31 December 2014

2015 Investment Outlook

We would like to wish all of you a Happy New Year and a profitable one in all your investments! As we close 2014 and look forward to a brand new 2015, we would like to share with you our thoughts of what the investment climate is likely to be.

Executive Summary: We expect the global economy to continue to chug along at a similar pace to 2014. We are still confident that equity markets will provide decent returns on the back of accommodative central bank policies and possible earnings upgrades from lower input prices. We are:

  1. confident that the US will achieve economic acceleration;
  2. hopeful that the Eurozone will muddle through successfully;
  3. optimistic that Emerging Asia will continue to expand; and
  4. sanguine that Emerging Markets may find a bottom early in the year.

We are aware that trends in the world are diverging and remain cognizant of deflationary and geopolitical risks. We will remain nimble in our strategies and pick the markets with the highest “win” probability.

Article:

A Look Back At 2014
We are not in the business of forecasting. We prefer ascribing probabilities to our investment calls after fully analysing the data and detecting changes in trends. We then execute our best ideas which have the highest probabilities of success. We are under no illusion that we will always make the right calls, as markets are fickle and can always change direction on a whim. That is why we need to remain nimble (and humble!) and reverse decisions quickly if the markets do not move as anticipated. Below is a quick reflection of some of our key calls in 2014:

Global Outlook in 2015
Looking at the world as a whole, the outlook for 2015 remains expansionary. We remain confident that markets will be able to eke out a high single digit return in the face of this growth environment, as risk premiums are still attractive and there is no sign of a global recession on the cards just yet. We note that trends are diverging and there will be pockets of weak economies but as a whole, there does not appear to be a large scale slowdown on the horizon. The OECD’s Composite Leading Indicator has remained on an uptrend since the end of 2013 and as long as it remains above the long term average of 100, the risk of a global recession is greatly reduced (Fig 1).

Fig 1: OECD CLI Shows Expansion Stretching Into The 18 Month.

A look into the composite PMIs of the various economic powerhouses shows that they have been in expansionary territory since 2013 (Fig 2). However, we have to accept the fact that we may not see the same explosive growth of the mid-2000s during the meteoric rise of the BRICS economies (Fig 3). What we can expect going forward is a more benign and moderate growth environment which would be helped along by accommodative monetary policies by the various central banks (Fig 4).

Fig 2: Decent Growth Outlook For The Big Developed Economic Regions

Fig 3: EM Growth Will Diverge Between Commodity Importers and Exporters

Fig 4: Monetary Policies To Remain Accomodative Even Without The Fed

US Outlook in 2015
The economic expansion in the US is well into its fifth year already. What is different from previous recoveries was that the economy did not really achieve escape velocity until 2014, as companies and consumers suffered from a bad case of debt hangover. Economic activity when measured through an index of leading and coincident indicators looks set to accelerate and continue into 2015 (Fig 5).

Fig 5: Us Coincident and Leading Indicators Still In An Uptrend

US consumption makes up around 65% of the country’s GDP. With the labour market continuing to gain strength, unemployment rates declining and planned compensation increases on the cards, we see the economy continuing to improve on the back of the US consumer (Fig 6).

Fig 6: Labour Market Has Steadily Improved

Consensus GDP forecasts for the US for 2015 hovers just below 3%. However, the recent decline in energy prices represents a boon to the US consumer and will boost the economy, especially in discretionary spending (Fig 7).

Fig 7: Lower Fuel Prices To Boost Economy and Consumer Spending

We are cognisant of the fact that there are risks to the US growth story stemming from a stronger US dollar and interest rate sensitivity to assets and some sectors from Fed tightening (Fig 8). The dollar strength is expected to continue as the US experiences net capital inflows and its economy strengthens. With the US economic expansion intact, we remain confident in the US equity market and will seek to keep our overweight position until the narrative changes.

Fig 8: A Dollar Which Is Too Strong May Affect Exports And Reduce Profits Of MNCs

Eurozone Outlook in 2015
The ECB and OECD are forecasting an approximate growth rate of 1% for Europe in 2015 with much of the economy still below its pre-crisis peak. To tackle much of the malaise in the area, the ECB is poised to buy a broad range of assets next year including sovereign bonds. Some hope has already been priced into the market, but there are bigger risks to assets should the ECB’s plan fail to provide the necessary outcome. In the shorter term, we see economic expansion hindered by slow loan growth as companies prefer to pay down debt, although it appears to have bottomed out in early 2014 (Fig 9).

Fig 9: Loan Growth Remains Weak But Is Recovering

The weak Euro should provide a positive catalyst to the economy in 2015 as such declines in the past have always led to exports increasing significantly in the following year (Fig 10). Large European multinationals typically derive 45% of their revenue outside of Europe so the weak currency will have a positive translation effect.

Fig 10: Weak Currency Will Be Good For Exporters Especially Germany and Italy

We are aware of the broad financial risks to the Eurozone but there is also political risk to consider. Elections are currently underway in Greece to select a new President, whilst in 2015 we will see elections in Germany, Netherlands, Spain, Switzerland and the United Kingdom. Recent surveys have shown that an increasing number of respondents view the Euro as a bad thing and should the leftists gain majority it could be a destabilising influence to the bloc (Fig 11). As such, we currently adopt a neutral view towards Europe but are open to allocating to the region at a later stage after we see more Euro weakness and political risk priced in.

Fig 11: More Respondents Now think The Euro Is A Bad Thing

Asia Pacific Outlook in 2015
The outlook for Asia appears to be a mixed bag, so selectivity will be critical. Most countries will benefit from reduced inflation due to lower commodity prices with the exception of Malaysia and to some extent Indonesia (as Indonesia is a net commodity exporter). Fiscal balances will be much better off, which will provide the APAC governments room to manoeuvre in the face of a stronger US dollar and weaker Chinese growth (Fig 12). Countries which have a large domestic consumer will benefit much more, and companies in related sectors like Consumer Discretionary, Healthcare and Staples will likely benefit from earnings upgrades.

Fig 12: Current Account Balances and Inflation To Benefit From Lower Commodity Prices

Chinese growth rates have steadily declined over the past few years as the country embarks on structural reforms and an anti-corruption drive. We accept the fact that manufacturing PMI and industrial production data will continue to trend downwards as the country reduces its reliance on the old inefficient SOE-led growth model. Consumer indicators and service PMI on the other hand has continued to show strength and it is likely that these sectors will continue to support the economy. Forward looking leading indicators suggest that the recent Chinese weakness has bottomed and the economy may pick up sooner than expected (Fig 13). However, the main risk to the economy comes from the real estate sector which is suffering from continued contraction. This deceleration comes with knock-on effects, from lower spending on household related items to a drag on coal and iron ore prices. This indirectly affects countries like Indonesia and Australia, where mining output and investments are forecast to slow down even more.

Fig 12: Current Account Balances and Inflation To Benefit From Lower Commodity Prices

We are generally upbeat about Emerging Asia’s prospects and are monitoring the best time for an allocation in 2015, but we are cognizant that a stronger USD and US interest rate hikes could be negative for markets. Hot money flows are expected to be stable as foreign holdings of APAC equities has largely been unchanged since 2009. We are more worried about the inverse correlations between the dollar and performance of Asia-ex-Japan equities (Fig 14).

Fig 14: The US Dollar Index and MSCI Asia-ex-Japan Displays An Inverse Relationship

Japan
For Japan, it appears that the markets continue to trade on JPY weakness. However, with the recent election victory, there is hope that it will renew the push for Abe’s reform mandate. Upcoming wage negotiations, promotion of female labour participation and entry into the Trans-Pacific Partnership will be beneficial for the economy. However, the liberalisation of inflexible labour policies may not be as successful as envisioned. Companies have been enjoying stronger profits from the competitive currency devaluation but have not deployed the money into CAPEX spending or wage increases. What is certain for 2015 is to expect continued JPY weakness from the BOJ’s reflationary push, and the giant Government Pension Investment Fund’s reallocation into more foreign equities and bonds (Fig 15). Every 1% change in allocation represents a flow of USD$10bn.

Fig 15: GPIF Reallocation Will Be Good For Both Local and Foreign Stocks, But Hedge That JPY Exposure!

Emerging Markets Outlook in 2015
The outlook for EM in 2015 looks as uninspiring as in 2014. The majority of EM countries have large commodity-oriented economies which will be affected by the commodity slowdown (Fig 16). We are much more upbeat about service-oriented EM economies compared to commodity-oriented ones, so selectivity is critical. Some of the key reasons for EM continued underperformance will be weak earnings growth, and stronger USD (weak EM currency) which raises import prices and affects current account balances. A lot of the EM economies will have to reform and adopt structural changes to keep up with the times, but this will take effort and a long lead time.

Fig 16: We Need To Be Selective When Allocating to EM Countries Especially Commodity Producers At This Tail End Of the Commodity Boom

Whilst many EM markets are now trading at attractive valuations relative to developed markets, they may continue to remain cheap for longer than expected. The growth outlook, in line with the slow global growth environment, is expected to remain soft. PMI and industrial production numbers have been trending sideways for some time. As mentioned in the previous paragraph, the earnings outlook remains weak, with consensus EPS growth around 8%. This is hardly exciting for growth economies and we would prefer allocating money where data is more solid. Couple this to the fact that the commodity super-cycle is on its last legs (Fig 17), the outlook for EM economies especially the commodity producers becomes poorer.

Fig 17: The Commodity Bull Run Appears To Be Over

In Conclusion
We expect the overall global economy to grow at a largely similar pace to 2014. However as mentioned in our executive summary above, growth will not be broad-based and some economies, notably the US and possibly some Asian economies, is poised to outperform the other major markets. Notwithstanding our market views, we continue to remain vigilant so as to protect our portfolios from major market crashes. In 2014, we have put in place our process of monitoring key market stress indicators which would signal to us that a major market crash is looming. We now monitor this on almost a daily basis and will take immediate steps to adjust our portfolios should the need arise. We believe that successful investing does not rest solely in chasing returns but in not losing.



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