Investment Outlook

Investment Outlook third quarter 2014



“Money alone doesn’t make anybody happy. You also need shares, gold and real estates” Danny Kaye, 1913-1987

Markets continue to work in mysterious ways. Of all the research that we analyse no one expected: Japan to be the country with the highest inflation among developed markets, a stronger Q1 GDP growth from European periphery than from the U.S. or to see Argentina as the best performing stock market.

During the last five years, easy monetary policies of the major central banks pulled economies through the most difficult period since the depression in the 1930s. Financial markets performed remarkably well in this environment of low interest rates. Stock prices more than doubled, bond yields in Europe dropped to levels not seen in almost five hundred years and a European disintegration was avoided.

We are now at the point where the Bank of England and the Federal Reserve Board in the U.S. are contemplating whether and when to change their monetary policies. Continental Europe and Japan are still lagging in terms of economic recovery and more stimulus by their central banks is likely.

The increase in global savings combined with the low return on cash has supported equities and bonds. Dividends and coupons provide higher current returns. So, after a good 2013, the first half of 2014 has continued to reward investors that took on interest rate risk. It is ominous that the bull market continued to rise with very low volatility, at around the lowest level in the last seven years. This is measured in the U.S. by the VIX – the so-called fear gauge on Wall Street – and shows that there is a lot of complacency among investors.

Calm before the storm? A hard landing in China could disrupt the bull market, but with the recent pick-up in Chinese exports we believe that that is unlikely. We continue to expect Chinese growth of over seven percent. The shadow banking sector seems to be a lot smaller than media is making us believe; hence we do not expect a growth threatening credit implosion.

Although worries have predominantly been about deflation in Europe, eight trillion dollars of money printing by central banks in the last six years could trigger higher inflation and lead to an increase in interest rates. This can happen when velocity of money increases. The Bank for International Settlements pointed this out in their recent annual report. Higher interest rates would have a negative impact on government finances, capital spending, the housing sector and financial assets.

Geopolitical risks also remain a threat. These are often unpredictable and most likely different than a decade ago. The Obama administration is more conflict averse than the former conservative governments and the American people are tired of wars. Furthermore the U.S. energy supply is becoming less dependent on foreign countries.

There can be additional “black swans” that are by definition difficult to forecast. However, we remain upbeat on the outlook for the world economy. Even though global first quarter economic growth has disappointed, leading indicators and employment statistics remain in positive territory. We expect global economic growth of three percent to be attainable and corporate profits to increase at a high single digit number. Tighter macro prudential measures and quicker intervention in developed and emerging markets have reduced risks for investors in recent years.

Asset Allocation

Aside from the decent economic outlook we expect inflation and interest rates to stay at relatively low levels for an extended period. This will support modest earnings growth of companies and underpin valuations to slightly higher levels, especially in the U.S. and Japan. We continue to be overweight in equities and remain focused on companies with strong balance sheets as the risk reward ratio in equities is superior to bonds. Emerging markets are still at lower valuations than the developed markets and could offer interesting opportunities, but rigorous stock selection is key.

Fixed income doesn’t look attractive and most investors including ourselves are positioned accordingly, underweighted and with a short duration. We believe the longer term outlook for fixed income remains relatively unattractive. Currently dividend yield on stocks is higher than the yield on non-investment grade bonds.

This low interest environment rewards being diversified in real estate, private equity and precious metals. Real estate and commodities give protection against unexpected pickups in inflation and private equity management companies attain higher returns on their unlisted investments through the use of leverage.