greater extent than
tinkering with exposure to the UK, US and Europe.
Fixed Income
We have already touched on some of the headwinds that are expected to face the bond
market during the coming years. The risk of credit default has rather receded and the
preoccupation is very much with the risk related to interest rates and/or bond yields rising. We
concur with the logic behind the relative preference for corporate debt vis-à-vis government
debt and our allocations within client portfolios generally reflect this. The one less welcome
upshot of this however is that returns on corporate bonds tend to move more in step with the
stock market and thus in seeking out higher returns we are also increasing portfolio risk. Our
response to this is to advocate the part of the government bond market that we believe is
the best place to counteract this risk and that is the long maturity end of the UK Gilt market,
though it could just as easily be US Treasuries or German Bunds instead.
By exposing portfolios to different parts of the fixed income market both from a maturity
and credit quality standpoint we believe it is possible to carve out a respectable return with
comparatively low risk. All parts of the bond market have a positive expected return if held to
maturity, barring exceptional occurrences of default but the challenge is caused by the path of
returns from start to finish. At any one time, some bonds are likely to fall behind the ‘run rate’,
something that implies higher future returns whilst others may run ahead of their ‘run rate’,
something that implies lower returns. Logically it should not be too difficult to blend these two
opposing forces together and thus ensure a smoother return over time and that is indeed what
we are seeking to do.
11. 11
During a very challenging fixed income environment in 2013 this approach has worked well for
us and we believe it can continue to deliver for the foreseeable future.
One of the benefits of this approach is that it positions us for a wide variety of possible
outcomes. If the consensus ‘normalisation’ occurs then our exposure to investments with
relatively short maturities would benefit us, since proceeds could be reinvested at higher
yields. If the global economy remains in reasonable shape then credit defaults are likely to
remain at low levels, thus benefitting our corporate credit exposure. If a renewed economic
downturn were to occur then our corporate credit would suffer, though closeness to maturity
should help. In contrast we would expect yields on government bonds and very high quality
corporate debt to fall and our relatively long maturities would stand to benefit.
The chart below shows how the Gilt yield curve changed during the course of 2013 and it can
be seen that very little happened in the early part of the year or since the end of August but
there was a substantial shift during the late Spring and early Summer that was triggered by a
reassessment on the part of investors as to when the Federal Reserve would start to reduce
the pace of QE, so-called tapering. The extent to which the curve has become steeper in the
two-10-year area and flatter further out means that we see less outright value at the longer end
than we did previously though we believe that it remains the optimal area in a portfolio context.
It is not too many years since we had an inverted yield curve where very long-dated bonds
had lower yields and we may yet see that again. Demographics, increasing life expectancy
and regulatory pressures on pension funds, insurance companies and banks in aggregate
represent a source of material buying support that should serve to prevent long bond yields
rising significantly.
The UK Sovereign Yield Curve
Source: Bloomberg LP
In conclusion we think it is too easy to just write the whole bond market off because there is
an expectation of rising interest rates and bond yields. Even if that expectation is accurate
there remain certain parts of the bond universe capable of delivering positive returns in such
an environment. More vitally, parts of the bond market in our view remain potential safe havens
for investors should a negative surprise occur with respect to the economy or investor risk
appetite. We believe that blending relatively short-dated corporate debt exposure with relatively
long-dated government debt represents a powerful combination that is well placed to cope
with a bond market that in aggregate faces higher volatility and lower returns than have been
seen during the last decade or so.
4
3.5
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3mths 1 Year 2 Years 5 Years 7 Years 10 Years 15 Years 20 Years 25 Years 30 Years 40 Years 50 Years
31st Dec 12 30th Apr 13 31st Aug 13 12th Dec 13
Summary
12. 12
What could go wrong?
In spite of the headlines, fixed income returns have been broadly flat in aggregate during 2013
with most stock markets, predominantly the major developed markets, heading meaningfully
higher. This adds up to a very nice result for a typical investment portfolio. Elsewhere in this
report we have talked about some of the underlying issues that concern us but it is very
easy to sweep such things under the carpet when markets are going up and risk appetite is
increasing. We may be guilty of this to a certain extent but we would hope to try and not get
quite so caught up in the euphoria that may be building. Therefore we identify below some of
the key sources of potential downside risk.
Front and central of our concerns are the unconventional monetary policy tools now being
used in the UK, US and Japan as a way of trying to return the economy to a more ‘normal’
state. This is effectively a live experiment with the global economy based on a very limited
historical sample size and the longer term damage that may be done as well as the challenges
of exiting such policies are as yet unknown. Historically, central banks have generally reduced
interest rates to stimulate economies and increased them to slow them down. Interest rates
in the US, UK and Europe have been virtually zero for a number of years now and investors
remain convinced that rate rises will occur sooner rather than later; this is a view that we would
challenge and have done consistently over the last few years.
It is worth remembering that interest rates were reduced to very low levels in the US in 2002-03
and they subsequently rebounded to more than 5% by 2007. However, this was much more a
conventional response to the ebb and flow of the economic cycle. The difference this time is
that five years on there is still no real sign of interest rates rising and more than anything this
is because we are dealing primarily with the after-effects of a financial crisis with the recession
being more incidental than anything else. It is here that the parallels can be drawn with Japan
where interest rates have been below 0.5% now for 18 years. Whilst the US banking sector
has made very good strides in repairing its balance sheet and moving towards a point where
it can once again be on the front foot from a lending point of view, regulatory and political
uncertainty look to be negatively suppressing both the supply and demand sides of the credit
creation mechanism. Japan has obviously taken its time in this regard and the UK has made
reasonable progress; Europe appears to be the area where most needs to be done and yet
the least has been done.
Following the Federal Reserve’s last flirtation with near-zero interest rates, a significant amount
of work was undertaken by academics, the IMF, the Federal Reserve etc. to look at the
implications for monetary policy of being near the ‘zero interest rate bound’ i.e. official interest
rates cannot be cut further; John Maynard Keynes hypothesised about such a problem back
in 1936. Policymakers had been fairly disinterested in such things previously, considering it a
problem confined to Japan, but this dry run for low rates has possibly been helpful in framing
options for central banks since 2009.
One leading paper from Eggertsson and Woodford in 2003 discusses many pertinent points
but one in particular cites Paul Krugman who argues that the only way to avoid being drawn
into a long-term deflationary trap is to target a sufficiently high positive rate of inflation. It is
interesting that a decade later the Bank of Japan has decided to seriously target 2% inflation
for the first time as a means of escaping deflation; somewhat ironically, back in 1999 Kunio
Okina who at the time was Director of the Institute for Monetary and Economic Studies at
the Bank of Japan said, “…because short-term interest rates are already at zero, setting
an inflation target of, say, two percent wouldn’t carry much credibility”. With core inflation
perilously low in both the US and Europe, that may yet be something the Federal Reserve
and the European Central Bank, though the Bundesbank in Germany would surely object, will
consider and the primary implication is that interest rates will stay very low for an extended
period of time.
Monetary policy
13. 13
This paper goes on to talk about the importance of forward guidance and a commitment to
keeping interest rates low for a substantial period of time. In the context of deliberately trying
to boost short-term inflation expectations, the authors also talk about the challenge of the
central bank maintaining credibility with respect to a commitment to long-run price stability.
They argue that if the central bank can push up multi-year inflation expectations whilst
anchoring people’s expectations for the future path of interest rates then they are tangibly
affecting expectations of real interest rates (interest rates – inflation) and that this should help
to stimulate aggregate demand.
The bottom line is that when interest rates cannot be lowered further, central banks can
replicate the impact of further interest rates cuts (that are not possible) by convincing people
that rates will stay low for longer i.e. postponing a future rate increase is an alternative to an
immediate cut and the authors argue that this is actually more effective. So, it is all about
managing expectations and this all sounds eerily familiar to how things are now playing out
around the world. However, theory is one thing and practice is something altogether different
and more complex.
If we think back to May/June 2013, the Federal Reserve did not actually do anything but what
was said materially changed people’s expectations of the future path of interest rates. This
caused volatility in both equity and fixed income markets and it has taken a lot of effort since
to undo that damage. How central banks signal this change of stance without causing a similar
impact is itself a major challenge and having multiple members of central banks continually
making speeches where they ‘talk their own book’ leaves substantial room for confused
messages. Whilst on balance we think central banks will persist with talking down future rate
increase expectations, the risk of a misstep is surely increasing. This creates challenges for us
as investors since whilst macroeconomic variables tend to change quite slowly, a reaction to a
central bank statement can take only seconds.
It has not gone unnoticed that whilst asset prices have generally risen substantially during the
last few years, the reaction in terms of economic output has been far more underwhelming
and thus central banks continue to try and stimulate the economy in spite of the evidence that
what they have done thus far has had little impact. The problem is that whilst central bank-set
interest rates grab all the headlines, what really matters for the underlying aggregate demand
in the economy are real interest rates which are essentially interest rates minus inflation; lower
real interest rates will tend to have a positive impact on demand. With interest rates at rock
bottom, the recent trend of less inflation visible over the last 18 months in the chart below
actually represents tighter monetary policy and a headwind for aggregate demand. The sole
exception to this is the recent move out of deflation in Japan which genuinely represents a
looser monetary policy. Central bankers are playing a dangerous game that could fail, but for
the moment it is the only game in town. We do not think that we are in the advanced stages of
an asset bubble so at this time we are relatively comfortable ‘going with the flow’.
Core Inflation (1993-2013)
Source: Bloomberg LP
Note: Core CPI measures generally exclude volatile food, energy and in some cases
tobacco prices.
Asset bubbles
and sentiment
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US Core CPI UK Core CPI Eurozone Core CPI Japan Core CPI
14. 14
This all suggests that whilst central bankers appreciate the limited impact on the real economy
of their pursuit of quantitative easing (QE), they are backed into something of a corner to
continue it. As occurred in mid-2013, a move to reduce QE is likely to have a material negative
impact on aggregate demand by raising real interest rates and this will surely encourage
them to keep pushing back the timing of reduced stimulus. A lot of emphasis is placed on the
unemployment rates mentioned by the US and UK central banks in their forward guidance
but our reading of the situation is that more focus should be placed instead on inflationary
trends. Whilst inflation remains below central bank targets and/or is falling and unemployment
is above the expected structural level of unemployment our interpretation is that central banks
will continue to try and talk down expectations of when interest rates will rise.
The upshot of all of this is that bond yields should stay low (and might even fall) which has a
knock on benefit on all those assets that are influenced by interest rates. The situation is likely
to remain supportive for corporate bonds with credit spreads declining and the obvious risk is
that credit spreads simply get too small and investors are not being properly rewarded for the
risks of default that will surely return at some point. We have mentioned about how we think
the ‘buy equities, sell bonds’ is very consensual and yet it is not difficult to find naysayers who
hold substantial parts of their portfolios in cash. Whilst somewhat less than scientific it does
nonetheless suggest that sentiment is not at an extreme yet. Widely fluctuating monetary policy
and a tendency to foster asset bubbles contributed to a major market setback in 2002-03 and
in 2008-09; it is to be hoped that we don’t see the same thing in 2014-15.
In the midst of an investment climate that appears to become increasingly short-term in
nature it is difficult to talk about trends that may play out over many years and even decades.
However, with life expectancy set to keep increasing, so too will the ranks of those living
off savings in retirement. This ageing population will be seeking to maximise their standard
of living whilst minimising the risk that they run out of savings before they die. Striking that
balance is a lot harder than it sounds and will require a disciplined long-term investment
strategy that can stand the test of time. There may well be opportunities to flex this tactically in
the short-term but this should not become a distraction to the long-term strategic positioning.
So, what is the consensus view? We would probably sum it up as demographic changes are
interesting but not really worth doing anything about for the foreseeable future. Additionally,
after an extended period of falling interest rates in developed economies that has boosted
fixed income returns, interest rates will move back to more normal levels during the coming
years. This means that owning bonds is a bad idea and the solution is to own equities where
returns can be far superior after a start to this new century that has already witnessed two
major market crashes. The key danger to this argument is simply that the recent past is not
normal, that we will not revert to it and that changing demographics will diminish the predictive
power of looking at the past.
Stock markets are currently being buoyed by improving investor sentiment and it is certainly
possible to craft a very logical argument as to why they may continue higher for a number
of years to come. An ‘equities to beat bonds’ argument is even easier to make with record-
low interest rates and still very low bond yields. Strategists everywhere are trying to outdo
themselves with how high they can go with their near-term stock market projections but
that is mere noise for the long-term investor and they should do their best to drown out the
Sirens that seek to lure them onto the rocks; if the situation changes, a strategist can just
amend their forecast whereas an investor cannot simply rewrite the consequences on their
retirement planning.
Similar criticisms might be levelled at us since we also expect the market to continue rising but
it is possible to expect something whilst also being alive to the alternate scenarios that might
materialise. Stock market returns over any time horizon are highly variable and to a large extent
unpredictable so it is more an emotional response than anything else to always expect
a positive outcome. So what do demographic changes have in store for us?
Summary
Demographics –
the biggest threat
to the consensus
view long-term?
15. 15
We spend a lot of time trying to weigh up a large amount of data that may or may not be
accurate and then trying to anticipate the future path. The magnitude of revisions for many
months or years after the fact can significantly change the view point relative to the situation
at the time. Close to home for example, the evaluation of the strength of the UK economy
changed dramatically as 2013 progressed. The beauty of demographics is that things move
much more slowly and if you know how many 40-45 year olds there are today you can be
pretty confident how many 45-50 year olds there will be in five years time. Whilst demographics
may not preoccupy many investors presently, it is something that academics and central
banks are starting to focus on. Although demographic projections run to the end of the century
thanks to the United Nations, the broader economic and investment implications are derived
from past experience. It is possible to find spurious links between multitudes of independent
variables but a common sense test goes a long way.
A 2011 report issued by staffers at the Federal Reserve Bank of San Francisco (FRBSF)
concluded that there was a strong relationship between the age distribution of the US and
stock market performance. Given future demographic trends this would be expected to act
as a negative drag on future stock market performance all else being equal. Theoretically this
merely recognises different behavioural patterns during peoples’ lives with their peak period
for saving coming in middle age and then a gradual disinvestment during retirement. The
Federal Reserve’s analysis suggests that the M/O ratio shown in the chart below explains
61% of the change in the stock market’s most widely used valuation metric over the past
half century or so.
P/E Ratio of US Stock Market vs. M/O ratio Projected P/E ratio (current to 2030)
(1954 to 2010)
Source: Bloomberg LP, Haver Analytics and Census Bureau
Note: The M/O ratio is the ratio of 40-49 year olds to 60-69 year olds
If you take this analysis and project it forward based on expected demographic changes in the
US (see upper right hand chart) you get the clear implication of a lower market valuation in the
future because of the unfavourable evolution of the M/O ratio in the future. The US is obviously
a country that sees net migration over time and this has the potential to mitigate this trend but
it would need a high proportion of middle-aged people at the height of their earnings power to
seriously affect the dynamics of this analysis.
Thanks to a comprehensive analysis by Arnott and Chaves that was published in 2012 we can
see the implications of their analysis of near-term demographic changes on expected future
per capita GDP growth. All the areas in orange suggest a shortfall of future growth relative to
the past whilst areas in blue represent an improvement. If this analysis were correct it would
suggest that the next decade could belong to sub-Saharan Africa and India.
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1954 1964 1974 1984 1994 2004
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P/E ratio M/O ratio
M/O ratio
(right scale)
P/E ratio
(left scale)
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1954 1964 1974 1984 1994 2004 2014 2024
P/E ratio
Actual
Model
generated
16. 16
Interestingly this same analysis suggests better stock market returns in the future with the
notable exception of North America, but with Brazil, Russia, India and China all looking
good, perhaps investors have been too quick to discard the BRIC countries. It is however an
even more comprehensive win for bond investors with higher expected returns more or less
everywhere barring sub-Saharan Africa; ageing populations should offer substantial buying
support for bond markets and may well lead to a longstanding suppression of yields over and
above what might have been seen historically.
Annualised real GDP per Capita Growth Forecasts, 2011-2020 relative to historic
growth rates
Source: Arnott and Chaves
Given all this analysis, what impact does it have on what we are doing on a day-to-day basis?
Firstly, it suggests that investors need to be realistic about the level of investment returns
that are attainable in the future for comparatively modest levels of risk. If we are right that low
inflation and lower interest rates are here to stay for a while yet then returns on average of
3-5% after costs are a very reasonable starting point at the low risk end of the scale moving
towards high single digits at the top end of the risk spectrum. After a stock market rally lasting
nearly five years it is easy to get over-excited but we believe double-digit returns are just not a
sensible expectation (though they certainly could occur) for the future; our long-term expected
return for equities would be around 8% pa.
Secondly, there are many dynamics that push and pull investment returns higher or lower over
time and realistically data can be found to support almost any viewpoint. With this in mind we
think one of the best things investors can do is seriously consider the potential for different
outcomes and even more so when there is such a lazy consensus in favour of a certain course
of action such as we believe there is currently.
Finally it is important that investors do what accords with their own personal circumstances
and we think it is perfectly possible that the kind of multi-year or multi-decade trends we
have discussed here are genuinely relevant to a client base that may spend three decades
in retirement. Just because many investors demonstrate increasingly short attention spans, it
doesn’t mean we have to.
17. 17
Conclusion
How do we think 2014 will evolve then? There are perhaps two answers to this and which path
is taken remains very much in the hands of a small number of central bankers. Unemployment
will likely keep trending downwards and will ultimately test the levels indicated in forward
guidance as being the point at which they will first consider raising interest rates. This will
naturally be accompanied by robust economic data but we believe that it is important that
attention is paid to the disinflationary trends currently being seen in the major developed
economies. There is a distinct risk that, as with spring 2013, even as central banks pledge
to keep rates low, any moves to choke off quantitative easing too quickly will have the effect
of achieving a much greater tightening of monetary policy than is intended. This could
prematurely choke off any nascent recovery and put us back to square one.
Instead we believe that the US and UK central banks need to pay attention to the potent
combination of policies now being pursued in Japan with alignment between the Government
and the Bank of Japan. If we consider the pillars of employment, growth and inflation we
believe that the latter should be of the least concern. In light of that, we believe central
banks need to maintain their ultra-easy policy for a considerable period of time in the face
of improving growth and at some point rising inflation. Given the sentiments expressed to
date by both Janet Yellen at the Fed and Mark Carney at the Bank of England we sense that
they agree with us but we will have to see whether they can carry sufficient support to stay
true to those views.
If they resist both internal and external pressures to maintain quantitative easing then we
foresee another positive year for investors ahead. 2014 should turn out to be a vital year for
the Eurozone which appears to have the most serious problems, has made the least progress
and has the central bank that appears least willing and most unable to do anything about it.
Europe remains the clearest example of a lack of alignment between the central bank and the
respective national governments. It is possible that these problems will once again fly below
the radar of investors but we see a reckoning at some point. The European Central Bank’s
main contribution so far has been to further align the systemic risks between the banking
system and each bank’s respective sovereign government.
If we have one message for investors for 2014 it would be to maintain an element of caution
and not bet everything on a perfect confluence of helpful tailwinds for stock markets. Greed
is likely to increasingly drive investor motives if the positive environment continues and we still
think it wise to prepare for the worst whilst hoping for the best. We certainly aim to maintain a
good balance of exposure across different asset classes for all but our most risk-taking clients.
We wish everyone a happy and prosperous New Year.
Stephen Walker
Head of Equities Research and Market Strategy
18. 18
Analyst certification
We, the contributors, hereby certify that except where otherwise stated, the views in this
strategy document accurately reflect our personal views about any or all of the countries,
sectors or securities referred to in this report. Further, no part of our compensation was, is, or
will be directly or indirectly related to the specific recommendations or views contained in this
report.
Risk warning
This review is designed primarily to give the clients and professional contacts of Ashcourt
Rowan Asset Management an insight into international markets, our opinions on the outlook for
markets and the economy and how we relate this to the investment strategies that we use to
manage client portfolios.
It has been compiled from sources believed to be reliable but is not warranted to be accurate
or complete. It is not designed to give advice on any specific investment or market and does
not constitute any recommendation to buy, sell or subscribe for any investment. Readers
should seek professional advice before investing.
• Past performance is no guarantee of future performance
• The value of your investments and the income from them can go down as well as up
• You may not get back the amount you invest
• Where securities are denominated in foreign currency your returns may increase
or decrease as a result of currency fluctuation
Marketing communication disclaimer
This material is a marketing communication. It is not investment research and has not been
prepare in accordance with legal requirements designed to promote the independence
of investment research and is not subject to any prohibition on dealing ahead of the
dissemination of investment research.
This material is issued by Ashcourt Rowan Group and has been obtained from sources
which we consider to be reliable but its accuracy and completeness cannot be guaranteed.
Any views and expressions of opinion given are those of the Ashcourt Rowan Group and are
subject to change without notice.
Ashcourt Rowan Group has arrangements for the management of conflicts of interest. A copy
of our conflicts policy is available on request.
Employees and connected parties of Ashcourt Rowan Group may own the securities
mentioned herein and may from time to time add to or dispose of any such securities.
This material is not intended as a direct offer or solicitation to buy or sell securities and may not
be available to or be suitable for all investors.
Investors should seek independent financial advice based on their own personal
circumstances, financial objectives, financial resources and attitude to risk.
19. 19
References
Liu and Spiegel, Boomer Retirement: Headwinds for US Equity Markets? Federal Reserve
Bank San Francisco, 2011
Arnott and Chaves, Demographic Changes, Financial Markets and the Economy,
Financial Analysts Journal, 2012
Eggertsson and Woodford, The Zero Bound on Interest Rates and Optimal Monetary
Policy, 2003
Lars Svensson, The Zero Bound in an Open Economy: A Foolproof Way of Escaping
From a Liquidity Trap, National Bureau of Economic Research, 2000
Janet Yellen, The Economic Outlook and Monetary Policy, Speech to the Money
Marketeers of New York University, 2012
Bloomberg LP
