A brief review of 2015

Last year delivered mixed results for investors. Starting with equities, geographical choices and stock selection made a significant difference to the performance that was experienced.

More specifically – investors in emerging markets have for the most part suffered because currency weakness has undermined shareholder returns when translated into stronger currencies, notably the dollar, but also for UK investors. There has also been significant volatility in Chinese equity markets so that although the Shanghai Index has ended higher on the year, very large rises and subsequent major falls have made that particular journey a very uncomfortable one.

The Japanese market rose over the year as the economic policies instigated by Prime Minister Abe have achieved some positive results. In the meanwhile, in the USA, the broadly based S&P 500 Index finished the year down 0.7% (if dividends are added, up 1.4%) and it is worth noting that the S&P’s constituents include a number of oil and material related companies which have performed badly. On the other hand, the technology heavy NASDAQ Index gained around 6% on the year while companies involved in medical sciences have generally performed particularly well.

In the UK, the pattern has been similarly mixed. The FTSE 100 Index is down by 4.9% on the year while the FTSE 250 Index is up 8.4%. Broadly, the underlying reason for this significant divergence is that the FTSE 100 Index is heavily exposed to mining and oil stocks and over the year, some of the major mining company shares have fallen by up to 70%. This has clearly dragged the FTSE 100 Index down and investors with modest exposure to commodity related companies will have seen a better result.

The Eurozone economy has shown some signs of stabilising with banks now extending increasing lines of credit to industry. Germany’s GDP grew by a relatively respectable 1.7% and the future of the currency itself appears more secure following the decision by Greece to remain within it. The ongoing Eurozone quantitative easing programme continues to provide significant stimulus and, by comparison with other markets, Eurozone equities have offered good value throughout the last 12 months.

While these clearly very divergent stock market performances have been seen, it is worth remembering that, with the exception of the commodity related sectors, many companies have continued to improve profitability through efficiency gains. Dividends have been increased at least modestly in many cases and continuing low interest rates have provided further opportunities for companies to fine tune their balance sheets. As for commodity related companies, it has clearly been a tough year, for some more than others, and we anticipate further corporate restructuring so that the proposed acquisition of BG by Royal Dutch Shell, for example, now looks more likely to come to fruition, leading over a period to worthwhile operating efficiencies.

As for fixed interest markets, volatility levels have been much less noticeable than many had predicted and the first interest rate increase for many years in the USA was delayed until the last possible moment in December. In anticipation of this, emerging market currencies have suffered but in general fixed interest markets have adapted in a relatively well tempered way. Against this background, the ten year gilt yield has risen from approximately 1.7% a year ago to 1.9% at the beginning of this year, implying a modest loss of capital for gilt investors. Corporate Bond funds have generally delivered a relatively steady return, underpinned by a flow of interest payments, while index linked gilts have also broadly held their own in a time of low, or on occasion negative, inflation.

Many investors have at least some exposure to commercial property funds within their portfolios. Many such funds have delivered positive returns over the last year, led by the UK market where returns have been strong and quality properties have been in demand.

Overall 2015 has proved to be a mixed year with a number of bright spots featuring in portfolios but also some disappointments, particularly in respect of emerging markets and commodity focused areas.

2016 outlook

At a global level, the outlook for the New Year continues to reflect factors that have been developing during 2015. Among other things, these factors include the speed and scale of future interest rate increases in the US and possibly in the UK: on whether within the Eurozone indications of economic improvement endure: on how the Chinese economy develops and, perhaps in some respects most crucially of all, as a confidence indicator, how raw material prices behave.

The first part of January has seen some exceptional volatility in equity markets, led by China, where last years’ net gain has been more than wiped out by rapid share price falls. This in turn has put pressure on commodities, notably oil, all against the background of indications that the Chinese economy is continuing to slow.

We believe there are a number of key points to consider in respect of China, the first being to put the slowdown into context. You will be aware that the Chinese economy has expanded significantly for many years and, after a period of such strong compound growth, a slowdown is surely bound to happen at some point. Arguably, China has over invested in infrastructure, some of which is under-utilised: this is perhaps the opposite to the UK’s situation where necessary infrastructure investment falls well behind demand. It remains the case that, based on all official figures, the Chinese economy still remains very in expansionary mode. Even if true GDP growth is nearer to 3% or 4 % than it is to the 7% official target then the Chinese economy, the second largest, will remain a powerful driver of growth although not at the rate that has previously become expected of it.

The implications of this are, firstly, that demand for raw materials will begin to stabilise, probably during the course of 2016, and in the fullness of time the current slowdown in investment by mining, oil and gas companies will give rise to a better balance between supply and demand for the rest of this decade and beyond. Therefore after a period of painful adjustment, a new equilibrium will emerge. For economies, those heavily dependent upon raw material production will continue to face revenue difficulties for the foreseeable future. This will bear down on a number of emerging economies so that risks associated with investment in these areas need to be considered carefully before any substantial additions are made in the short term.

Among developed economies, the fall in raw material prices has generally boosted prospects and in these circumstances, low inflation levels are not, in our view, a sign of weakness: they signal an opportunity. Monetary policy remains expansive, employment levels are improving and corporate profits are, in many areas, broadly sound.

We conclude from all of this that developed equity markets offer more appealing opportunities – in particular perhaps within the Eurozone and Japan where signs of revival are emerging after a number of difficult years.

Investors in UK equities continue to enjoy relatively high levels of income by international standards and we see reasonable value in most sectors of the market although we remain underweight in commodity funds. However we believe there will be opportunities in the latter for investors prepared to take at least some greater risk. It is also our view that the UK is likely to remain in the European Union following the referendum that seems increasingly likely to take place this year. It is our belief that for the UK to split away from its major trading partner (it is a far more important market for us than, for example, China) would be detrimental to our economy.

In our view, the market uncertainties early in the New Year will act to postpone further increases in US interest rates for a little longer than previously anticipated. In the UK, Sterling has slipped relative to the Dollar in anticipation that the timing of a UK interest rate increase may be later than originally anticipated. There is certainly no short term inflationary pressure to suggest that such a rise is necessary to stop the economy overheating. Depending on how markets generally settle over the next few weeks however, a small increase in UK rates looks possible this summer or autumn. It is also possible that quantitative easing in the Eurozone will be reduced or withdrawn as the year progresses so that markets may begin to speculate on the timing of the first rise in Eurozone interest rates. We do not consider that gradual interest rate increases will lead to major disruption in the fixed interest markets: rather we anticipate a gradual adjustment, which is, arguably, already underway whereby yields increase and prices settle correspondingly somewhat lower. We continue to be underweight in this sector where investors income requirements allow, focussing on income tax advantaged opportunities wherever possible.

Given the slightly uncertain outlook for the fixed interest sector, there is in our view a place for what are known as Absolute Return funds. In essence, through the use of an often complex range of derivatives, such funds aims to provide a positive return in all market conditions over a rolling period, usually three years. Such investments will not match equity returns in good market conditions but they do provide a possible alternative for some capital that might otherwise have been invested in the fixed interest sector and indeed for cash, particularly where investors hold large cash reserves elsewhere.

Overall, our New Year thoughts are driven by the prospect for slightly lower total returns on fixed interest investments and by what we see as sound medium term value in many developed equity markets, particularly after recent market turbulence. Furthermore, and with the exception of the raw material sector, many companies have improved their financial position since 2010. As for raw material producers, the immediate future looks set to remain difficult but at some point commodity prices will stabilise and investors will find value in this sector. At present we remain underweight in the sector, a position that may change as we go through the year. We also remain underweight in emerging markets and in China.

Diversification within portfolios has been a great help over the last year which has clearly been difficult in some areas of investment. One thing we can say for certain is that achieving diversification across a range of asset classes will continue to form a key part of our investment strategy in 2016.