Tales of the unexpected

So we are at that time of year where we spend some time looking both back and forwards. Reviewing the year gone by and making educated guesses about what we might face in the future.

Given the recent volatility of markets, we are unusually in a position where we still don’t know what kind of year 2014 has been. At the time of writing, the UK market is down by more than 6% in the current month to date. A rebound of the same magnitude before the year end would leave the benchmark index showing modest (if unspectacular) gains over the 12 month period. A further lurch down to the same extent would condemn the equity market to its worst calendar year loss since the depths of the financial crisis in 2008. It is still very much to play for.

Such volatility, in our opinion, is at odds with the reality of what is facing companies; and ultimately it is the value of companies that we are talking about.

Looking back over the course of 2014, for the majority of the world’s main economic hubs, things have pretty much turned out as expected. In January, the IMF expected global growth to be 3.6%; at the end of the year it had revised that down marginally to 3.3% not enough to make a difference. In the US, the decline in expected output growth was slightly greater, but that was all about freak weather affecting activity in the first quarter of the year. Since then the US economy has performed slightly ahead of expectations. European and Japanese growth forecasts have bobbled around the 1% level for the last 18 months. Only in Russia (much worse than expected) and in the UK (much better than expected) have there been any genuinely surprising outcomes. For all the scrutiny over China’s growth prospects, at the headline level activity has panned out as expected. A very similar profile exists for expectations into 2015.

That said, equity markets are typically more forward looking than economic forecasters, and it can be reasonably assumed that markets were pricing in more signs of life in the European economies than subsequently came to pass. So looking back, it is possible that at the start of the year, equity valuations were higher than could be justified by the persistent stream of earnings revisions downgrades that featured visibly throughout the period. It is fair to say,that we were watching valuation levels very closely at the start of the year yet in a year where we felt that earnings execution was crucial above all, we accepted a higher level of valuation risk in certain stocks for the trade-off of greater earnings security. By and large, that paid off, with a high degree of earnings (and dividend) delivery throughout the year. We must record, however, that there was a notable level of rating compression at the more highly rated end of the portfolio. Where the underlying earnings were associated with domestic UK profits, the positive trend in improved profits was enough to generate positive share price performance. Where those earnings were more internationally focused, the strength in the average value of Sterling held back potential for widespread upgrades, so share prices were more susceptible to falls.

This picture of relative economic stability is obviously completely at odds with the collapse of the oil price over the last six months. Based on purely economic considerations, there is very little justification for a near halving of the oil price over the second half of the year. So there are clearly technical (and geopolitical?) factors at play. Against that backdrop, there is very little chance of us accurately predicting what the “correct price” for oil should be over the short and medium term. But we are fairly confident in the assertion that over the long term the oil price must rise from current levels. In the meantime, if current prices are maintained, the effect on global consumption is a transfer of purchasing power from producers to consumers of roughly the scale of the last US quantitative easing programme. That it is directly going into the hands of consumers also makes it more like the fabled “helicopter drop” of cash. The impact will be considerable.

But what of 2015?

Well, the immediate challenges are not going to disappear. Indeed, just before Hogmanay we will learn if a Greek failure to elect a President has presaged a general election that the far left Syriza party look likely to win. Grexit will be part of investors’ lexicon again in the New Year. Elsewhere in the Eurozone, moribund growth and fears over deflation will be fur- ther entrenched after the effects of the falling oil price feed through. China’s growth rate is on a downward path, and there is a risk that it falls below the level needed to stop some of its economy’s obvious imbalances dragging it into deeper trouble. And as ever, there is the risk of geopolitical tensions across the globe spilling over into outright war – both in the military and the trade sense. Closer to home, the prospect of an inconclusive General Election could put Sterling assets under real pressure.

Yet there are reasons to be optimistic. In the Eurozone, things may just get so bad that radical economic reform and radical monetary policy are unavoidable. Europe is not a wasteland. It has an immense store of intellectual and economic capital. But it needs change to help release its potential. In the US, the Republican party is unlikely to want to queer its pitch ahead of the Presidential election in 2016; so for the first time in a while the US economy should be allowed to get on and grow without sticks being regularly stuck in its spokes by its dysfunctional political system. In Japan, Shinzo Abe now has a strong, long term mandate to roll out the Abenomics project. Setting politics aside, in the UK there are 700,000 more people in work than at the same time last year, and wage growth is finally on a path to run ahead of inflation for a sustained period of time. Moreover, general construction activity in the country is building momentum, and 2015 is likely to see an explosion of activity in the personal pensions and savings space.

Against that backdrop, we might set out a similar plan for approaching 2015 as we set out in 2014. The current environment is one where strongly financed companies with secure competitive positions can make decent headway. For those who are missing one of these features, the year could present challenges. 2014 proved once again that the stockmarket is no respecter of reputation. Some its darlings of recent years have come spectacularly unstuck. It is almost certain that 2015 will witness more.

Yet, looking dispassionately at our portfolio (and potential investment candidates), we are struck by the notion that there is much less in the way of valuation risk sitting in the portfolio than last year, and with current US$/UK£ rates sitting at lower levels than the average of last year, there is a natural tailwind to earnings revisions from overseas earners. With strong balance sheets and cash flows, the prospects for dividend growth are, again, encouraging.

One thing is for sure, however. When we come to write the review of 2015, it will include elements that don’t even register in our consciousness at the moment. Such is the challenge and frustration of investment management. Yet, it is also the feature that keeps us excited and engaged about a job, even decades after looking at our first investment idea.

May we wish everyone a Happy Christmas, and all the very best wishes for a prosperous New Year. To our clients, thank you once again for your support over the year. To those that aren’t – there is always next year.