The global recovery is generally on track with the support of low interest rates, accommodating monetary policy, improving employment rates and growing consumption. The risks remain the potential for US protectionist trade policies, the pace of China’s growth, the growing issue of political uncertainty in Europe, the rate at which US interest rates may rise and the implications this has upon commodity prices and emerging market debt repayments.
The US Federal Reserve is expected to deliver another hike in interest rates on the 14th of December. This comes at a time when the appetite for further additional stimulus from the BoJ, BoE and ECB is reducing. Therefore, global financial conditions may become less accommodating over the months ahead.
The effectiveness of quantitative easing (QE) to boost demand is losing its impact and so governments need to step in where previously central banks took the lead. The increase in government spending in such projects as Hinckley Point, HS2 and Heathrow’s third runway are good examples of the new focus on infrastructure expansion likely to be seen in 2017 and onwards.
We expect the concerns over China to resurface in 2017. A hard fall in growth is not expected but China is now likely to be past the peak of the mini growth cycle that was a result of last year’s stimulus. We are now seeing steps being taken to rein in property speculation through tighter mortgage restrictions. China’s stimulus withdrawal and the resulting gradual slowdown plus the pressure on the renminbi pose a risk to growth in both China and emerging Asian economies. We are cautious of falling Chinese growth but recognise that emerging Asia have the best long-term prospects for growth for any region in the world. We will therefore reduce our direct Chinese holdings but increase our Emerging Asia holdings.
American GDP growth is expected to finish the year at 1.5% as it picked up pace in the second half of the year. Throughout 2017 we should see continued growth in the labour market and an associated rise in wages. A strong US$ will have an impact upon export trade but the American domestic market should be robust particularly if Trumps infrastructure and tax reducing plans are fulfilled. With job numbers and wage growth improving, a December rate rise is likely and further moderate rate rises in 2017 look reasonable. We are positive about the prospects of the US$ and the relative strength of the US economy. We are happy to extend our positions in US equity with an emphasis upon private listed infrastructure and mid cap and small cap corporations who will principally benefit from Republican policies.
The steep fall in sterling following the Brexit referendum has supported UK equities given their high dependency on foreign earnings. However, the stabilisation of commodity prices also supports UK equities given the FTSE 100’s heavy exposure to the natural resources sector. While we enjoyed a quarter long boost to UK equity values, the relative strengthening of the pound and weakening of the euro has lessened this recent advantage. UK economic growth is likely to weaken over the medium term amid uncertainty over the Brexit settlement. UK consumer confidence has been strong since the summer but while the post Brexit economic data is holding up well, lower business investment, slower job growth and weaker consumption are likely to become a drag as Brexit related uncertainty starts to materialise.
The impact of currency depreciation is now noticeable with cost increases in imported goods. Post- Christmas inflation is expected as the higher cost of imports will boost inflation by 1-2%, peaking in 2018. With real income growth running at 2%, it will not be long before spending power is affected. Fiscal stimulus in the form of infrastructure investment, measures to boost consumer spending and business investment, including corporation tax cuts, will go a long way towards limiting Brexit fall out. We will ease down our positions in the UK but expect sterling to still hold a competitive valuation throughout the coming months.
The UK Brexit raises concerns over European growth prospects. Slower UK growth will have an impact on Europe. Europe is particularly vulnerable to stagnant global trade growth and its inability to formalise trade agreements easily does not help. Political uncertainty lies ahead in the form of the Italian referendum on constitutional change and then general or presidential elections in Holland, France and Germany in 2017.
Despite these uncertainties, European equities are very well priced and prone to upward movement given the region is at an earlier stage in the recovery cycle. The monetary backdrop is supportive as the ECB QE programme is in place until March. European growth has increased through wage growth and consumption. This may result in rising inflation. Any improvement in inflation will allow the ECB to start to taper or even withdraw its €80bn per month stimulus package later in 2017. Eurozone negative interest rates may also move back to zero. While growth in Europe is improving we are concerned about the outcome of the various European elections creating uncertainty and so will pare down our European exposure until later in 2017.
Earnings momentum has slowed in Japan despite the introduction of negative interest rates by the BoJ in January 2016. The ¥ actually strengthened which was a setback for export sensitive Japanese stock. However, for the greater part of 2016 the ¥ has fallen against the strengthening US$. The BoJ is likely to become a major shareholder in the Japanese stock market and maintain its extremely loose monetary policy. This framework allows for further negative interest rate cuts to further reduce the value of the ¥ and increasing the value of its overseas earnings. Stock values are attractive and Japanese corporations with large cash reserves have plenty of scope to boost dividends or make stock repurchases. The Abe government policies should support growth prospects. Growing US consumption will boost import sales from which Japan can benefit. While our Japanese holdings are relatively modest we will retain our exposure.
It is expected that emerging market growth will pick up this year with stable commodity prices and an increase in developed world consumption. However, as the major influences upon growth – Chinese stability, commodity demand and the fact that loose monetary policy from the major developed world central banks is now progressively coming to an end, emerging markets can be vulnerable to change. South Africa and Turkey with current account deficits of over 5% of their GDP are a concern. India and Brazil have both made significant progress in closing their deficits and can cope with a strengthening US$ while Korea, Taiwan and Thailand have near record surpluses.
Emerging markets are attractive given the expected direction of long term currency appreciation. It is important to be selective with Asia as the preferred region because their predictive returns look higher. The combination of strong cash flow growth and robust balance sheets to support stable dividend payments help maintain stock valuations in Asia. The main concerns will be the impact of future Fed rate rises, the possible start of protectionist trade agreement renegotiations, the rate of growth in China and the path of commodity prices. We do not think that Fed rate hiking will be overly aggressive so we are happy to maintain our relatively modest position in emerging markets but extend our exposure to South East Asian economies.
UK monetary policy is likely to stay highly accommodative for a longer period due to the negotiations over Brexit. The BoE has relaunched a QE programme and reduced interest rates from 0.5% to 0.25%. This places the BoE more in line with the ECB rather than being closer to the Fed’s position as was the case consistently pre-Brexit.
The returns on UK gilts are very low although yields have been driven up due to the threat of inflation. Similarly, the case is the same on the continent with overvalued bonds being hit by US Treasury yield rises and the risk that the ECB will taper or even end its QE programme. Therefore European yields can be expected to raise meaning bond prices will fall. With yields across the developed world very low and likely to remain relatively low, there has been a movement to emerging markets local currency debt. Corporate balance sheets remain in good shape and default rates are low.
With the expectation of both rate rises and inflation in 2017, we have reduced our exposure to fixed interest securities. Those we do hold will mainly be strategic bonds and investment grade corporate bonds. We will avoid government gilts and inflation- linked gilts. While there is an expectation of inflation in the UK in 2017 this may not be as high as some predict as sterling has regained some of its falls and GDP growth next year looks likely to be less than 2016.
We are very aware of the implications of the exit penalties that still apply to both the Henderson and Threadneedle Property funds that we hold. When these penalties were applied to discourage out flows in mid-June it stopped us from de-risking this asset from the portfolios ahead of Brexit. The result was a 5% fall in portfolio values. We expect this penalty to be lifted very soon and as a result the 5% reduction will be recovered meaning our portfolios will see an immediate uplift in value. As we have been overweight in property this 5% charge has held our portfolios back against national benchmarks. It is for this reason we are maintaining our property holding to the same percentage as held in the 24th Edition.
We expect further US$ appreciation which has a negative influence on gold prices. Throughout 2016 with a background of uncertainty gold priced mainly increase reaching US$1370po in July. Gold has since fallen back to US$1168po particularly with the prospect of the US$ rising in value further on the back of interest rate rises. It is for these reasons we have avoided holding gold.
We are however mindful that with a world of uncertainty facing us as well as the likely rise in inflation, gold is a useful counter balance. We may therefore consider adding a small gold position within the Defensive portfolio to reflect not only geopolitical policy risk, but the higher debt and potential inflation risk In other portfolios gold is represented in a broader natural resources fund.
As of 1st December 2016, our best performing funds held within our portfolios over the last 12 months have been;
|Schroder US Mid Cap
|Schroder US Smaller Companies
|Blackrock Paciﬁc ex Japan Tracker
|Old Mutual North America
|Fidelity China Focus
|First State Global Listed Infrastructure
|Henderson China Opportunities
|Man GLG Japan Core Alpha
|HSBC American Index
The reason behind these positive returns has been the significant growth in the USA economy resulting in the US stock markets reaching all-time highs. The growth in China is due to the recent government stimulus which we expect to start falling away, while growth in Japan is a result of government policy to devalue the ¥.
While our poorest performing funds were;
|Axa Framlington Biotech
|Invesco Perpetual Strategic Income
|Henderson Property Fund
The Biotech fund has been carrying losses over the past twelve months but recent performance has been much improved. Both of our property holding are suffering a 5% reduction as they and are priced at the exit price. We are expecting this charge to be lifted shortly adding the 5% value back to the fund.
As far as the 26th Edition of our portfolios is concerned, eight of the funds from the 25th Edition have been substituted while four new funds are added. Our asset allocation remains broadly in line with that of Edition 24 in order to retain the property allocation and the overall portfolios risk profile. However, they have been tilted towards sectors which we feel offer better security and growth prospects going forward. We continue to hold meaningful levels of cash and property across the portfolios to help dampen volatility but we have reduced our fixed interest exposure. Our general strategy is to remain well diversified across all portfolios.
We are pleased to report that the gross performance of our portfolios in each of our eight portfolios up until 1st December 2016, as measured against the associated national benchmark, has been quite satisfying. The relative performance is measured over six time periods from 6 months, 1 year, 2 years, 3 years, 4 years and 5 years. Five of our portfolios showed up very well producing some significant gains ahead of benchmarks over all time periods. Collectively the eight portfolios outperformed their respective benchmarks on 33 out of 44 occasions (75% competency). However, I am disappointed to report that this success factor is our lowest outperformances in the thirteen years we have been running them. Our Defensive portfolio has fallen short of its benchmark but in some respect that is expected due to its high cash and low equity content. It did however achieve its objective of comfortably beating cash returns. Our Balanced Income and Balanced High Income have recently fallen below their respective benchmarks due to our overweight position in property and the recent falls in bond prices. We will retain our overweight position in property funds awaiting the removal of the 5% reduction in exit price.
Collectively our eight portfolios outperformed their respective national benchmarks on 33 out of 44 occasions.