It is customary for us at this time of year to sit down and review the events of the past year, and roll out some informed guesswork on what we expect for the year ahead. 2015 proved, like the year before, to be something of an enigma. When we review what we wrote this time last year, much of it proved to be correct – and for the large part encouraging. Greek chaos, ECB “exceptional measures”, robust US growth, and a UK economy driven by construction and employment growth were all defining features of the investment landscape this year. Yet, we also suggested that the year would also be defined by things that we hadn’t yet thought of. The rout of commodity prices and the devaluation of the Chinese currency were not high on any list of fears we might have produced.
Like last year, we don’t yet know at this stage whether 2015 is going to be a positive or negative year for UK equity returns. This is all the more bemusing when one considers the highs and the lows that we have experienced this year. In April, the FTSE100 finally breached the 7,000 level after its last serious attempt more than 15 years ago. Yet by the end of August, using intra-day values, we were within 1% of a technical bear market in that same index. Such volatility was inspired by the uncertainty surrounding the Chinese economic position. Having spent the vast majority of the last two decades trying to stop its currency strengthening against its trading partners’ currencies, the concept of it having to defend its peg from devaluation shows the marked change in both capital flows in and out of the country, and fears over Chinese firms who have gorged themselves on cheap foreign currency debt.
Equity valuations became a concern for us during the year. Whilst this might seem an odd statement when aggregate equity values barely moved, the overall number hid sharp divergence in performance and valuation metrics at the individual equity level. Generally speaking, internationally facing, manufacturing businesses have struggled to make any headway as profit forecasts have been revised down. By contrast, many UK orientated businesses have enjoyed better trading conditions, and as a result investors have bid up the price of the shares to levels that are difficult to justify in many cases.
Regular readers will know that this prompted us to make some substantial changes to the portfolio structure, taking out some heightened valuation, liquidity and earnings risk. In a period of expansionary monetary policy, one can live with these risks more readily than in an environment when rising interest rates place greater scrutiny on the opportunity cost of buying expensive equity. Last night’s move by the US Federal Reserve marked the first step of what is likely to be a persistent theme through 2016 in the US, and latterly in the UK.
So, what of next year? At this point, there is still a huge amount of uncertainty over the dominant drivers of performance next year. It could be the year of the “Great Rotation”, as emerging market activity stabilises, commodities rebound, and the fantastic yields available on many oil and mining companies actually get paid. In that environment, investors will be less willing to pay exorbitant prices for small and medium sized companies delivering moderate growth. Alternatively, it could be more of the same – Iranian oil coming back onto international markets could spark a supply war between to Gulf’s two largest producers, driving oil to a price that destroys both weaker companies and unstable countries. This could further drive geopolitical tensions which overtake economic fears as the greatest source of risk to capital markets. Dividends from the commodity sectors would be decimated and income investors would need to drive higher the prices of an ever decreasing list of stocks just to meet investment mandate obligations.
The reality will probably lie somewhere between the two.
In general, we believe that the world’s leading developed economies will make further progress this year. Employment, consumption and construction are likely to be further drivers of economic growth in the UK and the United States. In Europe, ultra-loose monetary policy is finally prompting an acceleration in growth of the money supply, which should then feed through into increased economic activity. Across all these economies, consumers will further be boosted by the reduction in energy prices.
Yet, risks remain. We have no concept of the true state of the Chinese economy, and we really must view it as an exogenous factor; rather than one that can be modelled. One of the key risks we highlighted in our August “Wise Man” meeting was the threat of dislocation in credit markets as interest rates started to rise. The closure of a number of corporate bond funds in recent weeks is the start of a process that will inevitably see more casualties and a withdrawal of liquidity at certain ends of the market. Above all, the aggregate picture of profit growth in the UK market must improve to justify current valuations. After three years of persistent downgrades to profit expectations, the chances of a short term reversal in that trend look slim.
So, if 2015 was enigmatic, there is every chance that 2016 will be likewise. However, market strains and stresses always create opportunities. Share prices will normally over-react to short term trading news. There will be fundamentally strong businesses who disappoint relative to market expectations, but leave an opportunity for those with a slightly longer investment horizon to pick up a cracking business at a cracking price. Sitting with almost 20% cash in our portfolios, we are positioned for just such a scenario.
In the meantime, we would like to wish everyone a very merry festive period, and all the very best of luck for the New Year.
Once again, we thank all of our investors for their continued support through-out the past year.
To those who aren’t investors yet, we hope you have enjoyed our regular bulletins. We’ll be in touch.