Valuations at historically high levels

Source: Thomson Reuters Datastream, 15.3.18

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.

The first quarter of 2018 has been disappointing and unsettling in equal measure for equity investors. Disappointing because markets are essentially flat year to date despite delivering the best January in decades. Unsettling because, after last year’s unnatural calm, markets have become significantly more volatile.

This is unsurprising when you add up all the things investors have started to worry about. Trade wars tops the list, adding to inflation, interest rates, growth and ongoing political uncertainty. The reversal from last year’s Goldilocks scenario of synchronised global growth coupled with benign inflation and lower-for-longer interest rates has been swift. Although growth remains robust (indeed the latest employment data in the US were much stronger than expected), and inflation is not yet a meaningful problem, you only need a deterioration at the margin of these variables to call time on a bull market. This is especially true when, as the chart shows, valuations are at historically high levels.

Today we can’t expect any further upward re-rating in shares so earnings will have to do the heavy lifting if the equity market is to shrug off rising rates. The speed of the back-up in yields is important too. What spooked markets last month was not the fact of rising yields but the pace.

Stock markets respond less to the actual level of growth than the rate of change. So, markets often do very well when growth is weak but no longer deteriorating. The period when growth is above trend and accelerating can also be a good time to be in the market. It’s all about changing expectations. What is less favourable is a slowdown in the rate of growth even if the rate remains quite high. That is where we are now. It argues for more volatile and lower returns from equities this year.

As I’ve pointed out elsewhere in this Outlook, a case can be made for both value and growth styles. Both value and growth are in relatively short supply at the moment so investors are on the lookout for each of them. Some value opportunities are emerging in sectors like banks but value traps abound in areas of the market most vulnerable to technological disruption.As for growth, companies that can deliver it consistently will remain in favour. It’s the ‘bond proxies’, sectors like utilities and consumer staples, that look more exposed to rising interest rates.

Select 50 pick: We think markets could move sideways this year so it will pay to invest with an active stock-picker like Jeremy Podger, manager of Fidelity Global Special Situations.


Prime property yields in bubble territory

Source: Thomson Reuters Datastream, 31.12.17

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.

Commercial property has enjoyed an extended bull market that its champions have justified on the grounds that the sector is a source of high-quality yields. That case is becoming ever harder to make as the record prices being paid for prime property start to filter through into other more humdrum parts of the market.

Property fund managers may struggle to meet their clients’ expectations if they are looking to repeat the returns of the recent past. Interestingly, though, most say they are staying put because the high-quality income they receive from their property investments is doing a job in their portfolios and they know that most tenants are in good shape and will keep paying the rent. So, how might the valuation tension resolve itself? There could be a rapid price correction although this is far from the consensus. Rather the expectation is for property to deliver income plus low or zero capital growth over the next few years. That makes sense against a backdrop of slowly normalising rates.  A measured return to normal also looks likely in light of the fact that the other factors that typically trigger the end of the property cycle - oversupply, excessive debt - are not in place.

A key assumption for this benign scenario is that excess capital does not keep finding its way into the sector. The longer this goes on, the more likely a sharp correction becomes.

Important information: Some funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to cash in this investment when you want to. There may be long delays in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer's opinion rather than fact. 


Bond spreads are too optimistic

Source: Thomson Reuters Datastream, 15.3.18

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.

Value is hard to find in fixed income and bonds face a perfect storm of threats. Accelerating inflation, the ongoing transition from quantitative easing to quantitative tightening and relatively high valuations (particularly in lower-quality high yield bonds) point to a difficult period ahead for bond investors.

This might seem like a strange time then to partially reverse our long-standing caution on the asset class. The reason we are doing so is precautionary. The growth and inflation outlook is deteriorating In that environment, the ballast that government bonds, in particular, can provide is not to be sniffed at.

Government bond yields have risen quite strongly over the past year or so as investors have factored in rising inflation and higher interest rates. What is notable, however, is the willingness of investors to buy safe bonds like US Treasuries at these higher yields. Another reason to believe that yields will stay lower for longer is the remorseless arithmetic of record global debt levels and ageing populations. Debt and demographics will continue to put a lid on yields.

A third reason to think that yields won’t rise as fast as the bond bears think is the growing evidence that economic growth could flag this year. We are already seeing mortgage and loan rates rising. The oil price is significantly higher than it has been. The US’s protectionist agenda threatens global trade. It is quite easy to see bond yields actually falling from here rather than rising as the conventional wisdom believes. My growing enthusiasm for ‘govies’ does not extend right across the bond spectrum, however. Credit is where the greatest risks lie for fixed income investors. Adjust high yield bond yields for even average default expectations and there is no room for error. Look at worst case scenarios in terms of company failures and lower grade bonds make no sense at today’s prices.

Select 50 pick: With such differences between government and corporate bond valuations, asset allocation is best left to an expert. Both the Fidelity and Jupiter Strategic Bond Funds are worth a look while the new Fidelity Select 50 Balanced Fund has the ability to flex the bond allocation as conditions change.

Important information: Please be aware that the price of bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between corporate issuers.


Commodities thrive in the late cycle

Source: Thomson Reuters Datastream, 18.3.18

Past performance is not a reliable indicator of future returns.

The past year has given commodities a welcome breather after a dire few years in which the industry lived down to its reputation for poor management and volatility. Share prices of commodity producers rose strongly last year on the back of rising commodity prices Although the FTSE 350 mining index has more than doubled over the past couple of years, however, it remains as lowly-rated as ever as investors are yet to be convinced that mining companies have really learned much. In the good years, billions of dollars were splurged on new capacity only for it to come on stream just as China was slowing. It has taken years of austerity to get the sector back on track.

The other reason that investors are treading carefully is the realisation that rising commodity prices in due course always lead to rising costs for mining companies. The bit in the middle sees margins soar but the good news never lasts. Antofagasta, the copper miner, warned in January that it was seeing an uptick in costs so maybe the sweet spot is coming to an end.

As for oil, the period of low prices since the 2014 crash may soon come to a close. For the next couple of years, extra Shale output  should be enough to keep the market well supplied. But from 2020 onwards a chronic lack of investment while the oil price languished will make it ever harder to counter the constant falling away in supply caused by declining output rates from mature fields. For now, oil should remain in its current range but expect it to creep higher in due course.

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