Investment Newsletter April 2014

By Mike DeverellInvestment Manager

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission

The Great Rotation RotationOne of the big themes from 2013 was the so-called “great rotation”.

This was supposed to be where investors finally gained confidence in the economic recovery in the West, switching out of “safe haven” government bonds like gilts and buying into equities.

This did seem to happen to some extent as the FTSE Allshare rose by 20.8% during 2013, whilst gilts fell by 3.9%. A similar pattern was seen throughout the world.

Another “rotation” also occurred with investors moving money out of emerging markets and back into more established markets. As the West finally began to recover from the financial crisis - nearly five years on - investors removed money from the higher growth but riskier emerging economies and put their money back in Western markets.

This was exacerbated by the withdrawal of quantitative easing in both the UK and the US, both so called “emergency measures” to support our ailing economies.

In 2013 the MSCI World index of established markets was up 24.3%, whilst the MSCI Emerging Markets index was down -4.5%, a quite startling differential.

Looking at returns over the early part of 2014 however, we now start to ask the question whether the great rotation has rotated once more?

Year to date, the gilt index is up 3.2% whilst the FTSE Allshare is down 0.1% and MSCI World down 1.1% (at 10 April). However, emerging markets have recovered somewhat after a shaky start and the MSCI Emerging Markets index is up around 1.1%. In fact the emerging market index is up 8.2% since 14 March after starting the year in negative territory.

As the economy picks up, we believe this should cause inflation to rise again. In our view you would still experience a negative return in real terms over 10 years.

Interest rates will probably be increasing in the next 12 months or so. Whilst we believe that rates will only go up slowly thereafter, rising rates tend to lead to falling capital values in bonds such as gilts.

So what of the other part of the “rotation”, from established stockmarkets to emerging ones? Is this the start of a new trend or a temporary blip?

Investment Newsletter April 2014

So is this part of a fundamental shift and a trend that is likely to continue? In our view the answer is both yes and no!

Looking at the first part of the equation, government bonds such as UK gilts, we think the answer is probably no. A 10 year gilt now yields 2.62% pa. In other words, if you tied your money up for 10 years and lent it to the government for this fixed period, you would receive only 2.62% pa. This is only marginally above RPI inflation, which is 2.6% at present, the lowest it has been since 2009. That is a real return of 0.02% pa at a period where inflation is lower than at any time since the financial crisis.

As many of you will know, for some time we have been saying that the underperformance of emerging markets cannot continue. This is especially so now after such a difficult period, which has led many markets looking “cheap” based on company earnings, both relative to their own histories and to established markets.

Underperformance had been caused by several factors, notably the withdrawal of quantitative easing in the US and fears of a slowdown in China. The impact of the tapering of US QE is too boring and complicated to go in to much detail here! We have covered some of this before, but suffice to say it has caused investors to move money back to the US from emerging markets. This has led to falling currencies as well as stockmarkets in many emerging economies.

The Great Rotation Rotationcont’d

Emerging Returns

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission

We believe this effect might now be accounted for in market prices, although it is difficult to tell.

Slowing growth in China has a more obvious impact; however it is something we think investors are overly worried about. China has grown at, give or take, 10% pa over much of the last decade or so, slowing recently to 7.5% in 2013. China is again targeting 7.5% in 2014.

China cannot continue growing at the same pace as it has done. This has been during a period when it has been rapidly industrialising, spending a lot of money on infrastructure. China now needs to rebalance their economy more towards the consumer which will lead to lower but more sustainable growth in the long term. They are introducing reforms to that effect which should also boost competition in the market.

In addition, there has been a big increase in credit in China over the past few years, and this needs to be curbed or risk a “credit crunch” type scenario. Investors are worried about China trying to curb credit growth and rebalance their economy at the same time.

In our view, growth will have to slow but this should be a good thing in the long term as it should fall to more sustainable levels. China is also much better placed to deal with the possible fall out from a so-called credit bubble than the West was, as evidenced by its US$4 trillion of foreign exchange reserves.

In the end, when you invest in the Chinese stockmarket it shouldn’t matter whether the economy is seeing 6% or 10% growth. What matters is whether companies are able to grow their earnings or if earnings are likely to fall.

Investment Newsletter April 2014

We don’t believe earnings are generally likely to fall in China or the wider emerging markets, at least not to any great degree. However, even if they do, emerging market and Chinese equities in particular are cheap enough to soften the impact. For example, the Chinese market has a price/earnings ratio of around 6.3 times. A typical company is valued at three times its annual earnings.

By contrast, the US market has a price/earning ratio of over 19. That is more than three times the valuation of the Chinese market. We think that is a big enough discount to more than compensate for the extra risk of investing in China.

Emerging markets is a small part of most portfolios and the underperformance last year therefore did not really hurt returns. In fact, it was generally more than offset by outperformance in other areas, such as the UK funds we selected which typically returned far in excess of the FTSE.

However, one UK fund which did not do so well was M&G Recovery, a long standing member of the portfolio which, until recently, had beaten the market almost every year. However, it has underperformed of late partly due to its exposure to commodity stocks.

We don’t see commodity stocks doing especially well this year either and so we have now switched out of this fund for those discretionary clients that hold it. We have typically put three quarters of this into a fund with a similar style, the Miton UK Value Opportunities, whilst the remaining quarter topped up our holding in the Artemis Special Situations fund.

As always, we will continue to make small adjustments to your portfolio to adapt to market conditions.

Emerging Returnscont’d

Other Changes

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission

However, the recent reforms may benefit some companies in China at the expense of others. We have therefore switched out of the China tracker fund we held in portfolios previously, into an actively managed fund, the Invesco Hong Kong and China fund. We believe this may offer the potential for higher performance as the manager can pick and choose between those companies which will do better going forward and exclude those that will not do so well in the new China.

General Economic OverviewThe Global economy is continuing to pick up led by the UK and the US. However, emerging market growth remains weak in certain regions.

Inflation has fallen back and CPI is now below the Bank of England’s 2% target. However, RPI remains relatively high. Interest rates are likely to go up in perhaps 12 months’ time but will do so slowly and settle at levels significantly below the typical 5% level prior to the financial crisis.

Equity Markets

We have maintained our neutral outlook on equities from last month, meaning an expectation of around 10% pa over the next 18 months. We prefer UK, Japan and Emerging Markets where valuations look more attractive than the US and Europe.

Fixed Interest

Corporate and government bonds have had a pretty good start to 2014 after a poor 2013. We believe that returns are likely to remain relatively steady over the next 12 months and believe we could see perhaps 4% to 5% from our funds. We expect some small losses in gilts.

Commercial Property

Property returns continue to impress with capital growth supporting rental yields. The improving economy should provide support for returns. We firmly expect returns to exceed our long term 7% pa assumption over the next 18 months.

Cash

With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.

Balanced Asset Allocation

For a typical balanced portfolio we are underweight fixed interest and overweight property, we are neutral positioned towards equity and alternative equity. A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for commercial property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5 means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.

These represent Equilibrium’s collective views. There are no guarantees. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.

=

-2

+2

-5

Asset class key+ positive - negative = neutral (normal behaviour)

+5 strongly positive-5 strongly negative

Score

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission

Asset Class

Market Views April 2014