Quarterly Perspectives UK Q1 2016

Transcription

1 Quarterly Perspectives UK Q1 216 J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights. THIS QUARTER S THEMES 1 Mind the gap 2 Time to hedge your bets 3 High time for high yield 4 The case for UK equities STRATEGISTS Stephanie Flanders Managing Director Chief Market Strategist for the UK & Europe Vincent Juvyns Executive Director Global Market Strategist Dr. David Stubbs Executive Director Global Market Strategist Maria Paola Toschi Executive Director Global Market Strategist Michael Bell, CFA Vice President Global Market Strategist Alex Dryden Market Analyst Nandini Ramakrishnan Market Analyst MARKET INSIGHTS Guide to the Markets UK Q1 216 As of 31 December 215

2 1 Mind the gap Monetary policy divergence will be a key theme in 216. With the US and UK at or near full employment, the Fed and then the Bank of England should gradually tighten monetary policy this year while the ECB and the Bank of Japan should maintain an easing bias. In emerging markets, even though looser monetary policy would help to boost growth, many central banks could refrain from easing or even tighten, either because of inflation concerns or to avoid exacerbating capital flight, which could occur during the Fed tightening cycle. The only emerging market central bank which seems able and willing to ease is the PBOC, which is expected to cut banks reserve requirement ratios further. OVERVIEW 215 has been a year of monetary policy divergence. In January 215, the European Central Bank (ECB) announced an aggressive quantitative easing (QE) programme just as the Federal Reserve s (Fed s) balance sheet peaked. Over the year, the People s Bank of China (PBOC) cut rates and the bank reserve requirement ratio several times and surprised markets with a small depreciation of the renminbi. Central bank policy Market expectations for policy rate 2. Central bank balance sheets of nominal GDP 8 GTM UK 13 Projections* In December, monetary policy divergence continued with the ECB lowering its deposit rate to -.3 and committing to extending its QE programme by six months into 217, while the Fed increased interest rates by 25 basis points for the first time since 26. Global economy UK US Japan Eurozone 6 Japan Eurozone US UK '16 '17 '18 '7 '8 '9 '1 '11 '12 '13 '14 '15 '16 Source: (Left) Bloomberg, US Federal Reserve, J.P. Morgan Asset Management. (Right) Bank of England, Bank of Japan, ECB, US Federal Reserve, J.P. Morgan Economic Research, J.P. Morgan Asset Management. *Central bank assets as percentage of nominal GDP is forecasted from Q415 to Q216 using J.P. Morgan Global Economics Research nominal GDP forecasts and assumptions for central bank balance sheet size based on statements released by each respective central bank and its governors. Guide to the Markets - UK. Data as of 31 December 215. Some policy divergence is already priced in to markets, but the pace of rate rises will be key. 13 Source: Guide to the Markets UK, page 13 Foreign exchange: Dollar rally set to continue for now One of the consequences of continued monetary policy divergence is that the dollar rally will probably continue at the start of 216. However, the biggest part of the rally may be behind us as the dollar already looks overvalued and part of the coming divergence is already priced in. The US also still has a sizeable current account deficit and the growth differential relative to other developed markets such as Europe could well diminish in QUARTERLY PERSPECTIVES Q1 216

3 For sterling, concerns around the current account deficit and the European Union referendum will weigh against the support the currency might have gained from the prospects for gradually higher UK policy rates. Emerging markets could continue to struggle while the dollar remains strong, but the more vulnerable markets have already seen a significant degree of currency depreciation. The elephant in the room is China. The slight devaluation of the renminbi in August led to the fear that the PBOC might enter into a currency war. It is likely that the authorities will seek some further depreciation of the currency as they move to link the exchange rate to a broader basket of currencies. But the government s desire to see the renminbi become a major reserve currency and the International Monetary Fund s decision to internationalise the renminbi by including it in the currency basket for its Special Drawing Rights (SDRs) should prevent a large-scale devaluation. INVESTMENT IMPLICATIONS Divergence is already partly priced in by market participants, meaning that the level of conviction around currency forecasts is lower than last year. Though the dollar probably still has more room to rally, we could see some reversal of recent currency trends over the course of 216. The downside for emerging market currencies and the yen could be limited by already cheap valuations. The outlook for sterling is highly uncertain and the euro may also be less of a one-way bet. Global economy US dollar index Broad real effective exchange rate (REER) Global currency trends GTM UK : '73 '77 '81 '85 '89 '93 '97 '1 '5 '9 '13 Currency performance since 211 Real effective exchange rate : : : : Plaza Accord 1987: Louvre Accord RMB GBP USD EUR JPY EM* US dollar performance and US rate hikes Real trade-weighted exchange rate, rebased to 1 on the date of first rate hike : Average since 1973 Nov 215 US dollar index : Months Source: (Top) US Federal Reserve, J.P. Morgan Asset Management. (Bottom left) BIS, Bloomberg, J.P. Morgan Asset Management. (Bottom right) FactSet, US Federal Reserve, J.P. Morgan Asset Management. *EM currency measure is the J.P. Morgan Emerging Market Currency Index, which measures the currencies of 1 emerging markets against the US dollar in nominal terms. Guide to the Markets - UK. Data as of 31 December : Monetary policy divergence could also contribute to higher volatility in financial markets, because of the uncertainty over the pace of Fed tightening. Long bond yields are expected to rise, but not dramatically, with the yield curve likely to flatten. The dollar hasn t always rallied once US interest rates start rising. 16 Source: Guide to the Markets UK, page 16 Fixed income: Uncertainty around Treasury yields Markets continue to discount a slower pace of Fed rate hikes than the members of the Federal Open Market Committee (FOMC) predict, suggesting some potential for yields to rise. Historically, the short end of the curve rises the most at the start of the tightening cycle, and the yield curve flattens. Policy divergence could mitigate the negative impact of Fed rate rises, as higher Treasury yields should attract fixed income investors from countries where QE remains at full speed. This should anchor the long end of the US yield curve below 3, though there is naturally a lot of uncertainty around this, and the holders of long duration bonds will always be more vulnerable to capital losses in a higher-rate environment. J.P. MORGAN ASSET MANAGEMENT 3

4 2 Time to hedge your bets An ageing bull market: Expect lower returns The bull market in stocks has been going on for nearly seven years and government bond yields remain close to record lows after a nearly 35-year bond bull market. We don t think a global recession that could end the equity bull market is imminent, based on the warning signs we monitor. However, we do think that returns over the next few years for both stocks and government bonds are likely to be lower than they have been in the period since the end of the financial crisis. Equity valuations are nowhere near as expensive as they were in bubble periods such as 2. In fact, they are only around their 1996 level. But valuations are now higher than they were at the start of this bull market and growth forecasts are below their long run averages, which is why we expect returns to be lower going forward. Government bond markets look more extended relative to their past history. Returns in this sector are likely to be lower or even negative in 216, depending on the region and the pace of US interest rate increases. OVERVIEW For investors concerned that equity markets have run a long way but that government bond yields are very low, it can be hard to know where to turn. Hedge fund strategies offer the potential for better returns than cash or government bonds. Certain hedge fund strategies can also offer added diversification and reduced volatility for portfolios, and provide more downside protection than equities. US S&P 5 at inflection points GTM UK 43 S&P 5 Index 2,2 2, Characteristic Mar 2 Oct 27 Dec 215 Index level 1,527 1,565 2,44 P/E ratio (fwd) 27.2x 15.8x 16.1x Dividend yield US 1 year Dec 215: P/E = 16,1x 2,44 1,8 1,6 24 Mar 2: P/E = 27.2x 1,527 9 Oct 27: P/E = 15.8x 1,565 Equities 1,4 1,2 1, Total return: Valuations are no longer as attractive as in 29, suggesting future returns will be lower Dec 1996: 9 Oct 22: 9 Mar 29: P/E = 16.x P/E = 14.1x P/E = 1.3x '97 '98 '99 ' '1 '2 '3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 '15 '16 Source: FactSet, Standard & Poor s, Tullett Prebon, J.P. Morgan Asset Management. The P/E ratios are forward P/E ratios. Forward P/E ratio is a bottom-up calculation based on the most recent price data divided by the mean consensus estimates for earnings in the next 12 months and is provided by FactSet Market Aggregates. Return calculations shown in green are based on the total return index. Guide to the Markets - UK. Data as of 31 December Source: Guide to the Markets UK, page 43 4 QUARTERLY PERSPECTIVES Q1 216

5 Focus on risk-adjusted returns and downside protection As the likely returns available from traditional assets diminish, investors should focus on how to continue to achieve attractive risk-adjusted returns. The risk-adjusted return (the Sharpe ratio) of a traditional equity and bond portfolio has been very strong since the crisis. However, it may have peaked now that returns are likely to be lower and volatility could rise, as the economic cycle ages and interest rates increase. Different equity markets broadly tend to rise and fall together. Traditionally, investors have relied on government bonds to provide some protection when equity markets fall. However, government bonds are now a less reliable source of portfolio diversification and downside protection, as the correlation between bonds and equities has become less stable and yields remain near all-time lows, providing little cushion if rates rise. In such an environment, hedge fund strategies can offer a welcome focus on delivering positive risk-adjusted returns in varying market conditions, as well as additional portfolio diversification. Risk-adjusted returns and downside protection GTM UK 67 Risk-adjusted returns of a 5/5 portfolio Sharpe ratio of a portfolio of 5 global equities and 5 global bonds* year Sharpe ratio 5-year Sharpe ratio Three-month stock and bond correlations Total return on US equities (S&P 5) and US Treasuries (1-yr) Other assets and investor behaviour '6 '7 '8 '9 '1 '11 '12 '13 '14 '15 '16 1. Hedge fund returns in different market environments Average total return in up and down months, S&P US Bonds HFRI FW HFRI FW S&P 5 up S&P 5 down Bond up months Bond down months '3 '5 '7 '9 '11 '13 Source: (Left) MSCI, J.P. Morgan Asset Management. (Top right) Bloomberg, J.P. Morgan Asset Management. (Bottom right) Barclays, FactSet, Hedge Fund Research, Standard and Poor s, J.P. Morgan Asset Management. *The equity index is the MSCI World (EUR hedged) and the bond index is the JP Morgan Global Bond index (EUR hedged). Sharpe ratio is calculated as (Return - Risk free rate) / Volatility. HFRI FW is Hedge Fund Research Index Fund Weighted. US bonds is the Barclays US Aggregate Bond Index. Guide to the Markets - UK. Data as of 31 December 215. Hedge fund strategies can deliver positive returns in varying market environments and limit downside. 67 Source: Guide to the Markets UK, page 67 J.P. MORGAN ASSET MANAGEMENT 5

6 More tools to exploit more opportunities in choppy waters Hedge fund strategies have the capacity to make money in different market environments. At a time when volatility across asset classes has been increasing, hedge fund strategies have the ability to reduce volatility by taking advantage of return opportunities that have low or negative correlations with each other. With the ability to profit from expectations that assets will fall, as well as rise, hedge fund strategies have a much broader set of investment opportunities than traditional funds Multi-asset hedge fund strategies with a go-anywhere approach benefit from this wider tool kit and also from the opportunity to invest in more asset classes than traditional funds. They can express their positive, negative or relative market and macro-economic views across equity, bond, currency and commodity markets. Asset volatility and dispersion in returns Relative price volatility of key assets Rebased to 1 at January Volatility measures (index level) Average Latest Crude oil (OVX) 3 47 US Treasuries (MOVE) S&P 5 (VIX) GTM UK 66 INVESTMENT IMPLICATIONS Risk-adjusted returns for traditional equity and bond portfolios may have peaked and bonds may no longer be as reliable a diversifier. Investors should consider hedge fund strategies that attempt to provide positive risk-adjusted returns with lower drawdowns and volatility than equity markets. Multi-asset macro funds often have a very broad opportunity set used to reflect the manager s macro views with the aim of delivering positive risk-adjusted returns in different market environments. These funds can offer valuable diversification benefits to traditional equity and bond portfolios. In recent years, the number of funds able to use hedge fund strategies but also offering daily liquidity has increased Other assets and investor behaviour 3 '12 '13 '14 '15 Sector dispersion and market volatility Standard deviation across annual S&P 5 sector returns 16 Dispersion Dec '13 Feb '14 Apr '14 Jun '14 Aug '14 Oct '14 Dec '14 Feb '15 Apr '15 Jun '15 Aug '15 Oct '15 Dec '15 Source: (Top) BofA/Merrill Lynch, CBOE, Standard & Poor s, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom) CBOE, FactSet, Standard & Poor s, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 December 215. VIX Volatility has been rising across different asset classes. 66 Source: Guide to the Markets UK, page 66 6 QUARTERLY PERSPECTIVES Q1 216

7 3 High time for high yield Government bond yields are too low to provide a traditional source of income Government bond yields in developed markets the US, the UK, the eurozone (represented by Germany) and Japan are at their lowest levels in decades. Supportive central banks have raised asset prices, particularly through low interest rates and quantitative easing. Not only are yields low, but the divergence in short-term interest rates (bottom right chart) confirms that developed market government bonds can no longer be thought of in the same category when making asset allocation decisions. Investors received a 4.1 annualised total return from US Treasuries in local currency terms over the last ten years. US high yield provided 6.8 and European high yield 6.8 over the same period. With government rates remaining low, that extra 3 from high yield remains important. OVERVIEW The December interest rate rise by the US Federal Reserve (the Fed) has brought an end to the period of rock-bottom policy rates. But with US rate hikes likely to be gradual and many sovereign bond yields in the eurozone still negative, this does not mean the search for income is over. Higher-yielding corporate debt could be a solution for more income-oriented investors, at a time when the yield on many lower-rated bonds has moved up significantly. But investors need to understand the factors driving yields higher to judge whether the return justifies the added risks. Government bonds GTM UK 58 Fixed income 1-year bond yields Two-year bond yields Black Friday 1987 Britain leaves ERM 1992 Asian currency crisis '1 '11 '12 '13 '14 '15 '16 Source: (All charts) FactSet, Tullett Prebon, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 December 215. Government bond yield curves At the start of respective years 5 US Germany Dot com bubble Feb 2 9/11 attacks 21 Fed QE 28 BoE QE 29 Fed QE2 21 Fed QE3 212 Fall of Berlin Oil shock Wall '8 '82 '84 '86 '88 '9 '92 '94 '96 '98 ' '2 '4 '6 '8 '1 '12 '14 '16 US UK Japan Germany US UK Germany Japan BoJ QE 213 ECB QE m 1y 3y 5y 1y 3y Not only are bond yields lower than at any time in the past few decades, but shorter-term yields in the US and UK vs. Europe and Japan are diverging. 58 Source: Guide to the Markets UK, page 58 J.P. MORGAN ASSET MANAGEMENT 7

8 US high yield is the dominant high yield market, but the greater depth and maturity does come with higher sectoral risks. Yields on US high yield have risen over the past 12 months (top chart). This is partly justified by an increase in credit risk as the cycle matures and the Fed starts to tighten. But the largest increase in default rates usually comes when an economy is overheating and when there are multiple and frequent rate rises. This is not the situation we are in today. In fact, the rise in yields is more a sector story than a broad selloff. The yield for the energy sector has risen dramatically above the broad index as the oil price has fallen. We expect this elevated yield and the volatility in the sector to continue as long as the oil price remains in flux. US companies have generally used the past year of positive earnings and revenue growth to manage their debt better. Leverage has remained stable at 4.1x, while interest coverage has risen to 4.6x (bottom right chart). This means companies are better able to service and pay off their debt given current earnings. But this isn t true across all industry groups: the energy and metal & mining groups have seen falls in earnings of 17 and 29, respectively. That compares with 25 growth, on average, in food & beverages and automotive. US high yield bonds GTM UK 61 US high yield spreads and defaults 15 Asset class Average since 1986 Latest HY spread bps (rhs) HY defaults (lhs) Federal funds rate (lhs) 5 '86 '88 '9 '92 '94 '96 '98 ' '2 '4 '6 '8 '1 '12 '14 2, bps 1,5 1, 5 The difference between spreads for high yield energy issuers and the broad index ex-energy is 7 bps. Fixed income US high yield spreads 1,4 bps US high yield energy US high yield ex-energy 1, US high yield leverage measures Leverage* and interest coverage ratio** 5.5 x Leverage Interest coverage ratio '13 '14 '15 ' '8 '9 '1 '11 '12 '13 '14 '15 61 Source: (Top) Credit Suisse, J.P. Morgan Economic Research, US Treasury, J.P. Morgan Asset Management. Default rates are defined as the par value percentage of the total market trading at or below 5 of par value and include any Chapter 11 filing, prepackaged filing or missed interest payments. (Bottom left) ) J.P. Morgan Economic Research, J.P. Morgan Asset Management. (Bottom right) J.P. Morgan Economic Research, J.P. Morgan Asset Management. *Leverage is net debt to earnings before interest, tax, depreciation and amortisation (EBITDA). **Interest coverage ratio is EBITDA over interest expense. Guide to the Markets - UK. Data as of 31 December 215. Source: Guide to the Markets UK, page 61 8 QUARTERLY PERSPECTIVES Q1 216

9 Euro-denominated high yield offer less choice and depth to investors, but potentially healthier fundamentals European high yield is a smaller market than the US, and much more sheltered from energy woes (only 4 of the index is energy companies, compared to 15 in the US). Thus yields in Europe have not risen as much as in the US and the default rate has also remained low. But it is more than just a lack of energy companies in the European market that makes the asset class worth considering. Both revenue and earnings for European high yield issuers are at last accelerating, allowing them to better service their debts. The European high yield market is still a fraction of the size of the US, but higher issuance has expanded the potential universe for investors, with highly rated BB and B paper accounting for almost all of this expansion. European high yield bonds GTM UK 62 INVESTMENT IMPLICATIONS High yield bonds should be considered now more than ever, given ultra low government bond yields. US and European high yield offer healthy income, but there are risks that go along with those higher yields. Company and sector selection is important at a time of heightened volatility and concerns about liquidity. High yield companies have been benefiting from the economic recovery in both US and Europe, but investors need to examine company balance sheets to find the companies best able to service their debt as the cycle matures. European high yield: Spread to worst and default rates 2 Default rate 22: Asset class Average Latest HY spread - bps (rhs) HY defaults (lhs) ,5 bps 2, 1,5 1, 5 Fixed income '98 '99 ' '1 '2 '3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 '15 European high yield issuance by credit rating billions 9 Unrated CCC 6 B BB 215: 75.9bn European high yield earnings and revenue growth Change year on year 4 EBITDA* Revenue 2 Earnings and revenue growth rates are at a post-crisis peak '3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 '15 '8 '9 '1 '11 '12 '13 '14 '15 Source: (Top) BofA/Merrill Lynch, Credit Suisse, FactSet, J.P. Morgan Asset Management. (Bottom left) FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. (Bottom right) J.P. Morgan Economic Research, J.P. Morgan Asset Management. *EBITDA is earnings before interest, tax, depreciation and amortisation. Spread to worst is BofA/Merrill Lynch Euro Non-Financial High Yield Constrained.Guide to the Markets - UK. Data as of 31 December Source: Guide to the Markets UK, page 62 J.P. MORGAN ASSET MANAGEMENT 9

10 4 UK equities: Worth a closer look? The UK economy is picking up speed The UK has been one of the best-performing developed market economies over the last four years, with an average growth rate of 2.1 year on year (y/y) well above the G7 average of 1.5 y/y. Strong UK economic growth has helped drive down UK unemployment and push consumer confidence to near record highs (bottom right chart). Strong economic growth and a tighter labour market is now beginning to pay off for UK workers, with wages finally starting to rise after years of falling living standards. We are currently experiencing the longest prolonged period of real wage growth since before the financial crisis (top right chart). As consumption makes up approximately 65 of UK GDP, a healthier, more confident consumer should help drive growth in 216. UK economy UK labour market dynamics Productivity since the pre-crisis peak Productivity per worker rebased to 1 as of Q4 27 UK continuation of pre-crisis productivity trend UK US Wage growth Change year on year GTM UK 5 Nominal wage growth* Headline CPI Real wage growth '6 '8 '1 '12 '14 '16 UK unemployment rate and consumer confidence 9 Unemployment rate OVERVIEW With decent economic growth and a healthy consumer, the UK macro outlook is bright. Investors trying to play this UK economic recovery passively through the major equity markets will have been disappointed in the last three years as the FTSE All- Share has registered an annualised total return of just 7 compared to nearly 15 from the S&P 5. However, active investors have had a very different experience. In our recent paper on UK equities, A fresh take on UK equities, we take a deeper look at this trend of outperformance as well as highlighting some of the unique characteristics of the UK equity market and provide some food for thought for investors. UK productivity declined steeply after the financial crisis, but it is beginning to catch up with the US. 94 '7 '8 '9 '1 '11 '12 '13 ' Consumer confidence 5-5 '6 '8 '1 '12 '14 '16 Source: (Left) BEA, BLS, ONS, J.P. Morgan Asset Management. (Top right) FactSet, ONS, J.P. Morgan Asset Management. (Bottom right) FactSet, GFK, ONS, J.P. Morgan Asset Management. *Nominal wages include bonuses. Guide to the Markets - UK. Data as of 31 December Source: Guide to the Markets UK, page 5 1 QUARTERLY PERSPECTIVES Q1 216

11 UK fund management outperformance The favourable UK macro environment has not been reflected in the performance of the main UK benchmark indices. Both the performance of the index and the earnings have fallen over the last few years (left-hand chart), in part due to how little exposure UK mega cap firms have to the domestic economy. In addition, the significant exposure to commodity-oriented sectors has also weighed on the performance of the index. Despite the poor performance of the FTSE All-Share index in the last couple of years, many active managers in the UK equity space have been able to outperform. In fact, top-quartile UK fund managers have been able to generate an excess return of 5.8 annualised (net of fees) (bottom right chart). This represents an astonishing degree of outperformance when compared with continental Europe and the US, where the top quartile have outperformed by only 1.8 and -.3, respectively. What has driven this relationship? All that UK fund managers have needed to do to significantly outperform the benchmark is underweight the commodity-oriented sectors and overweight the small and mid cap sectors. This consensus trade has delivered strong outperformance. When the tide turns on commodities, this era of easy outperformance will come to an end and the focus will shift back to traditional drivers of outperformance: researchdriven individual stock views, portfolio construction and risk factor management. Some managers will handle the change of direction a lot better than others. INVESTMENT IMPLICATIONS The UK economic recovery has been one of the strongest among developed markets, driven forward by a healthier consumer. Investors are right to try to gain exposure to the domestic UK economic recovery. However, this is easier said than done, as UK equity indices have a significant exposure to large cap equities that source very little of their revenue from the UK. In recent years, many fund managers have outperformed the index by a wide margin, thanks to the heavy underperformance of commodity-related sectors. However, investors should be cautious of the risks that these fund managers have taken on and how quickly the tides can turn if the commodity markets were to stabilise. UK FTSE All-Share earnings and revenues GTM UK 4 FTSE All-Share earnings and performance Index level, analyst estimates of the next 12 months of earnings 32 FTSE All-Share EPS FTSE All-Share index level 4, Average percentage of revenue sourced from the UK 6 Concentration of largest quartile of stocks** UK 88 4 US 7 Europe ,5 2 Equities 24 3, 2,5 4 FTSE Small Cap FTSE 25* FTSE All-Share FTSE 1 Top quartile excess performance by region 8 UK Europe 6 US UK equity markets have a relatively high concentration of large cap companies compared to the US and Europe. 2 2, 2-2 '8 '9 '1 '11 '12 '13 '14 '15 '16 '98 ' '2 '4 '6 '8 '1 '12 '14 Source: (Left) FactSet, FTSE, J.P. Morgan Asset Management. (Top right) Citi, J.P. Morgan Asset Management. (Bottom right) Lipper, Morningstar, J.P. Morgan Asset Management. *Excluding Investment Trusts. **As a percentage of overall market capitalisation. EPS is earnings per share. Guide to the Markets - UK. Data as of 31 December Source: Guide to the Markets UK, page 4 J.P. MORGAN ASSET MANAGEMENT 11

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