Markets: What’s in store for the rest of 2015 and beyond?
At our recent forum in Edinburgh, five leading Schroders fund managers and chief economist Keith Wade met to discuss the state of global markets and assess what lies ahead.
28 May 2015
Keith Wade, Chief Economist & Strategist
Keith Wade’s view on the global economy is broadly positive, though there are a number of potential sources of market volatility or economic upset.
Consumers yet to feel the benefit of lower oil prices
A key theme driving the positive expectations for global growth is the lower oil price, the positive effects of which Mr Wade thinks we are yet to see.
“Judging the macro effect of the oil price is really about being able to judge the lags, in terms of how long it takes to feed through to the consumer."
"People have to realise that the oil price is lower - and is going to stay low - until they change their behaviour, and I don’t think they have quite got to that point.”
Although initial investor expectations that the falling oil price would lead to deflationary pressures are justified, fears about a permanent shift to deflation are misplaced.
“We are getting deflation, but this is good. Energy is something that everybody has to consume, and a fall in energy acts like a tax cut, which will help.”
Federal Reserve rate rise could unsettle markets
One development that could be less positive for markets is a Federal Reserve (Fed) interest rate rise, expected for 2015.
While Mr Wade points out that the US unemployment rate has come down significantly, he believes “the important point is that at 5.4%, the unemployment rate is in line with what people call the “NAIRU*”, or the equilibrium point of unemployment.
Once the unemployment rate goes below the NAIRU you start to see wages accelerating and that’s exactly what’s happening.” In his view, the central bank has to take notice of this.
Mr Wade believes that a hawkish tilt to Fed policy would give rise to significant bouts of global market volatility, which investors need to watch out for.
However, while the opening of a tightening cycle has historically led to short-term market setbacks, once investors adjust to the growth story that stimulated the rate hike, markets tend to perform well.
Nick Kirrage, Fund Manager, Co-head Schroder Global Value Team
Nick Kirrage’s view on the UK equity market was also broadly positive; highlighting that although valuations are definitely higher than average, value is still available to discerning investors.
The market has recently returned to levels last seen at the end of the nineties, but Mr Kirrage believes this need not automatically lead to a bearish view.
Don't fear the FTSE at 7,000
“7,000 for the FTSE 100 is not the same valuation as it was 15 years ago. I can understand why investors have become disenchanted with UK equity markets but huge things have changed.”
Most important amongst these changes is profitability. Valuations have changed substantially, due to how well earnings have grown.
The key is to do your homework, as there is always a risk of complacency. While bellwethers such as the iron ore and oil price have collapsed, many of the companies for whom these are huge earnings drivers have not.
“People talk about generational opportunities to buy oil and gas stocks and I’m not sure that’s true. BP and Shell are off 9-10% despite oil being off 50%.”
Ultimately, the price paid remains integral to generating returns. According to Mr Kirrage, “only one thing makes a great company a great investment and that is a great price.”
Rory Bateman, Head of UK & European Equities
With 15% returns year-to-date, Rory Bateman’s message for European equity investors was also positive, but with a hint of caution.
Mind the valuation gap
Many investors remain strongly in favour of European equity exposure for 2015, but Mr Bateman feels we could be getting ahead of ourselves.
Fundamental valuations drove the appeal of European markets over the past three years, but we have now seen the valuation gap relative to other markets close.
“It feels like valuations are relatively full. The difference between the US market and the European market is the profit differential and the earnings per share differential."
"The US is trading at peak earnings per share. In Europe we have had no earnings growth for six years. There has been no profit recovery in Europe.”
Earnings recovery is crucial to supporting European equities
As such, investors have to believe in the recovery story for earnings to participate from here. The good news is that there are a number of tailwinds. Currency weakness in Europe is a significant driver for profitability.
This, combined with the decline in the oil price, monetary easing and credit conditions easing, should impact earnings positively and is beginning to be reflected in the numbers.
For example, Mr Bateman pointed out that “in Q1, US earnings have seen widespread downgrades, but in Europe we have seen earnings upgrades for the first time in four years…with the exception of the troubled commodity related sectors, we are anticipating 15% earnings growth this year.”
Gareth Isaac, Fund Manager, Fixed Income
Gareth Isaac agrees with Keith Wade’s view that the global economy looks increasingly stable, but warns that because of this, some areas of the bond market may represent more risk than investors are aware of.
The looming spectre of bond volatility
Recent bond market volatility, according to Mr Isaac, should settle down in the short term. However, investors are advised not to get too comfortable.
Over the last 20 years or so, bonds yields have generally been falling. Inflation has been in decline, and more recently central bank policy easing has led to bond yields falling to historic lows.
However, Mr Isaac believes that yields have now reached a bottom. With a Fed rate rise around the corner, it may be a good time for investors to re-evaluate their bond holdings.
Investor perception of bonds has long been that credit risk - traditionally associated with fixed income investing - is the only risk that can erode capital.
However, inflation rate and interest rate risk also need to be accounted for. Government bonds, even those hitherto perceived as safe-haven assets like Treasuries and gilts, are not as low risk as many believe.
He said: “Investors are holding these assets without realising how much of their capital can be at risk.”
Mr Isaac does not believe that the recent market setback marks the start of a bear market, nor that a sustained re-rating will begin with the first Fed rate hike.
Cash is simply not an alternative for most investors. However, in 2016, when Mr Isaac expects base rates to have climbed to a more normalised level, bond markets could face material headwinds.
Andrew Rose, Fund Manager, Japanese Equities
Andrew Rose’s outlook for Japanese equities is more encouraging. Arguably, over the past six months, Japanese equity investors have had all they could have wished for.
Abenomics key to Japanese equity strength
In October 2014, the second round of quantitative easing was announced by the Bank of Japan.
This was followed up by a snap election, which was won by Prime Minister Abe; reinforcing the idea that “Abenomics” was here to stay.
Abe then postponed the planned increase in VAT.
Similar to the UK’s FTSE100, the Nikkei has recently reached levels last seen in the year 2000. The question now is how sustainable the current market strength is.
Japan's equity market valuations remain in check
In valuation terms, Mr Rose believes the backdrop is supportive relative to where we were at the start of the 21st century.
Mr Rose pointed out: “Since Mr Abe has come to power, the stockmarket has doubled. However, the price earnings ratio** is still at around 13 or 14, suggesting the corporate sector has turned in a very good performance as well.”
He went on to say that “Price earnings ratios and price to book ratios*** are half of what they were in 2000. Return on equity is around 50% higher, and dividends are around 2% today compared to a miniscule 0.7% back in 2000.”
Japan's economic outlook improving
The economic backdrop in Japan has not been as encouraging as many hoped over the same timeframe. However, the outlook from here is more positive.
The policy backdrop is still supportive and the low oil price will always be constructive for Japan. This is particularly so now.
Four years after the Fukushima disaster, Japan still has no nuclear power. The value of the decline in the oil price amounts to around a 1.5% boost to the economy.
In Mr Rose’s view: “There is a major plus from falling oil prices”.
Matthew Dobbs, Fund Manager, Asian Equities & Head of Global Small Cap
Matthew Dobbs’ view of Asian equities is less bullish. Growth has been challenging to come by in Asian equities for some time.
Profit growth and inflation a concern
Although earnings growth has been on a par with the rest of the world, capital growth has not appeared.
The problem, in Mr Dobbs’ view, is that the return on invested capital has come down. Profitability is weak, and a catalyst for an improvement does not look immediately forthcoming.
Mr Dobbs believes that “valuations are fine. They have been for a long time.” However, he believes the environment is challenging for those looking to find growth stocks.
Weakness in inflation, globally, is an issue, as deflationary forces are very strong in Asia.
“The energy, materials, banks and property sectors look cheap, but are they cheap in this sort of environment? I would beg to differ.”
More troubling is that the recent rally in Chinese stocks does not look fully justified.
Given the country’s influence on the rest of Asia, Mr Dobbs advises caution for the medium term; believing that valuations are high and there is a worrying level of margin financing#.
Take a look beyond China
There are areas of promise beyond China. India could offer the “best components of a real bull market in Asia” according to Mr Dobbs.
Furthermore, although many investors are concerned with Asia’s ability to deal with impending rate rises, the impact on Asian stock markets has historically been in line with other major indices, as detailed by Keith Wade earlier.
Mr Dobbs expects a short-term setback before investors start to focus on why interest rates rose in the first place; stronger growth.
However, until the uncertainty surrounding China’s future is resolved, the message is to tread carefully.
“China is not broken, but policy settings at the moment are not right for sustainable returns for investors.”
* Non-accelerating inflation rate of unemployment. In other words, the level of unemployment at which inflation does not increase.
** Price-to-earnings ratio is a ratio used to value a company’s shares. It is calculated by dividing the current market price by the earnings per share.
*** Price-to-book value is the ratio used to compare a company’s share price with its book value (the book value is the actual value of the company assets minus its liabilities).
# Margin financing is using borrowed money to buy securities. The investor borrows money from a broker, with the loan being secured against the assets purchased. The investor also has to put down a deposit, or margin. If losses go above this amount, the investor has to deliver more cash (or other assets) to the broker as security or the position is closed.
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