7 January 2015
By Nick Griffin, Jeff Thomson, James Tsinidis and Kieran Moore
K2 Asset Management is positive on global equities heading into 2015. This will be the 6th consecutive year we have favoured equities over cash, having turned bullish in March 2009. In 2015 we are forecasting positive returns from global equities as well as further tailwinds from a falling Australian dollar. Nevertheless, the equity bull market is now almost six years old, and US equities in particular have already enjoyed a significant re-rating, so returns are likely to be relatively muted compared to the earlier years of the bull market. Furthermore, a difficult and potentially hazardous process of “policy normalization” by the Fed is also likely to mean that volatility will continue to rise. A marked divergence with the rest of the world, where growth is generally mixed and monetary policy is still easy, means that the US dollar is likely to continue to strengthen.
Despite the backdrop of higher volatility and potential US interest rate rises, global equities still look reasonable value versus history and also good value versus other investment alternatives such as bonds and property. The below table flags the key metrics for a selection of global equity markets; headline valuation measures show little in the way of over exuberance, particularly outside the US.
Key risks to our outlook will likely come from a changing interest rate outlook in the US versus other developed economies and the associated currency volatility. In addition, political disruption in Europe continues to occur, specifically, problems in Greece, France and Russia. Finally, the re-emergence of deflationary forces in struggling regions such as Europe and Japan could put pressure on equity multiples in those economies. Below we highlight six investment insights for 2015 and how their evolution will affect the way we invest.
Six investment insights for 2015 and how we intend to benefit
1) The Fed will raise interest rates in 2015
The US economy continues to recover. US third quarter GDP growth was revised up to an annualized rate of 5%, the strongest period of growth since 2003, nonfarm payrolls have grown by an average of 258,000 over the last six months, and the unemployment rate has fallen to 5.8% and appears to be headed lower. All of this means that US rate hikes now loom large on the horizon. While the Fed remains “patient” (i.e. dovish), there is a clear intention to raise rates in 2015. The significance of this cannot be underestimated; this will be the first rate hike in over 8 years and the journey back from historically unprecedented levels of monetary stimulus towards some kind of normalcy will be difficult and uncertain. What does seem certain is that this will not be a smooth process and higher levels of volatility appear inevitable. There already appears to be a growing disparity between financial market expectations and current Fed intentions.
Nevertheless we see no reason why equity markets cannot ultimately continue to perform well as any rate increases will be associated with higher economic growth; and most crucially of course we expect the Fed to proceed in a measured and cautious manner. Bull markets traditionally don’t end with the first rate hike; they end with the last rate hike and ultimately if the Fed can successfully raise rates without derailing the recovery then this is long term positive for US equities.
2) It’s a strong USD world
While clearly it’s a consensus view, it is hard not to argue for continued strength in the USD over 2015. The US economy continues to exhibit strong growth and as discussed above there is no reason why US interest rates should not rise in 2015, diverging significantly from both Europe and Japan that look set to embark on further quantitative easing. Stronger growth, higher rates and potentially an improving fiscal deficit outlook all point to a stronger USD versus most regional currencies. While the AUD has already weakened significantly to date versus the USD, a diverging growth outlook suggests this tailwind can continue in 2015. Consequently we remain unhedged on our international investments as we enter 2015. Hedging aside it is also worth flagging that such large currency moves will provide a source of market and corporate earnings volatility in 2015, with those earning US dollars in various global markets the key winners. Conversely, non-USD earners will have a harder time as falling currencies reduce earnings power and credit problems grow in emerging markets.
3) Deflation is real
The recent collapse in the oil price is the latest in a string of commodity falls, starting with agricultural commodities, iron ore and now oil. Brent oil prices have fallen over 49% since June, alongside a 35% fall in iron ore, and sharp drops in both copper and coal, sending the Bloomberg Commodity index down 15.6% in 2014 to a five year low. The consequent effect of these falls means that, in a headline sense at least, inflation is likely to be negative for at least the first half of 2015. In our view this is likely to have two major consequences for markets in 2015. Firstly, central banks will be under less pressure to raise rates, and in many cases will need to provide more accommodation, particularly in Europe. Many central banks have built in reporting and policy functions once inflation drops below 1%, and while in theory transitory, many will be wary of letting any deflationary expectations build in the market place. Secondly, in a low rate and low inflation environment the hunt for yield will continue. Numerous global equity markets now have dividend yields well in excess of the risk free bond rate, while the earnings yield versus the risk free rate still points to a positive carry for equities. Consequently we expect risk capital to still favour equities over the year ahead, particularly those offering growing dividend and cash return credentials.
4) The Chinese equity market is back
The fact that we are in the 4th year of debate on whether China will have a hard or soft landing suggests the question has already been answered. With 2015 the start of the 13th 5 year plan, it looks set to be a big year for Xi Jinping and the ongoing reform agenda in China. Since taking power in March 2013 the current Chinese leadership have been targeting a wide ranging reform agenda designed to help China shift to a more sustainable economy funded by private capital and driven by consumer spending. Significant reforms to date have included banking reform, SOE reform and the formation of free trade zones. Capital market reform continues with the opening of the HK China interconnect, deepening of the corporate bond market and less foreign exchange intervention. Elsewhere, crackdowns on corporate corruption and SOE excess has kept the governing party popular through this transition period. While the reform agenda will help boost productivity and unlock latent growth potential, the PBOC has now also joined in by cutting interest rates and reducing the reserve rate requirement for Chinese banks. These growth tailwinds when combined with market valuations still well below slower growing peers suggest the explosive equity market rally that began in Q4 2014 may have only just begun. Since increasing our investments in October 2014 the funds remain significantly invested in both China H and China A shares.
5) The Internet of Things has arrived
Some may remember the exponential growth math problem involving the wheat and the chessboard from early education. That is, if you place one grain of wheat on the 1st square, two on the 2nd and four on the 3rd and so on (doubling the number of grains on each subsequent square), how many grains of wheat would be on the 64th and last square?
So it is with technology and connected devices. What started with one mainframe computer in 1960 has grown to one connected device per person with personal computers, to two with mobile telephones, to three with iPads and laptops and is now rapidly on its way to 10-12 connected devices per person with the onset of connected cars, homes, TV’s and other appliances. Do the maths on 7 billion people and from a connected device stand point 2015 is the year we enter the 2nd half of the chessboard where the numbers start to get really, really big. Three things have contributed significantly to the proliferation of connected devices; the internet, cloud computing and Moore’s Law, whereby the power of computing hardware roughly doubles every two years (or the cost for the same hardware roughly halves). These three factors have allowed the proliferation of low cost connected devices that provide real time updates to their users across all aspects of daily life and commercial operations. This has in turn led to the rise of social media, mobile apps and data analytics. As we move towards 50bn connected devices we see strong structural growth for those involved in the semiconductor industry and a collection of big winners who can unite platforms for cloud computing and social media.
6) Peak Car
We have all heard of ‘Peak Oil’ and after the oil price collapse of 2014 we now have some hypothesising of ‘Peak Car’. While we are in no way prepared to commit to car ownership levels peaking in 2015 we would highlight that the rapid shift to a digital economy described above is causing many previously unforeseen outcomes. In the car market there is now no shortage of data to suggest a rapidly changing market place. This is evident if we look at the average age of US motor vehicles which is at an all-time high of 11.3 years, US miles driven per car falling from 2008, or the alarming drop in car ownership amongst those under 35 years of age. All the data suggests car use in the US is actually falling despite a growing economy.
The rise of car sharing services such as ZipCar, DriveNow and ridesharing from Uber has led to an increase in the shared economy. Combined with rising congestion and better public transport sees little incentive to own your own car. The combination of connected devices, real time information and cloud computing have resulted in the rapid rise of peer-to-peer businesses and an increasingly shared economy. Cars are just one example where the effects are now real. Accommodation, banking, software and real estate agencies are now also under similar competitive threats, and potentially in danger of the same disruptive forces that caused large changes in the print media and retail industry. While we remain alert to the possible equity winners from these changes the list of potential losers is getting bigger as more industries are becoming affected. Ultimately most of this disruption is based around price and this is adding to the deflationary forces in the economy, while also creating a number of interesting short selling opportunities in previously growing industries. Some examples include the watch industry being displaced by wearable technology, the hire car industry being displaced by car sharing and the retail banking industry being displaced by online only banks and peer to peer lending
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DISCLAIMER: The information contained in this presentation is produced by K2 Asset Management Ltd (“K2”) in good faith, but does not constitute any representation or offer by K2. It is subject to change without notice, and is intended as general information only and is not complete or definitive. K2 does not accept any responsibility, and disclaims any liability whatsoever for loss caused to any party by reliance on the information in this presentation. Please note that past performance is not a guarantee of future performance. A product disclosure statement and additional information booklet or information memorandum or general information on the funds referred to in this presentation can be obtained at www.k2am.com or by contacting K2. You should consider the product disclosure statement before making a decision to acquire an interest in the fund.