Market Commentary November 2015 The Federal Reserve will, most likely, raise interest rates in December The last time rates were set up was in 2006. It could lead to higher volatility in the short term Returns have been disappointing, but better if we look at them excluding energy stocks We keep our neutral equity weight in our portfolios 1
Weak Results, but no crisis One important reason why we've been careful with equities since April this year is that we have been skeptical to developments in company results. Much of the rise in stock prices in 2013, 2014 and the first quarter of 2015, was linked to multiples expanding (increased pricing) and little was linked to the growth in company results. The timing of an interest rate increase in the United States have moved closer. A further market rise must therefore be based on improved results. Rising corporate earnings, must at least compensate for increased return on stocks, when interest rates go up. Growth in company results in 2015 has been weak. For example, companies in the US market struggled to show growth. The earnings season for Q3, for S&P500, is now virtually completed. Aggregate growth in net profit for the companies is minus 2 percent measured against its level one year ago. One should not forget in this context that during the past couple of years there has been a sharp drop in oil prices and a significant rise in the dollar in relation to other currencies. If we correct for the negative contribution from the energy sector, then the growth in company results, for the S & P 500, is at 9 percent over the past 12 months. This is no crisis. Corresponding figures for all developed markets measured by the MSCI World is minus 6 percent including the energy sector and plus 3 percent without it. Thus somewhat weaker than in the US. At the same time, we observe that the price of the stock exchanges this year have also been weak. For a Norwegian kroner investor it is easy to believe that exchanges abroad have increased a lot, but this year s returns are due mainly to favorable exchange rate movements - stronger dollar against the Norwegian kroner. Both the World Index and US equities measured in dollars are only slightly positive in the past year. Assuming that the oil price (and possibly also other commodity prices) have bottomed out and other factors remain unchanged, then company results could grow by at least 5 percent in 2016. In a world where interest rates are close to zero, investing in shares becomes an attractive investment alternative. It is a mistake to be too negative on equities now and we retain our neutral weight. If the growth outlook for 2016 improves then an overweight becomes a realistic possibility. The Figure shows the development in results per stock for companies that make up the American S&P 500 index. The time series is rebased to 100 the 1st of Jan 2013. The Green line shows that the result development for the whole market is 110. Results have in other words grown with 10% the last 3 years. The last 12 months the results have fallen with 2 percent. This is due t the strong fall of the energy sector (orange line) where results are 60% lower. If we measure the development ex energy then results have risen by 9 percent (grey line). 2
Risk Weights The risk weight scale takes into account the most important market drivers. It forms the basis to our recommendation to take more or less risk than the strategic portfolio, as indicated by the direction in which the risk weight scales tip. Liquidity Overweight equities Global Growth Valuations Momentum Hard landing in China Debt fears in emerging markets Underweight Equities Growth: The growth rate of the world economy has stabilized at 3 per cent. Macro statistics in November has been neutral to slightly positive, partly as a result of news out of China being better than expected. Global company sentiment rose slightly from the previous survey, while the OECD leading indicators continue to point to a somewhat weaker growth ahead. Private consumption in rich countries has been one of the few positive surprises this year, and the trend in unemployment and wages gives grounds to believe that consumption can be sustained going forward. If developments in China and commodity prices stabilize, it is therefore possible to become a little more optimistic for growth in 2016, but it is too early to conclude this now. Liquidity: Monetary policy is still loose, and is now our only factor in the green box above on risk scale. Central bank balance sheets have increased by over 300 billion dollars in the summer. Amongst others has Sweden s Riksbank increased its program of quantitative easing significantly. Interest rates were cut in China, India and Norway. The European Central Bank (ECB), will increases its quantitative easing and the odds are low that it also cuts interest rates further into negative territory at the meeting in December. The likelihood that the Federal Reserve raises interest rates the 16/12 is great and has helped the dollar rise to new heights. A rate hike itself is no big news. What is important is what signals the Fed gives for its future rate policy. We do not think it is very likely, but if the central bank says it will raise interest rates faster than market expectations this may lead to a further strengthening of the dollar. This in turn would then lead to a new round of falling commodity prices and emerging economies stock markets. Sentiment: The markets have risen steadily since the correction in August / September, and volatility has fallen. Sentiment among market participants we judge to be neutral - meaning that this factor does not provide a contrarian buy or sell signal as of now. Valuation: Following the recent widening of credit spreads, we consider Norwegian investment grade bonds as fair priced. The margin on high yield is far above its historical average. Equity markets appear to be fair priced when we look at the price relative to book value and relative to cyclically adjusted earnings returns. Norwegian equities appear somewhat expensive when we look at their price in relation to expected returns next year. For global equities, it is possible to argue that they are actually cheaper if we adjust the price / earnings multiples for the large cash holdings. This applies particularly for stocks in the technology and healthcare industries. 3
Recommendations The matrix shows recommended tactical deviations from a strategic portfolio divided into several asset classes. The deviations from the strategic portfolio should not constitute more than 5 to 15 per cent of the total portfolio to prevent excessive tactical risk taking. The scale must be seen in the context of risk willingness and the investor s investment horizon. Overweight Neutral Underweight Asset Classes Corporate Bonds Equities Money Market Government Bonds Equity Regions Japan Europe Nordics Global Emerging Markets Norway USA Equity sectors Technology, Financials, Consumer Discretionary Health Care Industrials, Utilities Energy, Materials Telecoms Consumer staples We made no changes in our market view for December. Corporate Bonds retained on overweight. Our biggest position is in Norwegian investment grade via DNB Obligasjon Fund. Widening in credit spreads has resulted in the corporate bond yields have risen to levels we find attractive. In addition, we maintain the duration of the portfolio as we believe in more interest rate cuts from Norges Bank. Those who do not want this interest rate risk may place capital in our money market funds, where yields are currently around 1.7 per cent. It is an attractive and less risky alternative to bank deposits. We are awaiting with increasing our weight to High Yield bonds. The credit margins in relation to issues with higher quality are at historically high levels. We think High Yield is a good long term investment, but we are still very uncertain whether we have seen the bottom in this space. Equities were held at neutral vs the benchmark. The growth picture is weaker than we would like and liquidity is tighter at the margins. The turmoil in emerging economies and a new round of falling commodity prices creates deflationary tendencies. The companies' pricing power is generally weak and revenue is falling in many sectors. The uncertainty surrounding the companies ability to grow future profits have increased, while the risk premium has shrunk as a result of market appreciation in October. Our portfolio exposure to equities remains unchanged. Our preferred regions are Europe and Japan and our preferred global equity sectors are the cyclical sectors of finance, consumer discretionary & technology, as well as the more defensive healthcare sector. It is in these regions and sectors we find the best earnings momentum and a price that is reasonable in relation to this. 4
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