Having ended 2013 strongly, developed market equities have fallen significantly through January. The major reason for the fall, experts say, is due to negative economic data out of the emerging markets and subsequent currency concerns.
As a result, the leading UK, US, European and Japanese indices have all posted a negative return in 2014. The FTSE 100, for example, stands at 6,454 at the time of writing, having been at 6,800 earlier in January.
Performance of indices in 2014
Source: FE Analytics
However Merricks, head of investments at Skerritts Wealth Management, says that this trend is unlikely to continue.
“2014 has got off to a somewhat unnerving start,” Merricks said. “January is traditionally a strong month in terms of stock market performance, but the latter half has seen some uncomfortably large downward movements, primarily due to the increased nervousness over the emerging markets, which we have been predicting for some while now.”
“We are fairly confident in predicting that this current wobble is just that – a wobble – rather than anything more to worry about. Too many of the bear market indicators seem to be out of synch for anything more serious to take hold,” he added.
Chris Darbyshire, chief investment officer at Seven Investment Management, agrees with Merricks.
He says the recent volatility has been driven purely by sentiment, not economic data. He adds that while the volatility started in the emerging markets, it is unlikely to have any lasting effect on developed markets and, as a result, he says that a rebound is imminent.
“The recent sell-off is therefore mainly a problem of market perception rather than economic reality. Sharp outflows in emerging market funds suggest panicked investors all rushing for the exit,” Darbyshire said.
“It is conceivable that extreme market movements could cause businessmen and consumers around the world to lose confidence and halt their expenditure plans, hence becoming a self-fulfilling prophecy.”
“However, this is a relatively small probability when compared with the impact of other real-economy forces. This will prove to be a speed-bump rather than a new mountain to climb and we continue to hold our positions skewed towards more risky assets,” he added.
The two commentators are more bullish than Henderson’s Stuart O’Gorman, who told FE Trustnet today that the ructions in emerging markets would continue unless central banks unleash more QE and perpetuate the artificial growth of that policy.
Merricks, however, says the recent sell-off can be categorised as short-term volatility because the signs that herald a bear market have not materialised.
He says that there are four key factors to assess when calculating whether there will be a prolonged downward movement in markets: monetary conditions, valuation, the economic outlook and technical indicators.
With regard to monetary conditions, Merricks says that investors have very little to worry about.
“Monetary conditions, at least in the developed world, remain extremely relaxed,” he said.
“Bear markets can begin when they [investors] anticipate a rise in rates that will be detrimental to corporate profits, but all the signals at the moment point to rates remaining where they are in the US and the UK for the rest of this year at least, and for the possibility of easing in both Europe and Japan.”
On top of that, Merricks says that Mark Carney has already backtracked from his previous promise to hike interest rates if UK unemployment falls below 7 per cent.
“So a bear market will not kick off due to monetary conditions,” Merricks added.
Performance of index over 5yrs
Source: FE Analytics
The next indicator, according to Merricks, is valuations. He says that these are more of a concern given the strong performance of equities over recent years, but they have not reached the territory of being overly expensive.
“One doesn’t need to be an investment guru to understand that the return on an asset will be greater the cheaper you can buy it for in the first place,” he said.
“However, valuations do not appear to be overly stretched at the moment despite stocks generally being more expensive to buy now than they were a couple of years ago.”
“Markets can take a long time to react to being stretched in price (hence the long periods of gain before a significant correction), with the economist Keynes summarising succinctly that 'markets can remain irrational far longer than you or I can remain solvent'.”
“[Research-firm] BCA reassuringly states that 'valuation measures are still far from the extremes that warn of serious risk',” he added.
Merricks points out that the economic outlook doesn’t look particularly tough, either.
He says that investors are witnessing a synchronised global recovery and although there are clearly headwinds coming out of emerging markets such as Turkey and South Africa, these are not enough to push the developed world into a recession.
He says the one component that is more concerning is technical indicators.
“Are technical indicators showing any more worrying trends than the previous three factors? A little,” Merricks said.
“Of most concern is the general optimism that was shown by investors as the year began. At a recent seminar, we said that one of our biggest worries for 2014 was that we didn’t see too much to worry about.”
“Overall though, it doesn’t seem to be the most compelling reason to go uber-defensive just from a contrarian perspective. It was fund manager Hugh Hendry who said that you only needed to be contrarian 20 per cent of the time,” he added.
Given his optimistic outlook, Merricks says investors should be looking to buy into the dip.
He is particularly bullish on Japan as he expects its central bank to continue with its quantitative easing programme to help reflate the economy and weaken the currency. As a result, he says he is “very tempted” to top up his Neptune Japan Opportunities exposure, because it is hedged back into sterling.
For anyone looking for a fund closer to home, Merricks recommends Franklin UK Smaller Companies, which is another one he would be happy to top up.
The £117m fund is a bottom-quartile performer over three, five and 10 years. Richard Bullas and FE Alpha Manager Paul Spencer took on the fund from the long-serving Stuart Sharp in June 2012 and have been restructuring it since then.
The fund is a top-quartile performer in the IMA UK Smaller Companies sector since the managers took over, with returns of 73.52 per cent, compared with 61.32 per cent from its Numis Smaller Companies ex IT benchmark.
Performance of fund vs sector and index since June 2012
Source: FE Analytics
The fund’s largest sector weightings are to industrials and technology, though the managers also hold around 5 per cent in cash. Franklin UK Smaller Companies has an ongoing charges figure (OCF) of 1.13 per cent and requires a minimum investment of £1,000.
