Politics and populism dominated headlines in 2016. For markets, a collective shift in perception from secular stagnation to global reflation was the main event. Monetary accommodation, as authorities’ policy tool of choice, was replaced with expectations of fiscal stimulus. Next year, politicians will be challenged to make this hope a reality and markets tested whether they are ready to kick their addiction to monetary largesse.
Market participants have flirted with hopes of economic recovery since the financial crisis only to be confronted by decelerating global growth. Quantitative easing has kept asset prices buoyant but economic activity has often failed to keep pace with indices, contributing to bouts of intense volatility and growing disillusionment about the efficacy of monetary policy.
While 2016 began with a collapse in confidence about global growth, 2017 should see improving expectations for demand. Already global trade is dragging itself out of the summer slump, with exports in all major regions strengthening. But hidden in the improving economic data is an implicit threat: for markets that have thrived on monetary stimulus, the risk of higher bond yields and rising inflation weakens equity valuations. A stronger US dollar would also summon the spectre of tightening liquidity and undermine commodity prices. Elevated debt levels will test the resolve of the Federal Reserve to normalise official interest rates – especially if politicians fail to provide fiscal stimulus.
The message for markets in 2017 is simple: be careful of what you wish for. Hopes for a new policy order may prove too optimistic, and will present challenges even if they are fulfilled.
Andrew Parry, Head of Equities
Looking ahead, one of our main concerns is the impact of pricing pressure on the healthcare sector. Pharmacy benefit managers are squeezing the margins of drug manufacturers, while a price war has erupted among distributors, undermining profitability as the industry adjusts to a new environment. Companies with limited ability to innovate will struggle and there will be an increased pressure on companies relying on patents and price hikes to grow earnings.
Elsewhere, the rhetoric from the European Central Bank has lately become more hawkish, and with the Federal Reserve seemingly intent on raising official interest rates, bond yields have started to increase in Europe and the US. This poses a big risk to sectors such as utilities and consumer staples, which have been sought for their bond-like income streams. Rising yields have hit major oil companies, which could be further challenged by a low and range-bound oil price as US shale producers can only start turning on the pumps when the oil price approaches $55 and OPEC has yet to confirm the scale of its agreed cut in production.
Political risk is also at the forefront of many investors’ minds. We believe the risks are exaggerated. This is not to downplay its importance: rather, it is to acknowledge that companies will continue to operate regardless of election or referendum results, and the best will adapt successfully to changes in the business environment. As such, we remain steadfastly committed to identifying attractively priced companies that are well-run and have demonstrated their ability to grow sustainably, while minimising our exposure to macroeconomic risks.
Geir Lode, Head of Global Equities
At the beginning of the year we thought the performance of emerging markets would strengthen, and indeed that has been the case. Profitability hasn’t caught up with stock prices yet, but a range of other indicators are positive: the GDP growth differential between emerging and developed markets is widening, and in the emerging world capex and labour costs are declining, estimate revisions have stopped falling, free cash flow yields are attractive, commodity markets have recovered their composure and investor positioning remains light. At the country level, Russia and Brazil should exit recession in the coming year, most Latin American nations are governed by market-friendly administrations, Chinese growth has confounded the bears (albeit at the price of ever more indebtedness), and India’s economy should begin to heal as banks repair their balance sheets and the agricultural sector recovers its poise after several years of drought.
Therefore in 2017 emerging market companies should become more profitable, though emerging market countries will become more differentiated. Carry trade economies (Brazil, Turkey, Indonesia and South Africa) will continue to experience competition from higher US bond yields. For exporters (Mexico, China, Korea, Taiwan), we expect renegotiation rather than rejection of existing trade agreements as the “Master of the Deal” shows the world how it’s done. Great companies with great business models, wherever they are, should find the economic environment supportive in 2017. Those countries avidly pursuing economic reforms will emerge much stronger from the current uncertainty. Valuations are once more very supportive of emerging markets, so we are constructive for the coming year.
Gary Greenberg, Head of Emerging Markets
Asia ex Japan
In our outlook for 2016, we expected a re-rating of Asian cyclical stocks relative to defensives. So far this year, we have turned out to be both right and wrong: the standout performers in the universe were largely limited to the so-called deep defensives, such as consumer staples stocks, but also the deep cyclicals like energy and materials companies. What did not perform as well were what we term quality cyclicals, which we define as companies with cyclical earnings that remain profitable even in down cycles, companies that typically experience shallow down cycles, have low debt and generate a good average return on equity through the cycle. Such stocks tend to be found in the industrial and consumer discretionary sectors – which have underperformed year to date. Given that many stocks in these laggard cyclical sectors are still attractively valued, we believe that quality cyclical companies offer the best value in our market despite their mixed earnings outlooks.
Jonathan Pines, Lead Portfolio Manager Asia Ex Japan
Asia ex Japan
The majority of the companies we invest client assets in today have endured eight years of economic and political turbulence. Many of the concerns that investors have today are similar to those we faced in 2012 and 2008. As we said at those junctures, we prefer to listen to companies’ messages of cautious optimism, of opportunity rather than risk. Investors remain fixated with policy decisions though creating volatility as large swathes of the market correlate with moves in yield curves and currencies.
Our approach seeks to cut through the noise by focusing on the delivery of earnings and cash flows which will ultimately drive individual share prices. This requires patience though and while Europe may not resolve its problems in the near future, the message we hear from companies leaves us far more optimistic as investors. Most are comfortable with their outlook for European demand, which remains unchanged. If there was a concern it lay with the US business cycle.
The continued focus on election and referendum polls, and what could cause the next “Lehman moment” has resulted in persistent outflows from Europe, which also creates anomalies at the stock level leading to exciting investment opportunities. So, no matter how Europe looks in the years ahead, we feel confident that many companies will continue to exercise control over their own destinies and thrive. Investors who recognise this will be rewarded, highlighting the importance of having a flexible, logical and forward looking mind-set, coupled with an active approach to managing clients’ assets.
James Rutherford, Chief Investment Office, European Equities
Small & Mid Cap
The prospect of rising interest and inflation rates is currently prominent in the minds of investors and will persist into 2017. The market impact is clear, with two examples being the units outstanding in the biggest US low-volatility exchange-traded fund, which reached their maximum level in July, and the S&P500 Real Estate sector, which has underperformed sharply since peaking at the same time.
The animal spirits of the market seem to have finally tired of bond proxy stocks, which has extended well beyond the utilities and telecommunications sectors, and this is a very welcome development for us. It will result in attractive entry points into companies with solid long-term growth stories that we seek. History has shown that relatively defensive stocks that benefit from strong barriers to entry and secular growth characteristics can keep up with rising markets, yet outperform in adverse environments, thereby producing good risk-adjusted returns throughout the cycle.
The early stage of a rates cycle is typically good for small caps, as it implies improving economic conditions. Indeed, in Europe at least, they demonstrate their strongest absolute returns when the yield curve on long-dated government debt is sloping upwards – and is steeper than it currently is. We advise investors to keep a close eye on long-term rates in 2017 – a steepening curve should be the sign of a healthy economy but could cause problems for leveraged investors.
Small cap stocks have outperformed large caps in all regions this year. It is reasonable to expect this to continue given the current low-growth environment. There is tail risk to the downside if contagion spreads from even a small number of participants getting caught out by the unforeseen effects of a rate rise, and previous central bank intervention for that matter. However, with a low-beta portfolio we should preserve capital to prosper another day.
Hamish Galpin, Head of Small & Mid Cap
Small & Mid Cap