Over the past year, every time the Fed thought that the world was strong enough to cope with a rise in the Fed Funds rate, China has countered by devaluing the renminbi. Each time has provoked a very negative reaction in financial markets. However, we may have broken out of that cycle, as the last few months have seen evidence of a recovery in global growth. Business surveys have improved considerably in the US while data from China suggests the stimulus applied after the stock market falls of August 2015 are taking effect.
It feels like markets have been down the hill and back up so far this year. The question is what will happen next? It is still difficult to make a case for accelerating growth other than a catch up for the lost ground in the first half of 2016. However growth will be aided by a reduction in risks such as rising oil prices, low US interest rates, a stable China and on-going quantitative easing (QE) programmes. Indicators are pointing to steady growth in the US but slowing in Japan. The case for European growth is good but is now clouded by the UK Brexit decision which will hit European stock markets as much as if not more than the UK.
For much of this year, the concerns over a Chinese hard landing have abated. There has been a sharp upward movement in a range of economic indicators, including industrial production, monetary growth and Purchasing Manager Index (PMI). On the expenditure side, fixed asset investment in property and infrastructure has increased. We now expect a China recovery to be a significant theme for the remainder of 2016.
The rise in oil prices are likely to result in inflation later in the year. US wage growth is yet to significantly rise, but once it does, we can expect an increase to US interest rates.
As growth resumes and inflation moves towards the 2% target, the US Federal Reserve will feel pressure to raise rates and as a consequence market volatility may return. Higher US interest rates strengthens the US$ which puts pressure on the renminbi and commodity prices. US$ denominated debt will become more expensive hitting emerging markets. Forecasters now think that will not occur until late 2017.
Recent easing by the ECB and the BoJ has been followed by significant appreciation in the ¥ and €, which is the exact opposite of the intended consequences. While this may not persist, it counters the whole action of rate reduction and asset purchase. Therefore, the US remains a less volatile growth region.
The Eurozone continues to be a major beneficiary of the low oil price. Domestic demand in Germany has been the major cause of Eurozone growth with rising real incomes and additional government spending. Austerity cut backs are no longer a significant drag on Eurozone growth. With the Fed wishing to tighten money supply and while the ECB remains in easing mode, a weaker Euro remains a key driver for European equities.
We are conscience that a delayed Fed rate rise will temporarily put off a return of capital to the US. This will boost Asia and the Emerging Markets. Emerging markets will be sensitive to any strengthening US$ hitting commodity prices. However the upswing in global growth may also stabilise commodity prices that have had a good year already. We have maintained our positions in China and India but added a general emerging markets dividend fund to broaden diversity.
As of 1st July 2016, our best performing funds held within our portfolios over the last 12 months have been;
|HSBC American Index
|Schroder US Mid Cap
|Old Mutual North America
|Barings European Select
The main reasons behind these positive returns have been the significant growth in the US, parts of Asia and European, particularly in mid cap markets.
While our poorest performing funds were;
|Axa Framlington Biotech
|HSBC FTSE 250 Index
|Aberdeen Property Shares
|Old Mutual UK Mid Cap
|Fidelity China Focus
The main reasons for these disappointing performances were the volatility in the health care and pharmaceutical sector in the US, the recent heavy fall off in UK mid cap stock and commercial property as a result of Brexit and the past years volatility in China.
As far as the 25th Edition of our portfolios is concerned, seven of the funds from the 24rd Edition have been substituted. Our asset allocation remains broadly in line with that of previous editions in order to retain the portfolios risk profile. However, they have been tilted towards sectors which we feel offer better security and growth prospects going forward adding such assets as infrastructure funds, UK and global corporate bonds and index linked gilts that were not present in the last edition. We continue to hold meaningful levels of cash, bonds and property across the portfolios to help dampen volatility although we have reduced our property exposure. Our general strategy is to remain well diversified across all portfolios.
In general, despite the volatility of the past twelve months, we still hold a positive outlook for equities particularly for the US and Asia which are less affected by the Brexit fall out and for UK large cap multi nationals who will benefit from a devalued GB£. Despite the political negativity both UK and European stocks can recover their current depressed values, particularly with low interest rates, an ongoing QE programme and low oil prices.
While we remain positive over US equities. We are concerned about a potential lack of earnings growth as price-to-earnings ratios in America’s large corporations are over 25. We still see the US as a growth economy and are happy to remain invested. US$ valuations are likely to hold as the Fed has postponed further rate rises and will aid America’s exporters.
Collectively our eight portfolios outperformed their respective benchmarks on 37 out of 44 occasions
We believe that China is over the worse of its troubles giving a boost to Asia and emerging markets as the region is generally heavily dependent upon China. We will retain our current holdings in Asia, India and China. Profits are returning to those markets and prospects look more favourable in the second half of 2016. We are less concerned about the smaller emerging markets as it looks as if the Federal Reserve will delay further interest rate rises this year and commodity prices are improving.
We see returns on government bonds to be exceptionally low value as the only gain is on capital returns because yields are so low. The massive move of capital to safe haven assets after the Brexit vote and the ongoing ECB QE programme will continue to suppress bond yields. Inflation caused through the devaluation of GB£ is likely to result in rising bond yields and a corresponding fall in bond prices. We therefor consider index linked gilts as attractive. Equally, while demand for income remains, corporate bonds and high yield corporate bonds are also attractive. Due to the low yields in the UK and in Europe, we have increased our exposure to global bonds.
We remain overweight in UK commercial property which has contributed to overall portfolio returns this year. We are conscious that the pricing of commercial property funds has had a negative impact on valuations but this enforced pricing will be a temporary measure until confidence is restored and the Brexit implications settle. We are confident this sector will continue to provide meaningful longer tern returns to investors but after it has gone through a significant short term downturn. We have however reduced our commercial property holdings.
We are reasonably pleased to report that the gross performance of our portfolios in each of our eight portfolios up until 1st July 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. Seven of our portfolios showed up well only the Defensive portfolio did not due to its high cash and low equity content. It did however achieve its objective. Collectively the eight portfolios outperformed their respective benchmarks on 37 out of 44 occasions (84% competency). However, I am disappointed to report that this success factor is one of our lowest outperformances in the twelve years we have been running them mainly due to the Defensive Portfolio’s relative underperformance.
The portfolios were tested during the equity falls of last August, January and June. Our portfolios held up well, protecting investors from the worst of the volatility. The post Oil crisis returns since February has been robust. We fortunately moved those clients who followed our recommendation to switch out of UK and European equity to cash ahead of the Brexit vote. This action protected the UK and European asset allocation from the subsequent falls. We will return to risk assets at this rebalance in line with our asset allocation.