Outlook 2015: Multi-Manager
Investors need to prepare for lower returns in the next few years, with a focus on capital preservation appearing prudent in the current environment
20 November 2014
We end 2014 with almost every asset class offering investors scant potential return for their risk. Five years into a period of unprecedented interest rate suppression, this should come as no surprise. The returns generated from every mainstream asset since 2009 have been striking. Those returns are now in the past. We believe the next few years will be characterised by lower returns, more volatility and greater risk.
We end 2014 with almost every asset class offering investors scant potential return for their risk ... the next few years will be characterised by lower returns, more volatility and greater risk.
We're going to cop out here and leave politics to one side for the purposes of this outlook. The economic backdrop is foggy enough! Suffice to say we will comment throughout the year on this particular risk factor.
To try and summarise consensus expectations for growth in 2015, we would say that investors are very optimistic about the US (yet still don’t believe the Federal Reserve (Fed) will raise rates) and to a lesser extent the UK, are willing to give Japan and much of Asia the benefit of the doubt for now (but are sceptical of China), and hate Europe full-stop.
Starting as we often do at the bottom, for our sins, we think the combination of an expanding European Central Bank balance sheet, a gradual pick-up in credit growth due to record low funding costs for corporates and consumers, and the disposable income boost from lower oil prices has the potential to confound very low expectations for Europe next year.
Momentum in the US looks sustainable at least into 2015, meaning the Fed should follow through and begin raising rates. We’ll defer to our 2016 outlook for a judgment of how the economy absorbs what will likely be baby steps towards a tighter policy backdrop.
If US rate hikes don’t occur next year, the likely scapegoat will be a deflationary impulse emanating from China – the elephant that never leaves the room. The risks to China and other emerging markets will correlate highly with the strength of the US dollar in our view. Dollar bulls need to be careful what they wish for. A strong US currency, all else being equal, is not bullish for emerging market liquidity.
Not banking on bonds
Almost irrespective of one’s economic outlook, the margin of safety in fixed income markets is wafer thin. Aggregate yields globally are as low as they have ever been. Spreads are also closing in on their all-time tights. As a result, correlations within fixed income have picked up worryingly. Traditionally fixed income does not do well in a rising rate environment. If US rates do rise in 2015 as the Fed is telling us they are likely to, every fixed income asset class will take a hit. In spite of this, judging by the scale of continued inflows, the majority of investors appear comfortable with the risk/reward set-up. We’re not, and therefore have only limited exposure. By definition, prospective returns today are pretty much as low as they have ever been, risks are high and liquidity is terrible. Investors need to tread carefully here.
We have a healthy cash balance across our portfolios at present, with some diversification into US dollars. Cash is currently considered an inferior asset as it generates a zero return. We believe it will become more desirable as the market sets about discounting higher US interest rates.
Assuming global aggregate demand can continue to expand in 2015, we would have sympathy with the view that equities offer a greater short-term prospective return than fixed income. Nevertheless, we judge equity valuations from a longer-term perspective, particularly in the US, to be on the expensive side at present. This tells you next to nothing about their potential for 2015, but does indicate their vulnerability to disappointment. Like fixed income, from a positioning standpoint, investors appear very comfortable with the risk/reward trade-off in US equities. Once again, we’re less sanguine. What equity risk we are taking is predominantly outside of the US, favouring Europe and Japan particularly. Both markets have relative value on their side and the potential for a catch-up in profitability. In contrast, US equities trade at historically high multiples of historically high earnings. The emerging market complex also strikes us as vulnerable to disappointment and we have next to no exposure there.
Fertile ground for alternatives
Fortunately, we believe the environment is becoming ever more fertile for short-selling, allowing us to generate uncorrelated returns in what may otherwise prove a difficult backdrop for investors. This opportunity set extends beyond equities, to bonds and foreign exchange markets also. The faith investors have placed in the Fed this cycle has made shorting a largely unprofitable exercise. We expect this to change.
Raging bull market enters new phase
The bull market that began in March 2009 has been one of the most rewarding in history, yet the economic recovery to date has been one of the weakest. With the US economy now on a firmer footing, the Fed should intervene less in asset markets in 2015.
Not for the first time we have been premature in moving to emphasise capital preservation within the portfolios (will we ever learn?!) while this new investment environment unfolds. However, such is the unbalanced set-up within markets in our view, when (not if) investors decide to become temporarily more risk-averse, the likely re-pricing will be swift.
We remain very optimistic about future investment opportunities, just not present ones. For the time being we consider capital preservation the most prudent strategy for the portfolios. This will change as the opportunity set evolves.
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