Sunday, 1 May 2016
Market volatility spiked early in 2016 and has since fallen due to no one factor. In our opinion, the rise in market risk is neither unusual nor sinister. In 2014 and 2015 complacency had washed through investment markets, some investors had seen one-way bets, and “crowded trades” had become common. Volatility is a healthy reminder that diversification and rebalancing are the best tools in an investment adviser’s tool box.
Overstated global recession fears, falling commodity prices and normalising (rising) credit spreads provided an early backdrop for bond and equity markets.
The week after Chinese New Year seemed to bring a turning point. More robust economic data and better than expected earnings results turned equity prices higher. Comments on probable central bank action and a return of fundamental buying also contributed to the rise. The fact is that a background level of uncertainty is always present.
As you consider the balance of risks, markets will no doubt still see headlines associated with speculation of a further gradual tightening of US monetary policy. From our perspective, current data supports up to three further rate rises in the US this year. To some extent a rise in US rates is not priced into markets.
Although the US Presidential election is a risk for markets, it may be overstated. The constraint of the Senate and Congress ought to temper policies that might stem from the rhetoric by candidates.
On more of a knife edge is the UK vote in June on exiting Europe, bearing in mind that London is still the second largest financial centre in the world.
Non-investment grade credit defaults seem exaggerated as a risk for markets. Although high yield implies default rates are above 10%, this risk seems largely priced into credit markets. However, it may be harder to form a judgement about more speculative energy related junk bonds.
In equity markets, high quality, high dividend yield defensive stocks remain expensive. In contrast financials and resource sector names are relatively cheap. We remain uncertain about resource valuations and prospects. It is hard to anchor earnings and dividends in many resource companies. Recently we have seen a strong rally in banks, and from here we would be more neutral in financial stocks in an absolute sense. Overall, however, we favour stocks in the technology and healthcare sectors, placing utilities as our most under weighted sector.
Our strong opinion is that at this stage of the cycle the best way to create value is to avoid pure beta in equity markets (the markets have already recovered sharply) and instead focus on idiosyncratic risk. This means it is time to identify active managers, rather than just be invested in market indices.
We think high active share portfolios with stock specific and company driven opportunities provide the best risk and return. We are finding the best opportunities in sectors with tail winds, like travel and tourism, healthy living and nutrition. The caveat is that from time to time the market gets carried away with projecting structural growth to infinity and valuations in these stocks can get too rich.
Near-term macroeconomic trends are most likely going to be benign. In New Zealand the down draft from the dairy sector is significant. Not only are farm cash flows tight, but banks have exposures that would be at risk should farm prices fall. The Reserve Bank has quantified these risks and doesn’t see a systemic issue. Nevertheless, low inflation expectations and other influences have prompted the RBNZ to cut rates and signal further cuts. A lower NZ dollar helps exporters. It will take some time to turn inflation expectations.
But a lower interest rate level may also prompt more corporate activity. Already, and for different reasons, we have seen two takeovers (Diligent and Nuplex). Latest earnings and dividend trends were encouraging, at least they didn’t negatively surprise. We favour export and growth oriented companies over those in industries facing structural headwinds - namely electricity generation, and old world media and retail.
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