This will be a year of two markets. Taking a two- to three-year view, we expect a rebalancing away from the developing world towards the developed world. Developed markets will be characterised by low rates, subdued inflation pressures and low to moderate growth. Furthermore, central banks will continue to err on the side of growth. We expect developing markets – defined here as Asia and emerging markets – to experience rising inflation and weaker growth.
There will be no V-shaped, momentum-driven resurgence in global economic growth in 2014. Instead, we expect a modest recovery, driven by the US. Consequently, we will remain focused on domestic-earners, particularly in the UK and the US, to provide the impetus.
We expect a shift from the risk-on/risk-off, yield-hunting environment of the last three years and a welcome return to fundamentals. We will need active equity funds to generate alpha, if we are to provide high single-digit returns. We expect volatility to rise in the first quarter of next year, as the market re-focuses on tapering.
As this has been well signalled, we do not expect equities to react dramatically, but there may be a small shake-out, which should provide a great opportunity to re-enter the market. Ultimately, we believe tapering will be beneficial to equity markets and lead to the strengthening of the US dollar.
Equity markets:
The Mild West
At this juncture, equity markets look fair value on a relative basis. Many companies in 2013 beat expectations on the back of margin expansion and cost-cutting, which is unsustainable in the long run. In 2014, we will need to see top-line revenue growth filtering through to earnings in order to drive markets higher for longer.
Elevated consumer confidence should feed through to increased capex and possibly a pick-up in M&A activity. Current market levels suggest that growth has re-rated versus value, meaning that pockets of value are increasingly scarce. Investors will, therefore, need to be very selective on the stocks they own, or invest in nimble, active managers, who can eke out valuation anomalies. For us, this means taking on significant stock-specific risk through concentrated funds.
We see the next two to three years dominated by growth in the West, albeit at trend levels at best, which has obvious implications for those who retain a developing world tilt in their portfolios. Key drivers of this growth will be lower commodity prices, driven by less demand from China and other developing markets, and the development of shale reserves.
Western governments have woken up to the fact that the energy advantage of the US is detrimental to them, in terms of a massive boost to the US manufacturing base, and they are now taking steps to reduce energy costs. In the UK, we could be on the cusp of reducing green tariffs, which should provide a healthy tailwind for consumers and their pockets.
Bonds:
Three percentage points and rising?
It is difficult to ascertain how far the bond markets will react to tapering. Generally speaking, we believe bond markets will struggle to find a floor and a level for normalisation, making this territory a difficult one to negotiate next year.
At the time of writing, gilts look over-priced, but we expect the UK benchmark 10-year yield to breach 3 per cent during the first few months of the year, at which point we may look to add to duration. At this juncture, we see little value in investment grade debt, and may re-enter emerging market debt once spreads have widened to 400 basis points over US Treasuries.
High yield looks expensive; however, so long as it is short duration, there remains a place for it in the portfolio. In our Strategic Growth and Total Return Portfolios, we are invested in Muzinich Global Tactical Credit, run by veteran credit manager Michael McEachern.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
US equities:
All about Main Street
Next year is not about Wall Street but all about Main Street. We remain overweight US equities, especially domestic US, which should benefit from the recovery and looks much more attractive on a valuation basis than the mega cap stocks.
Furthermore, we see a continuation of in-shoring – meaning the repatriation of manufacturing and services to the US. We believe the threat of a technical default is minimal, not least of all because to force another shutdown of government would be political suicide for the Republicans.
Both equity and bond markets have been relatively nervous about the prospect of tapering, but any reduction in asset-purchasing should no longer come as a shock. Incoming US Federal Reserve chairwoman Janet Yellen is perceived as dovish, in-line with her predecessor, but she may decide to show her mettle by surprising the market.
In our Enhanced Growth Portfolio, we own the Legg Mason Royce US Small Cap Opportunity fund, which is managed by Bill Hench. The fund holds stronger regional banks, whose profits will increase if interest rates rise.
China:
Can China really stop investing?
The Third Plenary Session announced 60 reform measures, with a time target of 2020. It is fair to say that the reforms were wide-ranging and met most expectations.
We are reasonably confident about China’s medium-term growth outlook, but the risk lies in the execution of the reforms by local governments, as the social and economic environment has changed dramatically over the past decades.
Let’s make no bones about it – the long-term political future in China is unclear. Many believe that these reforms will only benefit the rich, who live in coastal cities, and that around 60 per cent of the population will not benefit at all, and will require the investment-led growth to which China has become addicted.
Meanwhile, productivity is falling in emerging markets: labour costs are rising and profit margins have never recovered. China will remain supportive to global growth, but we are not relying on it as a primary driver of that growth.
We have reached the end of the emerging super-cycle and the end of the commodities super-cycle, which has implications for those portfolios that are heavily-weighted towards a China theme. We believe that investors may want to refocus on developed, domestically focused growth.
Performance of indices since 2000
Source: FE Analytics
We hold no direct exposure to China at this stage and prefer indirect exposure through the Veritas Asian fund, which is held in our Strategic Growth Portfolio. This is an index-agnostic fund, managed by the highly experienced Ezra Sun. His approach combines growth and dividend-yielding stocks.
Europe:
Will Draghi “put” it right?
Overall, the euro is being held together by the glue of uncertainty, as there are numerous fundamental problems that still require a response. The potential for deflation remains a huge issue and we expect a continuation of anaemic growth, especially as there is a great amount of de-leveraging to come. Banks in Europe represent the risk next year.
Key to any bullish argument on Europe will be a weaker euro, however. Apart from the so-far untested "Draghi put", it is hard to see what big stimulus measures can be implemented from here. This is in spite of recent talk of negative rates on deposits.
There may be some excitement from time to time on the back of positive data, with a temptation to extrapolate it into trends. But there is the danger that it will translate into nothing more than illusory multiples and value traps.
In our Strategic Growth Portfolio, we hold the Baring Europe Select Trust, a European small- and mid cap fund that seeks growth companies, often in a niche space and with significant competitive advantages.
UK:
Size matters
We are now more positive on the UK economy and moderately constructive on the UK market. Positive sentiment has been supported by a stoking of the housing market ahead of the general election in 2015, and we are mindful of bubble territory. The election will be critical and we are cognisant of any political grandstanding during the run-up.
With regards to interest rates, the situation is too nascent for a rise: indeed, a hike is unlikely ahead of the election. There is little wage inflation, notwithstanding any significant downward pressure on sterling, or an over-heated housing market.
We are not getting excited about the FTSE 100, but will be focusing on micro, small and mid cap domestic-earners. It is becoming increasingly difficult to find value in these areas because of outperformance, but there are enough stocks in the universe to take advantage of a return to growth.
We are invested in the Marlborough Special Situations fund, managed by Giles Hargreave, who invests in smaller companies, new issues, and those companies experiencing difficulties but with good growth prospects.
Japan:
Might it be different this time?
Given the amount of money that is being thrown at the economy by its authorities, Japan is difficult to ignore. Indeed, it would be pretty foolish to do so.
If one takes a more critical look at time-honoured paradigms about Japan, we might conclude that it may well sustain economic growth at a higher rate for longer, although this is not without issue. So far, there has been little evidence of Abe’s "third arrow". Weakness in the yen has been beneficial to exporters, although we suspect this is coming to an end.
Our main worry lies with the Japanese government bond market and its ability to survive negative real yields. With no external buyers of JGBs, who will finance the deficit and what degree of systemic risk is posed by a potential blow-out in JGB yields?
In our Strategic Growth Portfolio, we have initiated a small position in the JP Morgan Japanese Investment Trust, at an 8 per cent discount to net asset value.
Commercial property:
Caveat emptor
The problem with property investing is that a huge price discrepancy exists between quality and value traps.
In the current environment, we believe we are not being paid enough for the liquidity risk. Furthermore, there is a lack of niche vehicles available, so we have zero exposure. We would allocate more if we could buy specialist vehicles with the niche exposure we actually want – for example, offices in the West End of London.
The UK is so much less advanced than the US in terms of its product development in this area, as there is a huge gap in the market for this type of vehicle. As an alternative, we prefer companies that lend to commercial properties and gain access through the Starwood Real Estate Debt fund, which we hold in our Strategic Growth Portfolio.
David Coombs is head of multi-asset investing at Rathbones and is lead manager of four funds at the group. The views expressed here are his own.
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