Quarterly investment outlook Five key issues shaping current investment strategy First quarter 217
Five key issues shaping current investment strategy First quarter 217 Page 2 Five key issues shaping current investment strategy 1. Valuations and risk Equities are buoyant despite rising political uncertainty 3 2. Fixed income The road ahead for bond markets 4 3. Emerging markets The conundrum faced by investors 5 4. Real estate trends UK commercial property has been resilient 6 5. The green revolution Driving towards an electric future 7
Five key issues shaping current investment strategy First quarter 217 Page 3 1. Valuations and risk Equities are buoyant despite rising political uncertainty investors appear to be giving Donald Trump the benefit of the doubt, emphasising the positive impact of his proposed fiscal stimulus measures rather than any potentially damaging trade policies he may enact. We believe this is a leap of faith. stock markets are mechanisms through which investors discount future company earnings. The discount rate is the government bond yield plus the equity risk premium (ERP). when the outlook becomes less certain, the risks to future earnings increase. As a result, investors tend to apply a higher ERP to provide a cushion against the associated uncertainty (figure 1). we believe today s ERP may not be high enough to compensate investors adequately for the political uncertainty ahead (figure 2). As a result, we are cautious on global equities heading into 217. ahead of key elections this year, equity valuations in the eurozone are not cheap compared with their longterm average. In contrast, investors have started to penalise UK-focused stocks as Brexit negotiations approach. Assessing the equity risk premium 7% 6% 5% 4% 3% 2% 1% What if 1% % -1% -2% -3% US market implied ERP ERP falls back to 214 average Changes from current level of S&P 5 ERP falls back to 214 average; YC shifts up.5% +/- 1sd from historical mean ERP rises to 211 average assumes Trump tax break uplift to EPS % 1985 1995 25 215 ERP rises to 211 average and terminal growth revised down Figure 1 If Mr Trump is able to introduce tax breaks for US companies, the result could be a substantial shortterm boost to earnings. Source: Datastream, Rathbones Figure 2 This chart shows how changes to the ERP could affect the S&P 5 Index while such extreme outcomes are unlikely, it suggests valuations are becoming stretched N.B. YC is yield curve. Source: Datastream, Rathbones
Five key issues shaping current investment strategy First quarter 217 Page 4 2. Fixed income The road ahead for bond markets in recent years, economic growth has been lacklustre and inflation lower than expected. Bonds have defied expectations and at times delivered returns that have exceeded equities, helped by quantitative easing (QE) and other central bank actions. with government bond yields still low, they are likely to underperform in many scenarios. Little other than a recession would see them earning positive returns, and we see little chance of a downturn in 217. inflation expectations have been increasing (figure 3). This tends to be bad for government bonds, but high yield credit and inflation-linked bonds can perform well in an inflationary environment. despite hawkish guidance from the Fed, we believe a Goldilocks scenario is most likely where the economy is neither too hot nor too cold i.e. growth is moderate and inflation rises at a manageable rate, so interest rates only rise gradually (figure 4). on balance, we believe investment grade credit offers the best risk-reward profile heading into 217 with high yield bonds a close (but riskier) second. Inflation expectations are increasing Forecast CPI (annual change) 3.% 2.5% 2.% 1.5% 1.%.5%.% 214 215 216 217 US interest rates are forecast to rise gradually Fed Dots - Weighted Average 4 3 2 1 215 216 217 218 219 Figure 3 The outlook is for inflation to pick up throughout 217 and possibly break through the Bank of England s 2% target. Source: Bloomberg, Rathbones. Figure 4 The dot plot displays the interest rate expectations of Federal Reserve policymakers. Their projections suggest a slow increase in interest rates over coming years. Source: Federal Reserve, Bloomberg and Rathbones.
China Taiwan South Korea Philippines Mexico Turkey Thailand Pakistan India Malaysia South Africa Indonesia Brazil Russia Colombia Peru Chile Nigeria Venezuela Five key issues shaping current investment strategy First quarter 217 Page 5 3. Emerging markets The conundrum faced by investors emerging market (EM) equities reacted negatively to Mr Trump s election victory. Most have recovered since, but have still lagged developed markets considerably. Their currencies have also suffered. the Trump presidency could harm EMs in three ways: increased protectionism; changing patterns of global capital flows; and the impact of a strong dollar on EM funding costs and commodity prices. we have ranked 19 EMs in order of vulnerability to these factors (figure 5). But if Mr Trump abandons protectionism and implements an infrastructure programme, EM investments should perform well. EM equities started to look more attractive last year and were outperforming developed markets. Fed tightening may appear to be a risk, but they have outperformed developed markets through the past three tightening cycles (figure 6). investors face a conundrum. Should they continue to invest in EMs because the fundamental case looks strong? Or sell to protect themselves against the risk that Mr Trump pursues policies which are negative for EM growth? Vulnerability to the US Manufacturer exports, % of total merchandise exports 1% 8% 6% 4% 2% % EM equities and currencies Fed rate tightening MSCI EM relative to MSCI World, local currency EM currency index, weights = MSCI EM equity (right) 6 2 5 15 4 3 1 2 5 1 1988 1992 1996 2 24 28 212 216 Figure 5 We have ranked 19 EMs in order of vulnerability to the three main ways in which the Trump presidency could affect these countries. Source: Winterfloods, Rathbones Figure 6 EM equities have outperformed developed markets through the past three Fed tightening cycles. Source: Datastream, Rathbones
Five key issues shaping current investment strategy First quarter 217 Page 6 4. Real estate trends UK commercial property has been resilient UK commercial property values grew by 2.4% in the first half of 216, but gave up these gains immediately after the EU referendum total returns were more or less flat at the end of Q3 (figure 7). however, activity recovered in the third quarter and the sector has been more resilient than many expected. However, Brexit uncertainty is affecting business sentiment and remains a key risk. some open-ended funds suspended redemptions after the referendum, but have since reopened. Managers are still disclosing the sizes of the discounts at which they sold assets to meet redemption requests. at the sector level, offices have been most affected by the Brexit result (figure 8). In particular, central London property is suffering from uncertainty over whether international firms will relocate. high-street retail and shopping centres have continued their downward trend as consumers shift online. This has underpinned demand for out-oftown warehouses and logistics centres. UK commercial property IPD Index 15 12 9 6 3 1996 2 24 28 212 216 UK commercial property capital growth by sector* Offices Industrial Retail 115 11 15 1 95 Jan 215 Jul 215 Jan 216 Jul 216 Figure 7 The IPD index shows UK commercial property markets have recovered since the Brexit vote but remain more or less unchanged over the whole of 216. Source: MSCI/IPD, Rathbones Figure 8 Offices have been most impacted by the fallout from the EU referendum, while retail has continued its long-term downward trend as shoppers move online. *Rebased to 1 from January 215. Source: MSCI/IPD, Rathbones
Five key issues shaping current investment strategy First quarter 217 Page 7 5. The green revolution Driving towards an electric future electric vehicles (EVs) are closer to disrupting the internal combustion engine s dominance following recent technological innovations, which have reduced costs. However, purchase prices are still a barrier. other factors also stand in the way of mass adoption, including concerns about long journeys as well as recharging infrastructure and times. battery prices are falling (figure 9) and improving in range, acceleration and charging times. General Motors and Tesla are planning to launch models with ranges of 2 to 3 miles for around 26,. to reduce harmful emissions, governments around the world are implementing targets to move towards electrification, which has increased the popularity of EVs (figure 1). the implications of the expansion of EVs are far reaching, including the impact on oil prices, demand for lithium for use in batteries as well as the business models of existing car manufacturers. Drivers in towns and cities may decide to use Uber and car clubs like Zipcar, rather than continue private ownership. Battery costs are falling Average EV lithium-ion battery prices ($/kwh) 1,2 1, 8 6 4 2 21 211 212 213 214 215 Worldwide new registrations for electric vehicles Battery EV Plug-in hybrid EV 6, 5, 4, 3, 2, 1, 21 211 212 213 214 215 Figure 9 This chart shows the average prices of battery EV and plug-in hybrid EV batteries, including both cell and battery pack costs. Source: Bloomberg New Energy Finance annual battery price survey, Rathbones Figure 1 This chart shows battery and plugin hybrid EV new registrations from 21 to 215. Source: International Energy Agency 'Global EV outlook 216: Beyond one million electric cars', Rathbones
Asset classes First quarter 217 Page 8 Important information The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance should not be seen as an indication of future performance. Changes in rates of exchange between currencies may cause the value of investments to decrease or increase. Information valid at 31 December 216. Tax regimes, bases and reliefs may change in the future. Rathbone Brothers Plc is independently owned, is the sole shareholder in each of its subsidiary businesses and is listed on the London Stock Exchange. Issued and approved by Rathbone Investment Management Limited, which is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Registered office: Port of Liverpool Building, Pier Head, Liverpool, L3 1NW, Registered in England No. 1448919. Rathbones and Rathbone Greenbank Investments are trading names of Rathbone Investment Management Limited. Rathbone Unit Trust Management Limited is authorised and regulated by the Financial Conduct Authority. Registered office: 1 Curzon Street, London W1J 5FB (changing in early 217 to: 8 Finsbury Circus, London EC2M 7AZ), Registered in England No. 2376568. Rathbone Trust Company Limited is authorised and regulated by the Solicitors Regulation Authority. Rathbone Investment Management International is the registered business name of Rathbone Investment Management International Limited which is regulated by the Jersey Financial Services Commission. Registered Office: 26 Esplanade, St Helier, Jersey JE1 2RB. Company Registration No. 553. Rathbone Investment Management International Limited is not authorised or regulated by the Financial Conduct Authority or the Prudential Regulation Authority in the UK. Rathbone Investment Management International Limited is not subject to the provisions of the UK Financial Services and Markets Act 2 and the Financial Services Act 212; and, investors entering into investment agreements with Rathbone Investment Management International Limited will not have the protections afforded by those Acts or the rules and regulations made under them, including the UK Financial Services Compensation Scheme. This document is not intended as an offer or solicitation for the purchase or sale of any financial instrument by Rathbone Investment Management International Limited. No part of this document may be reproduced in any manner without prior permission. 217 Rathbone Brothers Plc. All rights reserved.