Though UK and US equities are still at or very close to all-time highs and implied volatility is extremely low, the euphoric optimism that categorised last year’s rally has made way for increasing scepticism among investors.
Experts have warned that the current market “lacks direction” while others have already significantly “de-risked” their portfolios, many of them building up large cash weightings in order to try and protect their clients against a market correction.
Here, we look back at the major changes investors have had to deal with in 2014, and what they mean for the future.
Mid and small caps can’t always go up
The FTSE 250 and Small Cap indices were two of the major beneficiaries of last year’s rally, both of returning more than 30 per cent.
The consensus seemed to be that this would continue in 2014 as the performance of mid and small-caps is largely tied to the UK economy which, by most accounts, is growing at a decent rate.
Also, while valuations on an index level had increased, the sector’s bulls pointed to the range of opportunities within the indices.
Last year’s rally helped active UK managers as many of them loaded up on mid and small-caps so that they could add value.
However, investors started de-risking their portfolios following a period of strong equity market performance and growing macroeconomic risks, causing them to rotate out of high multiple growth stocks, such as mid and small-caps.
This has contributed to the better relative performance of FTSE 100 mega-caps this year.
Performance of indices in 2014
Source: FE Analytics
This has not only hurt the indices, but also the large majority of active managers.
Our data shows that the average IMA UK All Companies fund has failed to beat the FTSE All Share in 2014.
FE Alpha Manager Mark Martin, manager of the five crown-rated Neptune UK Mid Cap fund, says that talk of interest rate rises has meant that FTSE 250 has been unable to bounce back, as the index is littered with rate sensitive stocks.
Bonds can still hedge against risk
A number of experts said that 2013 signalled the end of a multi-decade in bonds. Yields on government bonds had already spiked from very low levels and with the global economy set to strengthen, interest rates expected to rise and the belief that inflation would inevitably increase over time, many questioned whether there was any point in holding traditional fixed income assets.
However, those that have had exposure to gilts and other defensive bonds this year have been well-rewarded.
Not only have they acted as a hedge against equity market volatility, but they’ve also posted healthy returns along the way.
Performance of indices in 2014
Source: FE Analytics
“Everyone at the start of the year was saying it was curtains for bonds, but the problem is that when everyone agrees on something, the laws of investment tend to mean the opposite happens,” Premier’s Simon Evan-Cook said.
Evan-Cook is by no means bullish on bonds, but he says negative sentiment towards the asset class was overdone last year.
Gilt yields jumped above 3 per cent at the start of the year but have stayed around 2.6 per cent since January.
“I think bonds yields still reflect the uncertainty that deflation isn’t off the cards and that there are still headwinds, which mean a flying economic recovery still isn’t certain,” he said.
The fund of funds manager says that while gilt yields will probably rise from here, they are unlikely to spike to 4 or 5 per cent.
He says that there will still be demand for the asset class because most of the country’s money is with people who are reaching retirement and therefore don’t want to take on too much risk within their portfolios.
There’s hope for gold and gold equities
Gold bullion was one of the most hated asset class last year, with the price of the precious metal falling close to 30 per cent over the 12 month period.
Gold equities had an even worse time of it, with every funds focusing on that area losing more than 40 per cent in 2014.
However, like government bonds, gold bullion bounced back in January and is up 4 per cent year to date. Its price, at the time of writing, is $1,290.
Performance of gold in 2014
Source: FE Analytics
As Hawksmoor’s Jim Wood-Smith told FE Trustnet, the spike doesn’t seem to make much sense as inflation has been stubbornly low and there is even the threat of deflation in certain developed economies.
He attributes gold’s performance to increased demand from China and India.
“Very little attention has been paid to the latest reports from the World Gold Council and so very few commentators have noticed that its report of 20 May highlighted that jewellery demand in the first quarter of the year represented the strongest start to the year since 2005,” Wood-Smith said.
With this demand expected to increase, Wood-Smith says the rally in gold could well continue despite the strong dollar and lack of inflation.
Gold mining companies have been helped by changes in management, who have strived to be more shareholder friendly.
Gold funds are among the best performers in the IMA universe this year, with the likes of Smith & Williamson Global Gold & Resources and BlackRock Gold & General up 27.41 and 22.97 per cent, respectively.
The strong performance of the asset class could continue if chief executives continue to drop capex and prioritise balance sheet strength and dividends, says FE analyst Charles Younes.
Emerging markets may have bottomed
Emerging market equities have also come back strongly this year. Concerns about the slowing growth saw developing world equities serially underperform against the likes of the UK and US in 2012 and 2013.
The Fed’s plans to taper its QE programme created further headaches for emerging markets, especially surrounding currency weakness and current account deficits.
Though the MSCI Emerging Markets index lost 4 per cent last year and fell considerably again in January, it has returned 9 per cent year to date, beating the MSCI World index in the process.
Performance of indices in 2014
Source: FE Analytics
Evan-Cook says the reason why emerging markets have performed well is because they were very lowly valued and the current market lacks direction.
“Valuations had just become too stretched. It seems that there is a lot of tourist money jumping around from one asset class to another,” he said.
“I think there was very little hot money left in emerging markets and therefore investors have started to have a closer look. If we see emerging markets continue to do well, it will mean a lot of momentum investors will start getting very interested.”
“It has already started to happen as people are talking about the positives in emerging markets like low debt and long term growth. Those things haven’t changed over the last five years, but because valuations are lower, people are focusing more on the positives rather than the negatives.”
The Japanese bulls have yet to be proved correct
Japan was one of the real surprise packages of last year. The Nikkei jumped following the implementation of Prime Minister Abe’s reforms, with pro-inflationary rhetoric and huge amounts of money printing seeing confidence return to the highly volatile market.
Though the average fund in the IMA Japan sector returned more than 25 per cent this year, it has underperformed against all other regional IMA sectors this year with losses of more than 6 per cent.
Performance of sectors in 2014
Source: FE Analytics
Richard Scott, manager of the PFS Hawksmoor Distribution and Vanbrugh funds, told FE Trustnet earlier this week that the exit of foreign capital and the reluctance of domestic investors to sell their bonds for equities were the major reasons for that underperformance.
The belief that the third arrow of Abenomics – structural reform – will take time to implement and the lack of real inflation will have also contributed.
However, Scott and a number of his peers have been upping their exposure to Japan on valuation grounds recently, so maybe the second half of 2014 will be a different story.
One of the longest proponents of Japan, FE Alpha Manager Steve Russell, predicted a softer period for Japan back in March this year.
However, he said such a fall would present investors with a buying opportunity, insisting that there is 50 per cent upside in the Nikkei 225 over the next three years.
