Investing in an age of technological disruption
Is your portfolio Amazon-proof? Twenty years on from the stock market flotation of the online-bookseller-turned-disrupter-in-chief, this is a question that many investors will be asking in 2018. Amazon is not the only corporate revolutionary, of course, but it is the poster child of the seismic changes that have every chief executive looking nervously over their shoulder.
Technological disruption is moving well beyond retail. It is up-ending sectors such as energy and automotive manufacturing, too, as technology companies grab an ever-bigger part of the value chain. For the laggards in this process, the risk is that disruption is terminal. Some companies will simply never bounce back.
This matters to investors because it changes the rules. Simply waiting for the right point in the cycle to pick up underperforming companies on the cheap - classic contrarian value investing - just doesn’t work anymore. Successful investors now need to ask serious questions of the companies they invest in - like do they have a future at all? There are more value traps around today - companies that look cheap but will probably get cheaper still.
Then there is the challenge of valuing the winners. For a handful of the top companies, there really may be no price that is too high. For some, it really is ‘different this time’. The promise of the dot.com bubble is finally being delivered nearly two decades on. But watch out; different this time was the thinking behind the Nifty 50 stocks in the 1970s and it was an approach that ended badly then. Valuation clearly matters still and companies that let their investors down will pay a heavy price - investors are shooting first and asking questions later if the share price falls after profits warnings in the past year are any guide.
So, investing is more exciting than ever but also riskier. The potential gains from this technological revolution are enormous. The need to protect your portfolio against failure has never been greater.
Amazon: the rewards of disruption
Source: Thomson Reuters Datastream, as at 31.12.17, total returns in local currency
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may also affect the value an investment.
Central banks: getting back to normal
The biggest driver of stock and bond markets since the credit crunch has been central bank policy. The emergency measures implemented in the aftermath of the crisis succeeded in their principal objective - preventing a repeat of the Great Depression. Since then, however, the main achievement of rock-bottom interest rates and quantitative easing has been to boost the value of financial assets. For those of us lucky enough to have kept our jobs and owned bonds, shares and property, it has been a case of ‘Crisis, What Crisis?’
The era of abundant liquidity and cheap borrowing is slowly but surely coming to an end. Janet Yellen has been a safe pair of hands at the Federal Reserve and has preferred to fly with the doves, along with her counterparts in the UK, Europe and Japan. However, despite failing to restore inflation to the Fed’s target (the unfinished business of her four-year term), Ms Yellen has clearly set the US central bank on a path to monetary normalisation.
She delivered the promised three quarter-point rate hikes in 2017 and it is likely that her successor, Jay Powell, will deliver another three this year and two in 2019.
This will see America diverging from the rest of the developed world. Mark Carney has undone last year’s panicky post-Brexit cut but is under no pressure to deliver any more tightening at the Bank of England. The outlook is too uncertain in the UK to take the risk and inflation will fall back as the currency settles into its current band. In Frankfurt, Mario Draghi at the ECB is even more cautious and will not raise rates until this year’s tapering of QE is done. Policy remains super easy in Japan.
So, interest rates will be less helpful in 2018 than they have been, but only marginally so. The new normal in America will see rates of only about 3% and for the rest of the world even that hurdle remains a long way off. Seeking an income will remain a priority for investors.
Interest rates: starting to diverge
Source: Thomson Reuters Datastream, as at 31.12.17
Past performance is not a reliable indicator of future returns.
Tales of the unexpected: putting politics into perspective
It feels like politics should matter more than it does. The past couple of years has seen profound changes in the political landscape on either side of the Atlantic and an escalation of geo-political risks further afield. But the impact of all the dramatic headlines - from Trump to Brexit, North Korea to the Middle East - has been short-lived and largely inconsequential.
Politics does affect market sentiment, however, and so it cannot be ignored. Take the European stock markets, for example. At the beginning of last year, many were worried about a swing towards populism and protectionism. When mainstream candidates gained the upper hand across the region, investors were able to focus on improving fundamentals. Nothing really changed other than investors’ perceptions.
Something similar has happened in the UK, where anxiety about Brexit has had an impact on both the real economy and market sentiment. As with Europe at the beginning of last year, there is a danger that investors have overdone the gloom. Weak sentiment means that the UK is starting to look like an interesting contrarian play. It would not take much progress towards a trade deal (or even just the prospect of an extended transition period) for investors to start seeing the glass as half full again.
As for geo-political risk, history shows that markets can take even the most dangerous situations in their stride. While conflict in Korea or an escalation of the rivalry between Saudi Arabia and Iran would be catastrophic, it would be wrong for investors to treat either as their base case. Investment is a game of probabilities and both remain relative long-shots. It feels like 2017 was the year when we started to put politics into perspective after the upheavals of 2016.
Risks: what keeps us up at night
So, if politics is not the major risk as we move into 2018 what is keeping us awake at night? The biggest concern is that the lower for longer interest rate thesis is wrong. Bull markets do not die of old age, they tend instead to be ‘murdered’ by central banks. So why might interest rates rise faster than investors currently expect?
The most likely cause is a pick-up in wage inflation. Wages are a major driver of the overall inflation rate and it would not take much of a rise in labour costs to put pressure on the Fed to raise rates faster than the currently-expected trajectory. Rising wages are, in fact a double negative for share prices because if workers regain some of the bargaining power they have lost over the past 40 or so years today’s high profit margins will be unsustainable. The mismatch between historically low unemployment and a lack of wage inflation is a puzzle but history has shown that bull markets tend to peak as the jobs market approaches full employment.
A second reason why rates might rise more quickly than expected is if central banks decide they are stoking a bubble in asset prices and worry about the impact of market excesses on financial stability.
The third reason to fear higher interest rates is if the Fed starts to worry about the impact of excessive fiscal easing thanks to President Trump’s tax reforms. Tax cuts are a great way of stimulating a depressed economy (as Ronald Reagan knew) but they might be a reckless measure when the jobs market is already tight and debts are at record levels.
One knock-on impact of higher rates could be an increase in the default rate on corporate bonds (already rising). Problems in the high yield bond market tend to prefigure trouble in the equity market, so this is something to watch closely in 2018.
Wages: bouncing back
Source: Thomson Reuters Datastream, as at 31.12.17, 15.10.17, US Atlanta Wage Growth Tracker (3 month moving average)
2018 Fund picks: bracing for a tougher market
Nearly nine years into the current bull market, more caution is warranted than last year. But there are still some good opportunities in those regions of the world which have lagged the mighty US market in recent years.
The region that we like most as we move into 2018 is Europe. Valuations have certainly risen but they remain undemanding compared to those in the US. The region’s central bank remains supportive, so the Goldilocks backdrop of recovering economic activity but accommodative monetary policy should continue. The region is a treasure trove of excellent companies that will benefit from the ongoing global pick-up in activity.
The fund we have chosen to play the Europe theme is the Invesco Perpetual European Equity Income Fund, managed by Stephanie Butcher. This is a value-oriented fund, which means it has lagged somewhat in 2017 as growth has remained the style of choice for most investors. If economic recovery picks up then Butcher’s style could have its moment. An income-focused fund looks attractive in an environment of persistently low interest rates (which I don’t expect to change until the region’s quantitative easing programme is unwound).
Sideways-moving markets are quite common and can persist for some time if there are offsetting positive and negative factors at play. In such an environment, a strong case can be made for active stock-picking as well-selected shares can outperform a crab-like market significantly. For this reason, we are recommending another out-and-out stock-picker from Fidelity’s stable of strong active managers. Jeremy Podger’s Fidelity Global Special Situations Fund has the additional merit of being an unconstrained global fund which can chase opportunities wherever in the world the manager finds them. With a decent exposure to Japan, this fund also fills the gap left by not having a Tokyo-focused fund this year.
The last of our three recommendations is another quantitative Old Mutual fund run by Ian Heslop. This time it’s the Old Mutual Asia Pacific Fund, which has a broad spread of holdings across the region, including Australia. The fund has done well over the past couple of years, helped by holdings in both Tencent and Alibaba, China’s equivalent of America’s soaraway FANG stocks. With sentiment likely to be more volatile next year, we like Old Mutual’s focus on this key driver and the manager’s ability to move in an agile way between stocks and sectors as the market mood shifts.