UK Equity Insight: China, commodities and monetary policy
In the first article of a new series, David Docherty and Rory Bateman consider some of the key issues facing UK equities in 2016 including China, commodity prices, monetary policy, political concerns and M&A activity.
22 January 2016
Plenty of food for thought
For those investors who had hoped to ease themselves gently into the new year, global markets had other ideas.
In fact, by the end of the first week the FTSE 100 had fallen 5.3%, the biggest fall in the first week of a year since 2000.
By the end of the second week, the blue chip index was down further, notching up a decline of 7% for 2016 to date.
For UK fund managers the to-do list of things to think about is headed by China, commodities, Federal Reserve (Fed) policy, the UK economy, domestic politics and geopolitics.
In short, the sustainability of global economic growth is being questioned at just the time that the Fed’s monetary largesse is being withdrawn.
This is critical for UK equity investors because, outside the commodity sectors and some financials, UK corporate profitability looks high and many stock valuations rather full.
We therefore believe these headline issues - alongside ever-presents such as disruptive technologies and merger & acquisitions (M&A) - will frame the investment debate and inform portfolio strategy for the year ahead.
Despite the current pessimistic mood, we see interesting stock selection opportunities and think the overall market can move higher from current levels.
More of the same
We may have turned the calendar on a new year but the preoccupations of 2015, particularly China and commodities, have not gone away.
Indeed, a quick look back at the performance of UK equities in 2015 shows that investor angst on China and commodities is already well established.
Industrial metals and mining were down 53% and 48% respectively last year and were joined at the bottom of the league table by oil & gas producers (-21%) and oil equipment (-20%). Bedfellows such as industrial engineering (-17%), automobiles (-10%) and industrial transportation (-5%) were also sold off.
Given the sheer magnitude of the heavyweight resources sectors, mathematics ensured that most other sectors outpaced the market.
Of the 38 FTSE All-Share sectors, 25 outperformed, the best tending to be those offering stable or growing earnings and reliable dividends at a time when these virtues seemed to be becoming scarcer elsewhere.
These included software (+35%), household goods & home construction (+28%), fixed line telecom (+17%) and tobacco (+13%).
This contrast between the perceived victims of slowing growth and looming deflation and the relative winners of these trends was reflected in a number of other divergences. Examples of this included:
- The outperformance of defensiveness over cyclicality.
- Developed markets over emerging markets.
- Gilt proxies over inflation proxies.
- Consumer cyclicals over commodity cyclicals.
- Growth over value.
- The FTSE Mid 250 over the FTSE 100.
On the last point, the FTSE Mid 250 returned 11% leaving the resource-heavy FTSE 100 trailing in its wake with a return of -1%.
Figure 1: UK Mid Cap versus Large Cap – 36 month rolling performance
Source: Bloomberg, December 2015.
The fact that these and other bifurcations are themselves highly correlated means that the ramifications of any snap back in performance and positioning would be profound for the market.
We will discuss this later but first it may be as well to sift through the inbox currently facing UK equity investors.
As fund managers arrived back at their desks, they were confronted by a sea of red and several trading halts in Chinese markets.
The Shanghai Composite Index set the tone by closing down 7% on day one. A declaration from the country’s foreign exchange regulator that the financial system was ‘largely stable and healthy’ unsurprisingly failed to impress.
The issues facing China are genuinely front page news and markets are only too well aware of the growth slowdown, debt burden and overcapacity afflicting the economy.
Figure 2: Chinese GDP
Source: Haver Analytics, China National Bureau of Statistics. Data to September 2015, % change year on year in billion yuan, nsa.
Nonetheless, the debate continues to rage as to whether there will be a soft or hard landing and markets continue to fret about the extent of contagion to other economies.
This will be another tough year for companies exposed to China, such as the miners.
We also remain wary of capital goods companies with fat profit margins and full ratings where softer pricing and slowing volumes in export markets can have a significant effect on profits.
Fears of a slowing China have contributed to a further slump in commodity prices.
Concerns about a global deflationary slowdown were particularly intensified by August 2015’s renminbi devaluation, prompting renewed weakness in oil and metals prices.
Figure 3: Brent crude oil price
Source: IEA, short-term economic outlook, DataStream, Bloomberg, Cazenove Capital Management, as at January 2016.
Brent oil and iron ore now trade at $29 per barrel and $41 per tonne respectively compared with $104 and $90 just 18 months ago.
The oil sector has continued to suffer with analysts expecting demand downgrades at a time when the Saudis and non-OPEC alike are pumping flat out and Iran is preparing to return to market.
Our sense is that a major reduction in industry supply through drastic capital expenditure cuts (Wood Mackenzie estimate companies have scrapped $400 billion of new projects so far) should lead to an eventual recovery in the price of the black stuff.
We therefore see opportunities in the better financed oil companies which should be able to weather the storm.
These look as cheap as they have for many years and the stronger companies may be able to benefit from industry consolidation, either as opportunistic bidders or targets.
We are more cautious on the oil service companies in the face of cancelled orders and enforced price cuts from much larger customers.
More broadly, engineers and other service suppliers to the oil companies also look vulnerable and we are watching closely for any second-order implications of the oil industry’s pain.
Indeed, capital flight has already started as oil producing nations repatriate capital to struggling sovereign wealth funds so there will be implications for other asset markets such as real estate.
The highly indebted mining companies look existentially challenged in the absence of any material reductions in industry capacity.
In this sense our preference is for the lowest-cost producers with the better balance sheets. They should benefit from the withdrawal of production were any competitors to fail.
Monetary policy in the US has also kept markets on their toes in the new year.
There is intense debate as to how dovish or hawkish the Fed is likely to be while the US economic data which will inform policy is itself erratic and unclear.
Many analysts were disconcerted, for example, by the revelation from the December Fed minutes that for some members their decision to raise was “a close call, particularly given the uncertainty about inflation dynamics”.
A subsequently stronger-than-expected payroll report served only to add to market confusion.
On balance, we welcome the beginning of policy normalisation since emergency rates look inappropriate given ongoing falls in unemployment.
Figure 4: US unemployment rate versus job openings
Source: DataStream, Bloomberg, Cazenove Capital Management, January 2016.
We would expect bouts of volatility in markets, however, as investors attempt to gauge the pace and trajectory of further tightening.
China and the emerging markets will clearly be impacted by the Fed’s actions as capital seeks out rising US rates by buying a relentlessly strengthening greenback.
Their policy options are therefore complex and their vulnerability to foreign exchange challenges high.
As for the US economy itself, America’s economic performance is patchy, in no small part owing to the capital investment effects of the falling oil price, and tightening could take its toll with obvious implications for corporate earnings.
The latest US retail sales figures even managed to disappoint despite the supposed benefit of lower gasoline prices.
For our portfolios we are carefully monitoring the US economy and companies with exposure to it.
We would tend to favour companies with greater exposure to Europe where we believe the economic recovery has further to run and where there is increasing scope for much needed microeconomic structural reforms.
Figure 5: Healthy eurozone credit demand and retail sales
Source: DataStream, as at 31 December 2015.
Closer to home, the Chancellor of the Exchequer, George Osborne, had no sooner taken his Christmas tree down than he had warned of a “dangerous cocktail” of risks including emerging market instability and falling oil prices.
He also urged the country to be ready for rising interest rates just at the time that retailers like Marks & Spencer, Next and Sports Direct were announcing disappointing trading results.
In this respect, it is therefore worth remembering that many of the best sectors in the market last year were those with the greatest interest-rate sensitivity.
- Housebuilders were a highlight with the average FTSE 350 sector constituent up 38%.
- Real estate investment services (+16%)
- Media (+13%), travel & leisure (+12%)
- Real estate investment trusts (+5%)
- General retailers (+2%) also fared well against the market.
In fact our numbers show that consumer cyclicals were the best part of the market, outperforming by 18% in 2015. This compares to 26% underperformance for the unloved commodity cyclicals.
As an inflection point in domestic UK rates gets closer, we believe that consumer cyclicals will become increasingly vulnerable to a derating as peak earnings approach and as consumer indebtedness remains stubbornly elevated.
Figure 6: UK consumer saving and borrowing
Source: ONS, DataStream, December 2015.
As further fiscal austerity kicks in, we do not see the domestic economy making much further headway and we are conscious too of companies’ warnings of margin pressures from the impending living wage.
Our current thinking is to avoid housebuilders and to be highly selective on retailers and leisure, preferring instead attractively valued stocks with steadier consumer demand patterns such as domestically focused food and beverage stocks.
More broadly on the UK, we are uncomfortable about the current account deficit while the prevailing manufacturing recession counsels further caution on the capital goods sectors.
Like his next door neighbour in Downing Street, David Cameron was also straight back to work, announcing that he would suspend collective cabinet responsibility to allow Eurosceptic ministers to campaign for a Brexit in the run-up to the referendum.
We would expect the EU referendum to be an influence on financial markets and indeed some commentators are attributing a stuttering start for sterling corporate bond issuance this year to Brexit uncertainty.
Figure 7: Brexit polls - % voting intentions
Source: Morgan Stanley, December 2015.
As the Brexit debate heats up, our task as investors will be to have a stab at the probabilities of various outcomes for individual stocks and to take a view of what is priced in. This will be essential and we are working hard on this particular topic now.
In a far broader sense, politics will influence markets because the painful hangover from the Global Financial Crisis has left governments around the world short of cash and keen to raise taxes and impose regulations.
It is clearly notoriously difficult to predict individual government interventions but this has to be part of our thinking in any individual stock analysis.
A related dissatisfaction with governing elites across the world has led to the development of insurgent parties or the success of “mavericks” such as Jeremy Corbyn and Donald Trump in established parties.
Once again uncertainties abound but to the extent that political developments can be market moving, we must expect volatility. For example the seemingly endless race for the White House will require investors to understand the market implications of front runners’ policy platforms.
“May you live in interesting times”
As if all this were not enough, geopolitical tensions have also been thrust onto centre stage.
Riyadh’s execution of a prominent Shia cleric led to a new low in Saudi-Iranian relations while the North Koreans demonstrated their capacity to shock with their decision to conduct a hydrogen bomb test.
Syria remains a powder keg while the resulting migrant crisis has massive implications for eurozone domestic politicians.
Angela Merkel has discovered this to her cost with intensifying opposition to her “open-door” refugee policy.
European voters’ views on the EU, including the British people’s view on Brexit, will be influenced by such matters, ensuring that the link between domestic, international politics and markets will be close.
There have also been further terrorist outrages in 2016 with attacks in Turkey, Indonesia and Burkina Faso so the spectre of further ISIL incidents looms large.
From a purely investment perspective, geopolitical events are difficult to discount into share prices. Tensions in the Middle East, for example, can be read both ways for the oil price.
On the one hand some commentators believe that Saudi-Iranian tensions might cause the kingdom to pump more oil so as to protect market share against Iran.
On the other, if tensions were to boil over into any form of military action beyond current proxy wars, oil markets would strengthen in anticipation of supply disruptions.
In both of these environments, defence stocks, of which there are many in the UK, tend to benefit on anticipated spending increases but stock specific research on programme exposure remains critical.
The investment implications of the tragedy of terrorist incidents in terms of customer behaviours and company responses are even harder to quantify.
Windows of opportunity
At this point it is perhaps appropriate, given the current focus on events in China, to remember John F. Kennedy’s observation (hotly debated by linguists, incidentally) that the word “crisis” in Chinese is composed of two characters, one representing danger, the other opportunity.
As far as our UK equity portfolios are concerned, we certainly believe there are sufficient opportunities to add value to our funds despite, or indeed because of, current market volatility.
On a stylistic basis, as discussed earlier, we are acutely aware of the sustained underperformance of value over growth.
We are therefore looking for opportunities in the former while acknowledging the danger in investing in so-called value traps which lack the inflection points to deliver performance.
This quest is more easily said than done because traditional value areas like the defensive utilities have performed well in their capacity as gilt proxies and now look dear while forays into commodities remain hazardous.
Nonetheless, we have found exposure to a combination of resilient earnings and attractive ratings in a number of companies in consumer staples and healthcare.
Figure 8: Value versus growth
Source: MSCI, Morgan Stanley Research, December 2015.
The white heat of technology
Despite the divergence between value and growth there is a distinct danger of shunning highly rated stocks with the capacity to positively surprise and re-rate yet further in an era of low growth.
In this respect, insurgent, disruptive technologies such as the so-called FANGs (Facebook, Amazon, Netflix and Google) as well as Airbnb and Uber need to be understood since they are challenging and disintermediating established incumbents.
These developments pose a major challenge for equity investors since it is not just a question, important as at is, of working out which companies are the winners of technological change and which are the losers.
It is also crucial and much more difficult to calculate what the winners and losers are worth because markets too often overpay for the shares of the former and underpay for those of the latter. In other words, we need to be pragmatic on technology.
In the software and media sectors, for example, there are a number of relatively straightforward businesses with limited technological risks which we believe can benefit from the inexorable desire for businesses to increase their efficiency and improve their customer relationships.
Sainsbury’s approach for Home Retail looks very much like a technology-driven initiative since it covets Argos’s logistics expertise as a means of fending off the threat of Amazon. It is also part of the ongoing theme of corporate activity which made 2015 a record year for M&A.
Figure 9: Global M&A activity over last 10 years
Source: Schroders, Bloomberg, January 2016.
We expect there to be further such activity this year as companies seek to grow volumes or advance profits through cost cutting in a period where organic growth might be tough to achieve.
In our research on individual companies, an understanding of industry structure is therefore critical, as is a feel for the optionality possessed by companies with the balance sheets and strength of management to add value through judicious corporate activity.
Fears about China, commodities, Fed policy, the UK economy, politics and geopolitics have materially impacted UK equities and the start of 2016 has been inauspicious to say the least.
Figure 10: FTSE All-Share since end-2014
Source: DataStream, 31 December 2014 to 19 January 2016. Daily price of the FTSE All-Share, rebased to 100 as at 31 December 2014.
The mood of the market is one of increasing pessimism as investors fear the effect on profits and valuations of the pincer movement of slowing growth and an eventual withdrawal of monetary accommodation.
Nonetheless, as we have outlined above, we see a number of interesting stock selection and positioning opportunities in UK equities.
For the asset class as a whole, the FTSE All-Share has now fallen more than 16% since the high water mark reached in April last year and sentiment indicators look very depressed.
On a prospective price to earnings ratio of 13 times and dividend yield of 4.2%, we therefore believe there is decent scope for the market to move higher from current levels.
NB. Please note that year-to-date performance and valuation figures quoted are as at 15 January 2016.
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