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Schroders
Investment Outlooks 2016
Welcome to
Schroders Investment Outlooks 2016
Schroders Investment Outlooks 2016
brings together the views of Schroders’
global experts as they share their thoughts
on the coming 12 months.
We hope that these outlooks will provide
an informative snapshot of what to expect
in 2016 and beyond.
For more articles, please visit
www.schroderstalkingpoint.com
2
Contents
01
2016: Asian ex Japan Equities
Robin Parbrook
Head of Asian ex Japan Equities
02
2016: Asian Fixed Income
Rajeev De Mello
Head of Asian Fixed Income
03
2016: Business Cycle (Europe ex UK Equities)
James Sym
Fund Manager, European Equities
James Rutland
Research Analyst, European Equities
04
05
06
07
08
2016: Business Cycle (Pan-European Equities)
Steve Cordell
Fund Manager, European Equities
2016: Business Cycle (UK Equities)
Matt Hudson
Head of Business Cycle
2016: Commodities
Geoff Blanning
Head of Commodities
2016: Convertible Bonds
Dr. Martin Kuehle
Investment Director, Convertible Bonds
4
13
2016: Global Corporate Bonds
Rick Rezek
Co-Fund Manager, US Fixed Income
34
7
14
2016: Global Equities
Alex Tedder
Head of Global Equities
36
15
2016: Global High Yield
Wes Sparks
Lead Fund Manager, Global High Yield
38
16
2016: Global Real Estate Securities
Hugo Machin
Co-Head of Global Real Estate Securities
41
17
2016: Greater China Equities
Louisa Lo
Head of Greater China Equities
43
18
2016: Japanese Equities
Shogo Maeda
Head of Japanese Equities
47
19
2016: Multi-Asset
Johanna Kyrklund
Head of Multi-Asset Investments
49
20
2016: Multi-Asset Income
Aymeric Forest
Head of Multi-Asset Investments Europe
51
21
2016: Multi-Manager
Marcus Brookes
Head of Multi-Manager
Robin McDonald
Fund Manager
53
57
10
12
14
17
20
2016: Emerging Markets Debt Absolute Return
Abdallah Guezour
Head of Emerging Markets Debt Absolute Return
22
09
2016: Emerging Markets Debt Relative
James Barrineau
Co-Head of Emerging Markets Debt Relative
26
10
2016: Emerging Market Equities
Allan Conway
Head of Emerging Market Equities
11
2016: European Equities
Rory Bateman
Head of UK and European Equities
12
2016: Global Bonds
Bob Jolly
Head of Global Macro
28
22
2016: UK Commercial Real Estate
Duncan Owen
Head of Real Estate
30
23
2016: US Equities
Matthew Ward
Portfolio Manager, US Equities
59
32
24
2016: US Multi-Sector Fixed Income
Andrew Chorlton
Head of US Multi-Sector Fixed Income
61
3
01
Outlook 2016:
Asian ex Japan Equities
Robin Parbrook, Head of Asian ex Japan Equities
Looking back on 2015, Asian stockmarkets have had a
challenging year as slowing global and emerging market
growth, particularly in China, have weighed on investor
sentiment. However, in retrospect, the beginning of 2015
bore striking similarities to the previous year when brokers
were also recommending clients buy into China. In 2015, the
advice came at the start of a clearly unsustainable run-up in
Chinese A-share markets. We look with interest to see what
recommendations will be for 2016.
– Demographics, deflation and
disruption are challenges
to returns in Asia.
– Valuations are not as cheap as
they look on paper, with many
quality domestic and consumer
names we like still expensive.
– Making money in Asia has always
been about investing in good
quality companies not countries or
sectors. But we can still find enough
investment ideas to fill our portfolios.
In our view, the key is to ignore the market noise in Asia. Our warnings of a bubble driven
by margin lending were vindicated when stock prices duly collapsed in the middle of
the year. This further reinforced our view that investing in the region requires seeking
out quality companies that provide consistent shareholders returns and which trade at
reasonable valuations.
Asia continues to offer significant structural advantages in terms of growth potential
over the longer term, but there are short-term headwinds that need to be factored into
investment decision making. Asian companies are faced with three key global trends
which will impact the landscape: demographics, deflation and disruption.
Disruption in Asia
The Volkswagen (VW) diesel emissions scandal that was uncovered in September
may at first glance look like an issue that only impacts European car manufacturers, but
we believe this is part of a wider global trend where watershed moments for industries
can be the ringing of dire warnings for certain companies. It is also a prime example of
an event where “disruptors” can benefit from the downfall of industry incumbents. In the
case of autos, the VW scandal has the potential to accelerate the long-term shift of the
“old” car industry, dominated by petrol and diesel, to one where electric vehicles and
hybrids dominate.
In a world where technological change is moving increasingly fast, this shift is just as
applicable in Asia as it is in Europe. Long-term winners could include Taiwanese and
Hong Kong technology companies (as electric cars are electronic products) while losers
may end up being the current original equipment manufacturers (OEMs) that provide
autos with parts, and oil companies.
If our predictions end up being correct, then OEMs and oil companies could turn out
to be value traps – much like Asian department stores and supermarkets that have
seen their market shares, and profits, eroded by online competitors. The point is that
anticipating this disruption will be key to long-term returns and no industry in the region
will be immune from it.
4
Outlook 2016: Asian ex Japan Equities
Surely Asian markets are cheap?
The main question we keep getting asked by clients is “are Asian markets cheap?”.
Our response remains “not as cheap as you probably think”. This has been treated with
some incredulity given the disappointing performance of Asian markets this year and
indeed for the last five years, where returns on the main MSCI All Country Asia Pacific ex
Japan index have effectively been zero in US dollar terms. When a lot of the banks and
commodity stocks, of questionable value, are removed from indices, the resulting price
multiples are in line with long-term averages (see charts below). Furthermore, many of the
quality consumer and domestic names that we are really keen on are still expensive.
Chart 1: Stockmarkets look cheap on paper
MSCI Asia Pac ex JP – 12m Fwd PE (x)
20
Robin Parbrook,
Head of Asian ex Japan Equities
Robin Parbrook has 24 years’
experience covering Asia, all of it
with Schroders. Robin is currently
the Head of Asia ex Japan Equities
and also a Regional and Alternatives
fund manager, based in Hong Kong.
In 2008 he moved to Edinburgh to
focus on managing Asian investment
strategies with a focus on absolute
returns, and returned to Hong
Kong in August 2010 to continue to
manage Asian Total Return as well
as other Asian equity strategies.
In his career he has successfully
managed a range of Asian funds.
18
+2SD, 16.9
16
+1SD, 14.9
14
Avg, 12.8
12
-1SD, 10.8
10
-2SD, 8.8
8
6
Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14 15
Source: Datastream, MSCI, CLSA, 16 October 2015.
Chart 2: But unfortunately not that cheap when questionable banks and commodity
stocks are removed
MSCI Asia Pac ex JP ex JP ex financials and materials – 12m Fwd PE (x)
20
18
+2SD, 16.2
16
+1SD, 14.9
14
Avg, 13.0
12
-1SD, 11.4
10
-2SD, 9.8
8
Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
Source: Datastream, MSCI, CLSA, 16 October 2015.
The problem remains that a combination of overinvestment, excessive leverage, weak end
demand and major technological disruption has, and is still, causing significant headwinds
for Asian corporate earnings. This has caused a major compression in return on equity
(ROE) in the region.
To get a sustained recovery in Asian stockmarkets we are going to need better earnings
and returns on invested capital. For this we are going to have to see a return of inflation
and economic growth, and some creative destruction of excess capacity.
5
Outlook 2016: Asian ex Japan Equities
“Our preferred areas for
investment are companies
with strong cashflows and,
in this low earnings-growth
environment, low
cost producers that
also have a flexible
cost base.”
Where are the opportunities?
We continue to be relatively cautious on the Asian equity outlook as we head into 2016.
We can still find enough ideas to remain close to fully invested, however, clients should
be reasonable about likely returns given rerating potential is low. Our caution stems from
our view that deflationary forces and the sluggish global economy are headwinds for
Asian stockmarkets. Deflation is also not good if you have excessive amounts of debt
– significant leverage have been added since the Global Financial Crisis, particularly in
the corporate sector in Greater China. We do not see Asian stockmarkets enjoying a
deflationary boom as sluggish investment and consumption mean return on invested
capital (ROIC) is likely to remain under pressure. Asian stockmarket returns have been
disappointing as too many companies focus on growth rather than ROIC.
We can find quality investment opportunities in the region but it is difficult and involves
ignoring large parts of the market index or “beta”. Our preferred areas for investment are
companies with strong cashflows and, in this low earnings growth environment, low cost
producers that also have a flexible cost base. We continue to like companies that are able
to tap into the growing trend of urbanisation and the rise of the middles class.
The views and opinions contained herein are those of Robin Parbrook, Head of Asia ex Japan Equities, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy
or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and
investors may not get back the amounts originally invested.
6
02
Outlook 2016:
Asian Fixed Income
Rajeev De Mello, Head of Asian Fixed Income
The coming year will lay the foundation for attractive entry
points to add risk in Asian bond markets, particularly once
the US Federal Reserve (Fed) signals its trajectory for
interest rate hikes.
News in 2015 was, and still is, very much dominated by the growth slowdown in China
and the collapse in oil and commodity prices. The collapse has been driven to a large
extent by a combination of oversupply as well as the moderation in Chinese demand.
Furthermore, relatively larger debt loads in certain emerging markets, when compared to
developed markets, and mixed signals from the major G3 central banking policymakers,
have unsettled investors.
– The best opportunities in 2016 are
likely to be found in sectors that
stand to benefit the most from a
slow growth environment.
– Lower oil and commodities prices
should continue to support Asian
countries, on the whole.
– History tells us that once the US
Federal Reserve’s timetable for rate
hikes has been priced by the markets,
emerging markets tend to perform.
Against this backdrop, market participants have not been able to make up their minds.
The uncertainty centres around five positive developments:
1. Chinese reform programmes and policymakers’ concerted push towards
economic growth dependence on services rather than manufacturing
Firstly, China wants to avoid the “middle income trap”, whereby a country does not reform
its economy after having grown rapidly, and instead gets stuck in activities that stop it
from achieving wealth comparable to an advanced country. For this reason, Chinese
policymakers have engaged in a significant push towards moving the economy away from
being the “factory of the world” towards one that focuses on moving up the value chain
towards more high-tech, value-added services – in a similar vein to the transition of other
Asian countries such as Singapore and South Korea. Providing services to its increasingly
affluent consumer and the rest of the world is the long-term goal and should result in
higher revenue generation, further development and enhanced wealth creation.
This ties in neatly to debt. As most investors are aware, China has a debt problem and,
by some counts, has the third-highest debt burden in the emerging world behind Hungary
and Malaysia – if you ignore the financial sector – at over 200% of GDP. Although the
desire to avoid the middle income trap can partially explain the willingness to take on
debt, Chinese authorities have recognised the drawbacks of excessive borrowing and
are engaged in deleveraging through reforms of central and local government finances,
dealing with debt in state-owned enterprises (SOEs) and the private sector, and pulling
the plug on leveraged activities.
The short-term effect of these two reforms has historically resulted in slowing GDP growth
in other countries. China appears to be no different. What this implies is that the winners
in the old economic model will now be the losers, such as basic manufacturing industries,
steel companies and firms that consume vast amounts of commodities. The winners in
the new economy are likely to be well-run technology, healthcare and infrastructure firms,
amongst others.
7
Outlook 2016: Asian Fixed Income
For bond investors, a slower/lower growth model is a good thing. Chinese government
bonds become the choice instruments for investors looking for safety and high quality
investment grade corporate bonds benefit from investors’ de-risking bias towards safer
and less leveraged firms. In the long run, Chinese deleveraging and a push towards a
higher value-added economy point to stability and arguments for a lower risk premium.
Rajeev De Mello,
Head of Asian Fixed Income
Rajeev De Mello is Head of Asian
Fixed Income, based in Singapore.
He joined Schroders in July 2011
and previously worked at Western
Asset Management as Senior
Investment Officer, Country Head of
Singapore, and member of the Global
Investment Strategy Committee. Prior
to that, he was Head of Asian Fixed
Income at Pictet Asset Management.
Until 2005, he was Head of Fixed
Income with specific responsibilities
for European bonds and Global
bonds. He started his investment
career in 1987 and has a Bachelor
of Science in Economics (Hons),
London School of Economics and an
MBA from Georgetown University.
2. Beneficiaries of low oil and commodity prices
Lower commodity prices are proving painful for commodity-producing countries and
companies, as revenues and profits fall whilst servicing debt burdens rise. The reverse
is true for commodity consumers. The US, eurozone and Asian countries, bar Malaysia
and Indonesia, are big consumers of both oil and hard commodities. Any reduction in
the cost of these imports has a positive effect on the current accounts of commodity
importers and the wallets of commodity importing nations’ consumers. In Asia, where
growth has slowed, this is a welcome respite for economies and consumers. It also allows
governments and central banks in the region the much-needed wiggle room, in terms of
monetary/fiscal policy, to mitigate the slowdown being caused by a lower growth rate
in China.
There is also the inflation effect. Lower food, commodity and energy prices translate into
lower inflation in Asia. This implies that central banks in the region have the flexibility to cut
interest rates, which should be supportive of bond markets in the region.
3. An increasingly resurgent US economy and a eurozone that appears to
be stabilising
Asia is the manufacturing hub of the world. Even though numerous studies have
suggested that global trade has reversed, a resurgent US and a stabilising eurozone are
both likely to translate into better prospects for Asian companies – particularly those who
have good links to these economies. Good quality investment grade companies stand
most to benefit from this phenomenon.
4. Japan’s renewed internationalism
For too long the Japanese have been focused on investing their vast savings into the
domestic Japanese bond market. Following the push by the Japanese government to
diversify away from Japanese bonds and into overseas bonds and equities, capital from
Japan is flooding financial markets and Asian bonds are turning out to be a beneficiary of
this trend.
5. The end of easy (destructive) monetary policy
Many can point to historical instances where a period of tightening in US monetary policy
is typically accompanied by pain in emerging markets. This time is no different. Since
2013, the Fed’s intention to disengage from easy monetary policy has been a contributing
factor to weak performance in the emerging market complex.
However, if historical precedent is anything to go by, Asian and emerging markets tend
to recover once the tightening actually occurs. So while the anticipation of rising US rates
tends to have a negative impact on Asian markets, the actual point at which rates are
raised and when clarity around the pace of rate hikes begins to emerge, tends to result in
a stabilisation of returns for Asian investors.
Although many expect the US dollar to keep strengthening on the back of rate hikes in
2016, we believe that once the path of Fed hikes is priced into the dollar, the currency
may top out. It is already a crowded trade and a stronger US economy should lead to a
greater US trade deficit and therefore, an increase in the supply of dollars. As a result, we
expect there to be some viable opportunities in 2016 to go long Asian currencies versus
the greenback.
8
Outlook 2016: Asian Fixed Income
Conclusion
All of the above imply that good quality Asian government bonds hedged or partially
hedged to the US dollar will benefit – given lower inflation and the likelihood of central
banks easing monetary policy in the region. Furthermore, Asian US dollar-denominated
investment grade bonds will be in demand on the back of the low growth environment
and also as investors de-risk away from the high yield sector amidst rising defaults. The
yield spread between Asian government bonds and other markets continues to be high,
especially after the decline in European yields, and we see this trend continuing into 2016
as monetary policy in Europe looks set to be in easing mode for a while yet.
The views and opinions contained herein are those of Rajeev De Mello, Head of Asian Fixed Income, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy
or sell. Past performance is not a guide to future performance and may not be repeated The value of investments and the income from them may go down as well as up and
investors may not get back the amounts originally invested.
9
03
Outlook 2016:
Business Cycle (Europe ex UK Equities)
James Sym, Fund Manager, European Equities
James Rutland, Research Analyst, European Equities
We do not see a major turning point in the business cycle at
this point, but the potential for inflation to return in Europe
could see some currently out of favour areas of the market
perform better in 2016.
The outlook for European equities in 2016 is more nuanced than it has been for several
years, particularly given the potential for incremental stimulus from the European Central
Bank (ECB) and its knock-on impact on bond yields and therefore equity prices. Whatever
the short term effects might be, quantitative easing has the implicit aim of embedding
inflation. This has important implications for portfolio construction.
– The European Central Bank
is trying to stimulate reflation;
should this occur it could benefit
value areas of the market that
have been out of favour.
– The economic outlook for Europe
looks reasonable and pent-up
demand could lend support.
– We see potential opportunities
in energy producers, even
without an upturn in oil prices.
“We think we now
need to encompass
value more broadly, making
sure to avoid value traps.
This will not change our
core positioning since
we do not see a major
turning point in the
business cycle currently.”
10
For the past few years we have been making a call on recovery, essentially by comparing
equity valuations today to what we would consider a normalised level of profitability. We
favoured those stocks where the risk-reward looked to be the greatest, were economic
recovery to take hold in Europe. This process has served us relatively well, but has led us
into the value compartment of the market.
As we look into 2016, and despite the fact the “recovery” profit pool has nowhere near
recovered to historical levels, we think we now need to encompass value more broadly,
making sure to avoid value traps. This will not change our core positioning since we do
not see a big turning point in the business cycle currently. We still favour limited exposure
to growth which is approaching bubble valuations. The risk is that bubbles can grow
bigger. Having said that, we remain open-minded and would consider opportunities within
this compartment of the market should we find them at attractive valuations.
Value and consumer stocks could perform well
Our positioning is heavily influenced by our belief that inflation will return as the ECB is
committed to it. We think we are in the process of shifting from one investment paradigm
to another i.e. from “lower for longer” to reflation. The key beneficiaries of “lower for
longer” have been growth stocks, which have outperformed value by 15%/19%/31%
over the past one/three/five years respectively. The key beneficiaries of reflation should be
value stocks, in particular financials and this is one pocket of the market where we think
absolute value remains.
For us, the other key driver is economic momentum. We continue to see a relatively
reasonable outlook for Europe. We think the market underestimates the recovery potential
of the European consumer and the level of pent-up demand that exists. Before 2015,
Europe had been through six years of credit crunch. That said, we cannot discount an
impact in Europe from the weakness in the US and China. Recent data has been more
encouraging with the US Economic Surprise Indicator moved back to positive for the first
time this year recently and Chinese data picking up more broadly. We remain watchful.
Outlook 2016: Business Cycle (Europe ex UK Equities)
Opportunities in energy producers
One area of the market we have been focusing on is oil and gas producers. We see the
potential for an enormous step change in cash generation, without an improvement in the
oil price. In fact one thing we are sure of is that we have no ability to predict the future
oil price!
“We still favour limited exposure to growth which is
approaching bubble valuations.”
James Sym,
Fund Manager, European Equities
James Sym is a member of the PanEuropean Equity team at Schroders.
James graduated from St John’s
College, Cambridge with a degree in
Natural Sciences and is a Chartered
Financial Analyst. James has eight
years of investment experience.
Like other commodities, oil went through a massive bull market for 15 years (excluding
the financial crises) during which time the price more than quadrupled. Despite this,
the cash generation of the sector remained flat. Where did all that value accrue? The
value went to the oil service companies (still unattractive in our view, incidentally) as the
bottlenecks across the supply chain endowed these widget makers with pricing power.
The level of operating expenditure and capital expenditure (capex) required per barrel of oil
rose significantly.
“One area of the market we have been focusing on is oil
and gas producers. We see the potential for an enormous
step change in cash generation.”
There is a historical precedent for “lower for longer” with respect to oil prices. Between
1987 and 1997, oil remained roughly flat in nominal terms and declined 3% in real terms
per year. During this time, upstream profit margins grew from 6% per year as, amongst
other things, costs fell. Looking at expectations in the market today, the extent of cost
reduction that is possible (20%? 30%? 50%?) is nowhere near being reflected in current
share prices. Further, during 1987–97, free cash flow more than covered dividends, which
grew at 9% per year, despite capex rising 6% per year. In short, we have identified a
section of the market which is very un-consensual and offers 50–100% upside over the
next three years.
James Rutland,
Research Analyst,
European Equities
James Rutland is a member of
the Pan-European Equity team
at Schroders. He graduated from
University College London with
a degree in Economics and is a
Chartered Financial Analyst. James
started his career at Evercore, before
moving to Goldman Sachs as a
research analyst. He has six years of
investment experience.
The views and opinions contained herein are those of James Sym, Fund Manager, European Equities, and James Rutland, Research Analyst, European Equities, and may not
necessarily represent views expressed or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes
only and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments
and the income from them may go down as well as up and investors may not get back the amounts originally invested.
11
04
Outlook 2016:
Business Cycle (Pan-European Equities)
Steve Cordell, Fund Manager, European Equities
Steve Cordell sees the business cycle remaining in the
expansion phase in 2016 and discusses why domestic
consumer cyclical stocks should fare well in Europe.
Central bank divergence complicates market backdrop
For the global economy, the business cycle looks like remaining in the expansion phase
in 2016. This will allow the US Federal Reserve (Fed) to raise interest rates for the first
time since 2006. The expectation is currently that rates will rise 0.25% in December
2015 and thereafter it is seen as less than 50% likely that rates will rise any further! This
is understandable perhaps when the US economy is struggling to grow over 2% in real
terms and inflation is barely above zero.
– The global economy looks set to
remain in the expansion phase of the
business cycle in 2016.
– Diverging monetary policy in the US
and eurozone is likely to complicate
the picture.
– Economically-sensitive consumer
stocks should be among the winners
in Europe, along with selected
industrials.
“Consumers should be
the winners again in 2016
as wages grow in real
terms and unemployment
falls further in Europe.”
The growth rate and inflation picture is very similar in Europe, but here the European
Central Bank (ECB) is taking a completely different monetary stance by expanding
money supply. Recent commitments to remain in a phase of monetary easing have been
extended to March 2017, by which time the ECB’s balance sheet will have expanded by
€1.4 trillion. This transatlantic divergence in monetary policy makes forecasting 2016
very tricky.
The policy moves are even more confusing in the light of the recent economic data,
which has surprised on the downside in the US and on the upside in Europe. Earnings
expectations for Europe are expected to benefit from monetary policy easing, a weaker
euro as a result, and stronger demand for credit. Yet the latest announcement from the
ECB was met by a stronger euro, an ECB survey of small businesses that said availability
of credit was no longer an issue, but demand for credit was just not there! The money
supply may be expanding at around 11–12% per annum, but demand for credit is not,
and with negative interest rates for cash left with the ECB, banks are struggling to grow
earnings this cycle.
Consumption to boost Europe’s domestic recovery
The domestic European recovery may therefore not be best played through the banks this
cycle, especially if the US credit cycle continues to deteriorate as the Fed tightens policy.
Ironically, the US dollar usually peaks as soon as the US raises interest rates, so the
export sector in Europe may not find a tailwind from a weaker euro either this year.
Consumers should be the winners again in 2016 as wages grow in real terms and
unemployment falls further in Europe. This continues the trend of the last few years, but
with fewer governments pretending to hit budgetary targets, thanks to elections on the
horizon in Italy and France in 2017, maybe consumption will accelerate in these two
countries after years of lagging their German and Spanish neighbours. This should allow
domestic growth to match or even exceed the rate of 2015 in the eurozone.
12
Outlook 2016: Business Cycle (Pan-European Equities)
Consumer stocks may perform well; commodities remain unpredictable
The wild card is what happens to commodity prices in 2016. Currently depressed by
excess supply globally and slowing demand in China, commodities could see a rebound if
the Chinese manage to run down their excess inventories, but supply has yet to contract
meaningfully, and it is the contraction of supply that could send prices higher. Oil is the
most likely commodity to see such a discipline return first, but with little sign of real
distress other than in parts of the US shale oil and gas industry, we may be bobbing along
the bottom for some time.
Steve Cordell,
Fund Manager, European Equities
Steve Cordell is a European
equities investor with over 21 years’
investment experience. He joined
Schroders following the acquisition
of Cazenove Capital in July 2013.
He was a senior member of the panEuropean equity team at Cazenove,
having joined in 2002. Prior to
Cazenove, he was at HSBC Asset
Management (Europe) Ltd where he
was responsible for several retail and
institutional pan-European portfolios.
It is the slow speed of nominal global growth that makes this an unusually protracted
cycle, and this has driven multiples of growth stocks to high levels. Next year the trends
are likely to remain in place, and if the growth stocks tumble it will be because bond
yields finally move higher. The US Fed has started that process, but in doing so has
made slower growth even more likely. A flatter yield curve in the US would put even more
pressure on value stocks and expand the multiple on growth stocks. Easier policy in
Europe should, on the other hand, lead to a steeper curve and lower multiples for growth
stocks and defensives.
For this reason we continue to favour domestic cyclicals over global plays but we have
shifted our preference from banks, where low rates are a hindrance, back to consumer
cyclicals where earnings estimates are rising as well as selected industrials. We have
moved overweight commodities via oil but with low expectations of a quick return.
“We have shifted our
preference from banks,
where low rates are
a hindrance, back to
consumer cyclicals
where earnings
estimates are rising.”
The views and opinions contained herein are those of Steve Cordell, Fund Manager, European Equities, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy
or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and
investors may not get back the amounts originally invested.
13
05
Outlook 2016:
Business Cycle (UK Equities)
Matt Hudson, Head of Business Cycle
Do investors face showdown or slowdown in 2016?
Investors have endured a volatile ride in 2015 as the economic slowdown in China and
emerging markets more generally has weighed on global activity. Despite aggressive
monetary easing, European growth has also disappointed some of the more bullish
expectations and while US GDP growth has been more robust, activity has faded recently
as the oil industry has contracted due to the fall in the oil price.
– Capital returns will be harder to
sustain and therefore income such
as dividends and special returns of
capital will become an even more
important factor in overall returns.
– A preference for growth over value
will likely remain an important theme
going into 2016 and domestic
consumer-focused companies could
maintain their run of outperformance.
– UK base rates remain low, and any
tightening is probably going to be
gradual, and so unlikely to derail
the British economic recovery.
“After a more turbulent
year for markets and the
global economy in 2015,
to us it seems clear that the
business cycle has shifted
to the slowdown phase.”
Despite this, some areas of the FTSE All-Share have enjoyed strong relative returns in
particular domestically-facing sectors (for example consumer cyclicals such as house
builders) as they have been seen by investors as beneficiaries of a robust UK economy,
low interest rates and falling commodity prices. However, other sectors, especially those
exposed to global trends (such as commodities or Asian Financials) have been under
pressure in 2015 and have underperformed materially, with large-cap UK listed oil and
mining companies the most obvious examples.
Market confidence was undermined in the summer by a combination of the devaluation,
albeit small, of the Chinese currency and the prospect of rising interest rates in the US.
Together these developments suggest that the status quo of ultra-loose monetary policy
in the US and a pegged currency in China is coming to an end. In this respect, the
underlying economy in China is perhaps less resilient to an appreciating renminbi than
previously thought and is going through a period of profound structural change.
Slowdown not showdown?
Given this context, we are compelled to ask whether investors face showdown or
slowdown in 2016. In our view 2016 is more likely to represent a slowdown phase in the
business cycle, a period in which equities overall will still generate positive returns, although
with wider dispersion and more volatility, a trend already well established. In addition,
capital returns will be harder to sustain and therefore income such as dividends and special
returns of capital will become an even more important factor in overall returns for equity
investors. We will return to the subject of UK dividends more specifically later on.
Our contention was always that this would be an extended business cycle. It is extended
because aggressive monetary policy measures used to stave off a deeper recession in
2008 have been prolonged, helping to offset some of the downside, but in so doing,
these policy measures have prolonged the life of unproductive capital and this has meant
that nominal growth rates have been substantially below those seen in previous creditdriven cycles. Meanwhile, governments have retrenched and remained fiscally tighter,
thereby constraining investment and growth. This cycle is already long in the tooth and
showing increasing signs of tiredness.
One of the more obvious aspects of the cycle’s maturity has been the collapse in
commodity prices as the Chinese economic “miracle” has run into problems. Investors
have clearly recognised this factor in their negative view on commodity related sectors
such as mining and oils which have experienced substantial falls year to date. The decline
14
Outlook 2016: Business Cycle (UK Equities)
in commodity prices also undermines a much wider part of equity markets’ earnings
base. In general, rising commodity prices support corporate pricing power especially
in the industrial sector of the market, be it direct beneficiaries of the commodity boom
(such as mining suppliers) or indirect users of those commodities (such as chemicals).
At the same time wage inflation is starting to accelerate in both the UK and US, putting
further pressure on corporate margins and profitability. With the loss of “air cover” from
rising input prices to raise headline prices, the outlook for corporate pricing power and
profitability has already deteriorated.
Matt Hudson,
Head of Business Cycle
Matt is Head of the Business Cycle
equity team at Schroders and is
directly responsible for running UK
equity funds including the Schroder
UK Alpha Income Fund and the
Schroder UK Opportunities Fund.
He joined Schroders as part of the
Cazenove Capital acquisition in
July 2013 and is responsible for
research in the banks, construction,
electricity, mining, utilities and nonlife insurance sectors and has
17 years of investment experience.
Prior to Cazenove, Matt worked
for AIB Govett Investment
Management before which he
was a chartered accountant
at PriceWaterhouseCoopers.
He graduated from Cambridge
University with a degree in History.
“Investors will need to be
particularly vigilant about
balance sheet strength
going in 2016, especially
if a tightening rate cycle
precipitates a further
widening in credit spreads.”
It seems likely that the Federal Reserve will start to raise interest rates in 2016 as a result
of an improving labour market where wages are going up. Normally the start of a rate
tightening cycle coincides with corporate margins expanding as demand recovers and
companies benefit from operational gearing. However, this time we feel that margins are
already at elevated levels, particularly in the industrial areas and the rising cost of finance
will put further pressure on earnings and capital investment. In essence a rising rate cycle
may well coincide with a peak in margins this time. It looks to us that the period of peak
earnings on a global basis are behind us and while year-on-year growth in earnings will
remain positive, the rate of growth is falling. As usual, the US looks to be leading the
global business/earnings cycle with Europe someway behind, though potentially enjoying
a much-awaited later cycle recovery. The UK seems to be somewhere in the middle.
A key concern for investors has been the trajectory of inflation generally and wage inflation
specifically. While headline inflation in 2015 has been very low, core inflation (excluding
energy and food) in the US and the UK has been more resilient. A failure to raise interest
rates in September looks unlikely to be repeated in December 2015 after some very
strong labour market data. Focus from doves on the Federal Open Market Committee
seems to have shifted to the trajectory of interest rates rather than the timing of ‘lift-off’.
Credit spreads have already started to widen and financing for corporates, particularly
those with stretched balance sheets, will get more difficult. Offsetting this, the economy
is sustaining high employment levels, while a tightening labour market is set to drive real
wages higher. Consumption is the strongest driver of real end demand, meaning this
should serve to dispel deflation fears.
For equity markets these conditions are likely to result in a preference for growth over
value remaining an important theme going into 2016. We also expect the domestic
consumer-focused companies to maintain their run of outperformance. UK base rates
remain low, and any tightening is probably going to be gradual, and so unlikely to derail
the British economic recovery.
End demand in developed economies is robust, unemployment rates are low and falling
and wage inflation is accelerating. A return of some inflation, while concerning for central
bankers, would be helpful for total demand and we still see opportunities for selected
corporates to make good returns. In addition, recent market volatility has opened up
a number of shorter-term value opportunities. However, it is prudent to continue to tilt
portfolios to a defensive skew – with key areas for the portfolio in Growth Defensives and
Value Defensives (see graphic over page) on a selective basis.
15
Outlook 2016: Business Cycle (UK Equities)
The seven style groupings of the Business Cycle equity team
– Commodity Cyclical Revenues linked either directly or indirectly to a commodity
product such as oil, steel, gas, mining or bulk chemicals e.g. BHP Billiton
– Industrial Cyclical Manufacturing capital goods or with revenues linked to
industrial production. Includes engineering, aerospace and construction e.g. GKN
– Consumer Cyclical Revenues reliant on consumer spending. Includes retailers,
automotives, house builders and leisure e.g. Marks & Spencer
– Financial Revenues depend on interest rate spreads, financial markets and asset
valuations. Includes banks, insurers and real estate e.g. Barclays
– Growth Revenues well in excess of GDP but sometimes with a degree of uncertainty
or volatility. Includes luxury goods, medical technology and IT e.g. ARM
– Growth Defensive Grow revenues in excess of GDP with low volatility and high
visibility. Includes pharmaceuticals and support services e.g. Compass
– Value Defensive Grow revenues at or below GDP with low volatility and high visibility.
Includes telecoms, utilities, tobacco, and food retailers e.g. Imperial Tobacco.
Source: Schroders.
For illustrative purposes only and not to be considered a recommendation to buy or sell securities.
Our portfolios
While our overall tilt in portfolios is towards a more defensive and/or stable income skew
we have maintained some higher-beta exposure in the form of Consumer Cyclicals and
Financials, in order to benefit from the ongoing recovery in domestic demand. After a
more turbulent year for markets and the global economy in 2015, to us it seems clear that
the business cycle has shifted to the slowdown phase.
Rising wage inflation, interest rates and peaking corporate margins are all hallmarks of this
phase of the cycle. GDP growth will remain positive with developed markets more robust
than developing markets. However, credit spreads while still at historically low levels,
have already started to widen and not just in the more obviously troubled sectors e.g.
oil, mining and related industrials, but also in previously more resilient areas. This, to our
minds, is confirmation that the slowdown phase has begun. There are still good returns to
be made from equities, but a more defensive skew is prudent.
Dividend dynamos
One of the brighter spots for the UK may be dividends, although we anticipate
pressure on the UK market’s total aggregate cash dividend. There were two notable
disappointments in 2015, with British Gas owner Centrica and mining group Glencore
both reducing their dividend payments, and we expect more disappointments to come.
In light of these potential risks, investors will need to be particularly vigilant about balance
sheet strength going in 2016, especially if a tightening rate cycle precipitates a further
widening in credit spreads.
There are still a good number of companies in the UK market that are able to sustain
dividend growth of 5–6% over the next few years, in line with the long-term nominal rate
of UK market dividend growth. In a low growth, low inflation environment, dividends and
dividend growth in particular will still offer attractive returns for investors in the face of
potential capital losses from fixed interest securities.
The views and opinions contained herein are those of Matt Hudson, Head of Business Cycle, and may not necessarily represent views expressed or reflected in other Schroders
communications, strategies or funds.
16
06
Outlook 2016:
Commodities
Geoff Blanning, Head of Commodities
After five years of declines, the commodity bear market is
long in the tooth and we certainly expect bullish surprises,
when they occur, to trigger strong recovery rallies in 2016
and beyond.
Commodity investors suffered in 2015 as major headwinds continued, primarily the
strengthening dollar and the weakening Chinese economy. In the energy market, the new
Saudi-led OPEC market share policy drove oil prices much lower than many expected,
while weather played an unusually important role too, reducing demand for both oil and
gas in the US and Europe and supporting near-record production of grains and oilseeds
worldwide (to date the effects of the record-breaking ‘El Niño’ have been benign).
– Energy looks like the sector with
the greatest potential for price
appreciation in 2016, although risks
remain in the short-term.
– We remain cautious on base metals,
although the potential exists for shortcovering rallies, particularly in nickel.
– Gold could benefit from an increase
in geopolitical or macroeconomic
concerns, or from any weakening of
the dollar.
– 2016 is expected to be a
turnaround year for major
agricultural commodities.
“With oil priced at $31/
barrel, it is more likely
than ever that US
production will fall steeply
in 2016, and commence
declines in many other
regions too.”
Looking ahead, three key catalysts for bullish surprises can be highlighted:
1. Geopolitics: historically important to commodity investors but now almost completely
forgotten. It is a matter of time before disruption to commodity trade flows occurs
again – most likely energy or food-related in the Middle East and/or Russia. In the past
quarter, Turkey joined the list of countries in dispute with Russia, while pressure on
Saudi Arabia’s rulers continues to grow.
2. US dollar: with currencies being difficult to forecast, the confident consensus of further
dollar gains seems inappropriate, even foolish, especially when observing the Federal
Reserve’s tortuous interest-rate deliberations. When the dollar turns, commodities
could surge.
3. Supply/demand balances: this extended period of declining prices is setting the
stage for a return to supply/demand balance across a range of commodities. Distress
amongst miners and energy producers accelerated in Q4 and the inevitable adjustment
to supply will likely be extended. US natural gas, which has recently been trading
below the cost of production of even the most efficient producers, is a prime example.
Energy
Energy looks like the sector with the greatest potential for price appreciation in
2016, although risks remain in the short-term.
The big surprises for the oil market in 2015 came on the supply side: first, production in
the US and other non-OPEC nations held up much better than expected; and second –
more significantly – OPEC production actually increased, led by Saudi Arabia and Iraq.
With oil priced at $31/barrel, it is more likely than ever that US production will fall steeply
in 2016, and commence declines in many other regions too. Further potential gains
from OPEC producers – primarily Iran but possibly Libya too – will be insufficient to
17
Outlook 2016: Commodities
outweigh non-OPEC declines in the medium-term. Assuming global demand continues
to grow at a modest rate, therefore, it is logical to forecast a solid price recovery as the
year progresses.
The problem for oil remains in the short-term. The recent disastrous OPEC meeting,
which confirmed a production “free-for-all” (no quotas nor overall target), gives rise to the
possibility of higher OPEC output in Q1 2016. The favourable shift in the supply-demand
balance that we foresee in 2016 could, therefore, be delayed. Thus further downside
risk remains in the short-term but an eventual strong recovery towards $60 (i.e. +70%)
appears inevitable once supply gains have peaked out.
Geoff Blanning,
Head of Commodities
– Head of Commodities; Energy
Fund Manager.
– Head of Emerging Markets Debt
and Commodity Group since
December 1998, member
of the Schroders Group
Management Committee.
– Geoff conceived and developed
Schroders Commodity businesses
from 2003.
– Investment career commenced in
1985 at NM Rothschild.
Mild weather killed any chance of a rising US natural gas price in recent months. However,
there is a clear shortage of gas developing in the medium-term (1–2 years) – a bullish
outlook reinforced by the recent fall in price. We project a severely undersupplied market
by the end of 2016, offering gains of 30–40% on a 12-month view. EU gas could also
benefit from renewed Russia-Ukraine tensions.
Base metals
The outlook for base metals remains dominated by China. We remain cautious,
although the potential exists for short-covering rallies, particularly in nickel.
Base metals stabilised recently as short positions were covered due to signs of supply
adjustment. However, a constructive view will not be justified until we can be confident
Chinese demand has bottomed, or supply cuts are deep enough to engineer deficits
and inventory drawdowns. We are some way from this point and thus we believe prices
can still make new lows. Potential downside remains highest in copper; largest upside
potential is in nickel.
In China we face a backdrop of a still-high investment/GDP ratio, high housing inventory
and limited deleveraging. As a result, the risk that demand again disappoints market
expectations in 2016 is high. However, as the central government makes aggressive
efforts to reduce overcapacity in 2016, the reduction of credit to loss-making productive
capacity will become an important offset to weaker demand. Indeed, announced closures
in the zinc and copper industries, combined with closure of high-cost, small-scale supply
is leading to a tightening in underlying concentrate markets.
Supply-side behaviour highlights that we are much closer to the bottom of this cycle than
a year ago. Aggressive debt cutting, cancelled dividends, and spot prices below costs of
production all suggest a clearing market.
“Gold could gain anytime
there is pressure on major
equity indices, stress in
high-yield markets or a
further ratcheting up of
China’s financial crisis.”
18
Precious metals
In 2016 gold could benefit from an increase in geopolitical or macroeconomic
concerns, or from any weakening of the dollar.
In gold, a key question is whether the market’s focus will shift in 2016 from its recent
obsession with US interest rates and the dollar to a focus on demand and supply.
Although this is likely to be delayed, a greater focus on US real rates is probable;
recovering inflation will keep real rates suppressed, supporting gold. We also believe the
macro risk environment is underestimated; gold could gain anytime there is increased
pressure on major equity indices, stress in high-yield markets or a further ratcheting up of
China’s financial crisis.
Outlook 2016: Commodities
Platinum fundamentals remain neutral. A very weak rand (moving from 11.5 to over 15
to the dollar in 2015) has delayed supply adjustments in South Africa (70% of global
platinum mine supply). Moreover, investor sentiment was seriously impacted by the VW
scandal (implies less demand for diesel vehicles) and sizeable ETF liquidations followed
in September/October. The impact of the VW scandal, however, is likely to be less than
initially feared. Nevertheless, the market is carrying high inventories; evidence of inventory
draws and confidence that the market is in deficit ex-investor demand is a pre-requisite
for a sustainable price recovery.
Agriculture
2016 is expected to be a turnaround year for major agricultural commodities,
and prospects for price rises in some are already good: rapeseed, palm oil, cocoa,
sugar and rubber.
Three key themes will be supportive for agricultural markets in 2016:
1. Weather: the strong El Niño, currently being experienced, will likely turn into La Niña in
6–12 months. Periods of La Niña are typically associated with lower agricultural yields.
2. India: current planting difficulties for grains, oilseeds and sugarcane could result in the
country turning into a major importer of agricultural commodities once again.
3. China: meat production fell recently and could result in a rise in pork and poultry imports.
The negative fundamentals for the grains and oilseeds markets (i.e. large global crops and
inventories, export competition, slowing Chinese demand, freight disadvantage for US
products and the strong US dollar) are continuing, but are now largely factored into prices.
The fundamentals for vegetable oils are turning bullish due to lower palm oil yields and
growing Indian imports. We expect palm oil to continue to be the outperformer in the
oilseeds subsector, followed by European rapeseed and Canadian canola.
We rate cocoa as neutral-to-bullish as low supplies are balanced by lower grinding.
The coffee market should continue to trade sideways barring any changes in the
prevailing weather in Latin America or in other major growing countries, though we
favour Arabica compared to Robusta, where stocks remain high. Fundamentals
for sugar, which rose 20% in Q4 2015, are turning supportive for prices given crop
reductions in some major producing countries and there are expectations of a global
deficit in 15/16, the first in six seasons.
An increasing number of animals, growth in their average weight and low US exports
shaped the negative picture for meats in 2015. Bearish factors appear now to be reflected
in prices and we expect these markets to trade sideways during Q1 2016. However given
the fall in Chinese meat production, a sudden increase in imports of pork and poultry is
likely in 2016 and could well be bullish for this subsector, especially if the Dollar weakens.
The views and opinions contained herein are those of Geoff Blanning, Head of Commodities, and may not necessarily represent views expressed or reflected in other Schroders
communications, strategies or funds.
19
07
Outlook 2016:
Convertible Bonds
Dr. Martin Kuehle, Investment Director, Convertible Bonds
After the financial crisis, stockmarkets entered a sustained
bull market. Convertible bond investors were rewarded with
a prolonged period of strong returns. The Federal Reserve’s
(Fed) massive quantitative easing programme lifted markets
and revived the US economy. The Fed’s asset purchase
scheme was then followed by the Bank of England, European
Central Bank and the Bank of Japan. The latter two are still
supplying the global economy with vast quantities of liquidity.
– The market environment in 2016
is expected to remain volatile.
– Sudden market setbacks could
be triggered by negative shifts
in sentiment, swings in market
liquidity or unanticipated shocks
in fundamental economic data.
– Convertible bonds, with their in-built
stabilisers, should be well suited as
an asset class for volatile markets.
“With low but positive
economic growth there
are good reasons to stay
invested in risk assets.”
20
The Fed is now on the verge of lifting interest rates for the first time since it implemented
the ‘zero rate’ policy in 2008, but the size of the financial experiment still makes the
decision a first in financial history. Quantitative easing will continue to have direct and
positive implications for equity and convertible markets. Cyclically adjusted equity
valuations in Europe and Asia still look reasonable which, combined with a booming
monetary base, continues to support the outlook for equities. That said, we believe we
are without doubt in the later stages of a long-running bull market.
Sudden and strong equity market setbacks are now a normal occurrence. During the
summer, Chinese stockmarkets entered a nose dive, with share prices shedding some
40% before levelling out. In August and September, global stock exchanges lost more
than 10% before recovering in October. Each time, convertibles protected investors from
about half of the equity market losses. Convertible bonds, with their in-built stabilisers,
proved to be ideally suited as an asset class for the year’s volatile markets. We believe
convertible bonds should continue to reduce equity risk for investors in 2016.
Convertible bonds offer this protection through a characteristic called ‘automated timing’.
The automated timing function means that equity exposure decreases automatically when
the underlying equity falls. Importantly though, the equity exposure accelerates again in
rising markets. Successful active exposure management and good security selection
could add significantly to outperformance over the longer term.
Outlook 2016: Convertible Bonds
Our most likely scenario for 2016 is for higher volatility to persist. Sudden market setbacks
could be triggered by either a negative shift in sentiment, a shock in fundamental data or
swings in market liquidity, especially at the lower end of the credit curve. Does that bode ill
for risk assets in general? No, we do not believe it does. We believe that ‘recovery rallies’
that often follow a break in a bull market mean that these periods of weakness could offer
attractive entry points.
“In an age of unconventional monetary policy interest rates
are likely to remain unnaturally low on a global scale.”
Dr. Martin Kuehle,
Investment Director,
Convertible Bonds
Dr. Martin Kuehle started his career
as a trainee with Westdeutsche
Landesbank in Germany in 1990
and went on to study economics
and management at the Universities
of Münster in Germany and St.
Andrews in Scotland. He graduated
from St. Andrews with a Master
Degree in Economics (MLitt) and a
PhD in Management and Economics.
In 2000, he joined Credit Suisse
Asset Management in London as a
Risk Manager. He went on to head
the priority client team of Deutsche
Bank’s German and Austrian
institutional brokerage and clients
from 2003 to 2006. From 2007 to
2013, he was a Senior Partner at
Fisch Asset Management with sales
and product responsibility among
others for two Schroders funds.
In November 2013, Martin joined
Schroders as an Investment Director
for convertible bonds. Martin is a
Member of the Chartered Institute
for Securities and Investments in
London and serves on CISI’s national
Advisory Committee in Switzerland.
In an age of unconventional monetary policy interest rates are likely to remain unnaturally
low on a global scale. This will hold true in spite of slow and very carefully orchestrated
moves in the US interest rate. Elsewhere, interest rates should stay low and may even fall
further. With low but positive economic growth we believe that there are good reasons to
stay invested in risk assets. The question for us is not whether to hold equity exposure at
all, but how much equity exposure investors should keep in their portfolios.
“We believe convertible bonds should continue to reduce
equity risk for investors in 2016.”
Over the last few years, I have been repeatedly asked if the time for convertibles was over,
but we believe investors should stick to this asset class. Over the longer term, convertible
bonds should continue to provide investors with a compelling combination of smart equity
exposure while retaining bond-like downside protection.
The views and opinions contained herein are those of Martin Kuehle, Investment Director Convertible Bonds, and may not necessarily represent views expressed or reflected in
other Schroders communications, strategies or funds.
21
08
Outlook 2016:
Emerging Markets Debt Absolute Return
Abdallah Guezour, Head of Emerging Markets Debt Absolute Return
After yet another challenging year for emerging market
debt characterised by a collapse in currencies and a spike
in a number of local bond yields, attractive investment
opportunities are starting to appear.
The recent bear market has led to an improvement in valuations and to some positive
policy inflexions, with Argentina becoming the latest country to embrace change.
– Pockets of value should currently be
seized with caution, flexibility and a
focus on liquid assets.
– The recent collapse in EM currencies
has probably gone too far.
– Expected returns in EM external
debt are likely to disappoint.
“The recent bear market
has led to an improvement
in valuations and to some
positive policy inflexions,
with Argentina becoming
the latest country to
embrace change.”
However, the pockets of value in emerging markets (EM) should currently be seized with
caution, flexibility and a particular focus on liquid assets. While local currency bonds in
countries such as Indonesia, India, Russia, South Africa, Argentina and Brazil could perform
reasonably well in 2016, other sectors of the market should be avoided. This is particularly
the case in EM hard currency debt (i.e. US dollar-denominated sovereign and corporates)
which remains the next shoe to drop for the EM re-pricing cycle to be complete.
Outlook clouded by Fed actions and China’s economic woes
The US Federal Reserve (Fed) finally initiated its monetary tightening cycle in December.
This recent decision to hike rates was widely anticipated and is long overdue. The key
concern now is that this slow process of monetary normalisation may have started too
late and in an already unfavourable environment of depressed global credit conditions,
persistent deflationary pressures and decelerating global growth.
While the Fed has started to tighten, other key central banks (European Central Bank, Bank of
Japan and People’s Bank of China) are continuing to pursue activist monetary policies but with
very limited impact so far on global economic activity. Judging by the continued elevated level of
capital flight from China, we are particularly concerned that the recent measures implemented by
Chinese authorities appear to be failing to restore confidence in the country’s economic outlook.
Therefore, China’s deflating credit system remains the most serious structural threat to global
financial stability. The chart below highlights China’s contribution to global money supply. This
shows the extent to which China’s credit cycle remains dangerously overextended.
China’s Credit cycle remains dangerously overextended
35%
China
30%
25%
20%
15%
US
Eurozone
10%
Japan
5%
0%
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
Key Contributors to Global Money Supply M2.
Source: Thomson DataStream, Schroders, Bloomberg – October 2015.
22
Outlook 2016: Emerging Markets Debt Absolute Return
We returned from our recent research trip to China with the view that some encouraging
policy initiatives were starting to be taken in order to reduce inventories and excess
capacity in some sectors of the economy. However, these initiatives are still at the early
stages and remain underwhelming, especially given the extent of the credit problems
which continue to accumulate. Total credit outstanding remains unsustainably high and is
on the verge of exceeding 300% of GDP.
Following the market panic of August 2015, various monetary measures, financial repression,
moral suasion and the tightening of capital controls led to some stabilisation in China’s
financial markets. This period of relief appears to be ending given the current renewed
pressures on the renminbi and on the stock market. The charts below highlight how China
exhausted in succession key sources of financial liquidity during the course of the last few
years and the current difficulties faced in restarting these engines of credit creation.
China: Source of liquidity 1
2000–08: Reserves Accumulation
FX Reserves – Annual Growth (%)
60
30
25
20
20
0
15
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
10
-20
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
China: Source of liquidity 3
2011–14: Foreign Borrowing
Commercial Banks Foreign Liabilities – Annual Growth(%)
7,000
120.00
6,000
80.00
5,000
40.00
0.00
China: Source of liquidity 4
2014–15: Stock Market
Shanghai Stock Exchange – Index Level
4,000
3,000
2,000
-40.00
1,000
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Abdallah joined Schroders in 2000
and is lead fund manager for
Schroder ISF Emerging Markets
Debt Absolute Return. He created
the fund’s quantitative models and is
responsible for Asian country analysis
and global quantitative analysis.
Abdallah’s investment career
commenced in 1995 when he joined
Fortis Investment Management.
40
35
40
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Abdallah Guezour – Head of
Emerging Markets Debt
Absolute Return
China: Source of liquidity 2
2008–11: Domestic Credit Boom
Bank Credit – Annual Growth (%)
Sources: Thomson, DataStream, Bloomberg, Schroders.
The deflationary pressures emanating from China, as highlighted by the charts above,
have become widely publicised and a number of EM local debt markets have already
cheapened accordingly. Key EM countries have also now adjusted, to some extent, to the
new reality of collapsing demand from China.
While EM local debt has become cheap...
Currencies served as a shock absorber during the bear market of the last three years.
These devaluations allowed most EM countries to improve competitiveness and to restore
balance of payments sustainability. This can be seen in the improvements in EM trade
balances (albeit mostly as a result so far of contracting imports) and in the lower reliance
on short-term foreign capital.
Therefore, the recent collapse in EM currencies has probably gone too far. We believe that
major EM countries have witnessed in succession what appears to be the final “overshooting”
phase of their currency devaluation cycle. This was the case of India in 2013, Russia in
2014, Brazil, Turkey and South Africa at different points in time during 2015. We cannot yet
say with strong conviction that this apparent domino effect is complete, especially given the
risk of further dislocations which could result from the potential failure of Chinese authorities
23
Outlook 2016: Emerging Markets Debt Absolute Return
“We believe that major
EM countries have
witnessed in succession
what appears to be the
final “overshooting”
phase of their currency
devaluation cycle.”
to contain the persistent pressures on the renminbi. However, the compelling valuations of
selected currencies and the high yields on offer in a number of local bonds could lead these
markets to generate US dollar returns in excess of 10% in the next 12 to 18 months.
…External debt remains the next shoe to drop
In contrast, expected returns in EM external debt are likely to disappoint. The challenging
growth backdrop highlighted above and the deteriorating credit quality has yet to be fully
reflected in the level of EM sovereign and corporate spreads, which remain far too tight
(see chart below). A low exposure to EM external debt remains warranted, especially
given the illiquid nature of this sector and the potential acceleration in outflows.
EM sovereign and corporate credits: the next shoe to drop?
External Debt Spread (EMBI+ Index) vs. EM Currencies (JPM EM Currency Spot Index)
120
EMBI+ Spread in bps
200
100
400
80
600
The 5 year range for spreads
is being tested
800
1000
60
50
07
08
09
10
11
JPM EM Currency
Spot Index – RHS
12
13
14
15
JPM EM Currency Spot Index
0
16
EMBI+ Spread
Inverted Scale – LHS
Source: Schroders, Bloomberg – January 2016.
Selected opportunities for 2016
Asia: India and Indonesia still offer the most attractive investment opportunities
India and Indonesia have not yet fully seen the rewards from their better policy
frameworks, ameliorated external accounts and lower inflation. We retain small exposures
to Indian and Indonesian local bonds (unhedged) and stand ready to increase these
positions when they show more resilience to external shocks.
Valuations in most other Asian fixed income and currency markets remain unappealing
and do not compensate investors against the downside risks emanating from China’s
economic woes. The main exception is the Malaysian ringgit, which has already
experienced a substantial devaluation.
Emerging Europe Middle East and Africa (EEMEA): Russia and South Africa are
our top 2016 picks
The recent Russian ruble weakness is challenging the outlook for additional monetary
easing. Given the large gains already achieved by Russian local government bonds in
2015, it is now warranted to take some profits with the view to reinstate this position at
higher yield levels in Q1 2016. Russia is experiencing a protracted economic downturn
as a result of the collapse in oil prices. Authorities have shown a strong commitment to
maintaining a tight fiscal policy and the central bank is likely to regain its ability to cut rates
during the course of 2016.
In South Africa, the recent shocking mismanagement of the appointment of a new
Finance Minister by President Zuma has been severely punished by the markets with
a spike in bond yields and a currency collapse. These moves appear to be overdone,
especially given the recent attempts of the leadership to regain some credibility. We are
looking for opportunities to re-establish exposure to South African local rates (which
recently paid 10.5% on 10-year bonds).
24
Outlook 2016: Emerging Markets Debt Absolute Return
Latin America: Mexico and Chile remain strong; elsewhere, crisis is starting to
bring change
Given the continued strong macroeconomic fundamentals of Mexico and Chile, the recent
depreciation of their currencies appears overdone. This weakness should be used to
accumulate positions in exchange rates of Mexico and Chile.
Recent elections in Argentina and Venezuela highlight that the region is moving away
from left-wing populism. While Venezuela is still at the early stages of accomplishing
this transition, change has already occurred in Argentina following the recent election of
President Macri who is in the process of introducing market friendly reforms. This opening
up and the recently announced devaluation of the Peso should provide attractive multiyear investment opportunities in Argentina’s local bond market.
Brazilian local bonds and currency have started to show some resilience in the face of
escalating negative news headlines. This shows that the attractive valuations on offer
(10-year government bond yield at 16.4%) are now providing an important cushion. We
maintain a small core exposure to Brazilian local bonds and we stand ready to increase
the position to significantly higher levels in 2016. We expect inflationary pressures to show
signs of abating during the year. Political uncertainties, which remain another key concern
for investors in Brazil, have already been discounted to a large degree.
The views and opinions contained herein are those of Abdallah Guezour, Head of Emerging Markets Debt Absolute Return, and may not necessarily represent views expressed
or reflected in other Schroders communications, strategies or funds.
25
09
Outlook 2016:
Emerging Markets Debt Relative
James Barrineau, Co-Head of Emerging Markets Debt Relative
In 2015, the challenges for emerging market debt were mostly
internally generated, coupled with the headwinds from a
strong dollar and volatility surrounding the divergences in
developed country monetary policy.
Moving into 2016, we see the internal issues for the asset
class as slowly healing. Given the universally negative
sentiment surrounding the asset class, an improvement in
factors externally would bring a much better environment.
– As a consequence of the challenges
surrounding the asset class,
emerging market dollar spreads
to US Treasuries are attractive
relative to their five-year history.
– Even if the Federal Reserve pulls
the trigger on a rate hike as
expected in December, it is hard
to argue that this has not already
been well priced into markets.
– Unless the Fed embarks on a
surprisingly aggressive course,
modest positive returns are
achievable next year simply if
spreads return to historical means.
“For local currency
bonds, the dollar will
tell the tale.”
It’s (largely) about growth
Growth issues took precedence in 2015, especially for the major countries of Brazil,
Russia, and China. For Brazil, no end to a deep recession is currently in sight, but a much
weaker currency will eventually improve external accounts and competitiveness for a
long, slow return to expansion. In Russia, a favourable policy mix has mostly successfully
managed the economy through the steep drop in oil prices, and there are encouraging
signs that growth has seen the worst. China has been most impactful, and growth
challenges will remain, but the transition to a consumer-led model is underway within the
constraints of slower global growth, and we expect stable growth with low odds for a
hard landing.
Outside these countries, investors have mostly ignored the fact that emerging market
growth, while moderating, has been consistently better than the developed world.
Latin America, outside of Venezuela and Brazil, is growing between 2.5 and 3%, while
European emerging markets outside Russia are showing similar numbers. Asia ex-China
and India is showing over 3% growth and India remains the star at around 7% growth.
Investors spent 2015 anticipating that the slowdown in emerging market growth would
precipitate a crisis in the asset class. However, fiscal policy remained prudent across
countries, monetary policy was not excessively loosened to stimulate growth, and while
foreign exchange reserves declined, they were not spent in a futile attempt at stemming
currency depreciation. That policy mix provides the necessary, if not sufficient, conditions
for a modest recovery in overall growth in the coming year.
The macro environment will matter greatly
Negative sentiment surrounding emerging markets was also largely fuelled by global
factors. The steep slide in commodity prices became correlated with negative emerging
market prospects in the eyes of many investors. Even if prices only stabilise rather
than recover, we expect that would feed into more stability across assets, especially
currencies. Significantly lower investments for exploration should improve the odds of this
scenario playing out.
26
Outlook 2016: Emerging Markets Debt Relative
But the major driver for emerging markets has been the strong dollar. Since the “taper
tantrum” of May 2013, emerging market currencies have lost about 40% of their value on
average. This was accompanied by liquidity into the asset class drying up, credit default
swaps widening significantly, and currency volatility picking up.
Even if the Federal Reserve (Fed) pulls the trigger on a rate hike as expected in December,
it is hard to argue that this has not already been well priced into markets. If the rate
hiking cycle proves modest and the strong dollar simply treads water, currencies should
stabilise or appreciate. That would create a small virtuous cycle, where policymakers can
eventually respond to the resulting lower inflation pass-through with modestly lower rates,
reserve levels would likely cease falling, and growth prospects would improve.
James Barrineau, Co-Head of
Emerging Markets Debt Relative
James Barrineau joined Schroders in
April 2012 as Co-Head of Emerging
Market Debt Relative. Prior to
joining Schroders, he worked as a
Senior Portfolio Manager-Sovereign
from 2010 to 2012 at ICE Canyon,
an alternative investment firm
specialising in emerging market
debt. James worked as an emerging
market debt and currency strategist
for Alliance Bernstein from 1998 to
2010, with primary responsibility for
Latin America. From 1996 to 1998,
James was the Latin American
equity strategist at Salomon Smith
Barney, and from 1994 to 1996
he was the emerging market debt
strategist at the same firm. From
1988 to 1994, he was a senior
economist for the US government.
Asset prices reflect subdued prospects for recovery
As a consequence of the challenges surrounding the asset class, emerging market
dollar spreads to US Treasuries are attractive relative to their five-year history; now about
80–90% cheaper than historically, depending upon credit rating.
Those higher spreads have allowed dollar, sovereign and corporate debt to produce
about a 3% positive return this year despite ongoing fears about the asset class. Unless
the Fed embarks on a surprisingly aggressive course, modest positive returns are
achievable next year simply if spreads return to historical means.
For local currency bonds, the dollar will tell the tale. However, aggregate yields are near
their five-year highs and investors are well compensated now for currency risks. Real
exchange rates are fair-to-cheap, so any positive surprise to the global outlook would
potentially make emerging market local currency investing one of the top performers
across global fixed income, in our view.
“If the rate hiking
cycle proves modest
and the strong dollar
simply treads water,
currencies should
stabilise or appreciate.”
The views and opinions contained herein are those of James Barrineau, Co-Head of Emerging Markets Debt Relative, and may not necessarily represent views expressed
or reflected in other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a
recommendation to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go
down as well as up and investors may not get back the amounts originally invested.
27
10
Outlook 2016:
Emerging Market Equities
Allan Conway, Head of Emerging Market Equities
Allan Conway highlights the signposts investors should
look for as drivers of emerging markets equity
performance in 2016.
Stabilisation in the US dollar
One of the key headwinds facing emerging markets (EMs) has been the prospect of
monetary policy normalisation in the US and uncertainty around the timing of the first rate
hike has led to elevated market volatility. Heading into 2016 what has changed is the US
dollar (USD) has strengthened 12% on a trade weighted basis over the past 12 months
and all major currencies have weakened in comparison. So the ramifications of a tighter
global liquidity backdrop look better priced into markets than a year ago.
– The degree of bearish sentiment
towards emerging markets has been
unrelenting and has led some to
question the investment rationale.
– This appears short sighted, we
believe, not least given the strategic
case for an investment in these
markets remains compelling.
– Whether investors are able to
refocus on the strong fundamental
case for emerging markets in
2016, however, will be a function
of whether key headwinds
around the US dollar and Chinese
growth in particular dissipate.
“After three consecutive
years of underperformance
compared to developed
markets, valuations
across metrics look
attractive, especially
on a relative basis.”
28
The first rate hike, when it does transpire, will not resolve all concerns since decision
making by the Federal Reserve (Fed) will remain data dependent. It should, however,
subject to accompanying statements, serve to clear the air. We believe it is also likely to
pave the way towards modest tightening with rates peaking at a lower level than in a more
‘normal’ cycle given sub-par US growth. Historically, the impact of rate hikes in the US on
EMs has been mixed and ultimately dependent on the circumstances at the time; the past
two tightening cycles led to net capital inflows into EMs.
Notwithstanding the above, ongoing divergent policy between the US and developed
peers may well keep the USD supported and a strong dollar has tended to correlate with
weak EMs performance relative to developed markets. So until investors have greater
confidence that the USD has already done much of its strengthening, this headwind may
have further to run.
Thus while a start to tightening in the US does not prevent EMs from performing in 2016,
some stabilisation in the USD is likely necessary.
No major negative growth surprises
Developed world economic growth remains sub-trend but should benefit in 2016 from
the ongoing lagged effect of a halving in energy prices. It should also be supported by
further stimulus with the European Central Bank in particular looking to keep policy loose
for longer. This in turn should be positive for EMs where economic growth surprises have
been showing some signs of improvement after successive years of disappointment,
although earnings have so far been slow to pick up.
In 2015, growth and policy concerns in China were key headwinds for EMs so any
signs of improvement here should be a positive in 2016. We maintain our view that the
likelihood of a hard landing in China is overstated. Clearly ‘old China’ industrial-led growth
is under strain and a reluctance by the authorities to restructure some industries, given
social and political pressures, has led reform progress to disappoint. However, this is
Outlook 2016: Emerging Market Equities
only part of the story. ‘New China’ more consumer and technology orientated sectors are
benefiting from strong structural growth and the economy is clearly moving away from a
reliance on investment to drive growth. Indeed, growth in consumer spending looks set
to outpace that of investment in 2015 for the first time in over a decade. Whether the
property market continues to pick up in 2016 also bears close monitoring given property
has a more direct impact on wealth and consumption than industrial activity.
Importantly, the Chinese authorities have the tools at their disposal to support the
economy when necessary. Indeed, the authorities have recently implemented both
monetary and fiscal stimulus with more likely to follow. While we expect growth
to continue to decelerate over the longer term to a more sustainable level, the
implementation of expansive policy should help stabilise growth in 2016.
Allan Conway,
Head of Emerging Market Equities
– Head of Emerging Market
Equities, based in London.
Joined Schroders in October 2004.
– Head of Global Emerging
Markets for West LB Asset
Management from 1998 and
then Chief Executive Officer of
WestAM (UK) Ltd from 2002.
From 1997 he was Head of Global
Emerging Markets at LGT Asset
Management. Joined Hermes
Investment Management in 1992
as Head of Overseas Equities.
In 1983 moved to Provident
Mutual Life Assurance initially as
an Investment Manager and later
as Head of Overseas Equities.
Investment career commenced
in 1980 when he joined the
Occidental International Oil
Company as an accountant.
– Fellow of the Securities Institute
(FSI). Member of the Institute of
Chartered Accountants (ACA).
– BA (Hons) Degree in
Economics, York University.
Thus while hard landing concerns in China are unlikely to disappear, we expect them to
ease over 2016 which should be a positive for EMs.
Single country challenges and opportunities
Aside from China, reform implementation is underway in several significant EM economies
which could lift GDP. In India, for example, there is a strong political mandate for change
and an opportunity for a step change to a higher growth rate over the long term; India
has now overtaken China as the world’s fastest growing significant economy. However,
elevated expectations are susceptible to disappointment and valuations are currently rich.
Meanwhile the outlook for Brazil remains challenging. The authorities are trying to
undertake necessary fiscal reform, but against a backdrop of restrictive monetary policy
and weak commodity markets. Should orthodox policy be maintained and balance
sheets adjust, Brazilian growth should recover but in the immediate term political risk
remains elevated.
There are a number of geopolitical risks around the world, including Syria and the related
refugee situation in Europe, but should these events escalate they are likely to have more
global than EM specific ramifications.
Thus country allocation remains key and should only increase in importance as steps
towards monetary policy normalisation in the developed world result in lower correlations
between EMs.
Stockmarkets
The degree of bearish sentiment towards EMs has been unrelenting with record
outflows from dedicated EM equity managers and after three consecutive years of
underperformance compared to developed markets, valuations across metrics look
attractive, especially on a relative basis. The MSCI Emerging Markets Index is currently
trading on around 11.0x forward price-to-earnings which is around a 30% discount
compared to the MSCI World Index.
On balance then, EMs head into 2016 facing some of the same challenges they faced
at the beginning of 2015. However, importantly we are further along in the adjustment
process and should headwinds dissipate, could provide a basis for recovery. So in our
mind, providing tightening by the Fed is modest and the USD shows signs of stabilisation,
investors can refocus on the strong fundamental case for investing in EMs.
Thus no hard landing in China, an ongoing recovery in developed world growth and
reform implementation should help EMs earnings to pick up and given attractive
valuations, EMs are well placed to perform much better in 2016.
The views and opinions contained herein are those of Allan Conway, Head of Emerging Market Equities, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy
or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and
investors may not get back the amounts originally invested.
29
11
Outlook 2016:
European Equities
Rory Bateman, Head of UK and European Equities
At the time of writing, the MSCI Europe equity index has
delivered a total return of around 10% this year and we
believe investors should see further gains in 2016 given the
continued earnings recovery in Europe.
Scope for profit margins to improve
Corporate profit margins within the eurozone particularly remain at depressed levels
relative to the US. This gap has been significant since the global financial crisis and a
narrowing of the disparity would support European equities. At the same time, valuations
are compelling versus historical levels and most other equity markets.
– Earnings recovery should support
further stockmarket gains in 2016.
Trailing 12 months net profit margin %1
Cyclically-adjusted price to earnings ratio2
10
55
50
45
40
35
30
25
20
15
10
5
82
8
– Careful stockpicking will be needed
as correlations within markets are
likely to unwind.
6
– Eurozone economic recovery to
continue, driven by the improving
credit cycle and domestic demand.
0
95 97
4
2
1
2
“We believe the
opportunities within
equities for 2016 will
require careful stock
selection...”
99 01 03 05 07 09 11 13
MSCI EMU
S&P500
15
86
90
94
Pan Europe
98
US
02
06
10
14
Asia-Pacific ex Japan
Bloomberg. As at 31 October 2015.
Thomson DataStream, Schroders. As at 31 October 2015.
Stock selection crucial as correlations unwind
Whilst we are constructive on European equities overall it is probable that there will be
significant differences in terms of thematic and sector leadership. Correlations within
equities have increased markedly since the summer when the Chinese devalued the yuan
and intervened in the stockmarket. A possible US rate increase and concerns about a
hard landing for the Chinese economy triggered a market sell-off across asset classes
which reflected a ‘risk-off’ period of uncertainty. We believe the opportunities within
equities for 2016 will require careful stock selection as correlations unravel, leading to
more differentiation between stocks and greater opportunity to generate alpha.
Correlations increased in 2015
0.80
0.75
0.70
0.65
0.60
0.55
0.50
0.45
0.40
0.35
0.30
Jan 05
Highly correlated market
Low correlation
Jan 06
Jan 07
Jan 08
Jan 09
Jan 10
Jan 11
Jan 12
Jan 13
Source: Schroders, Bloomberg. Based on the Eurostoxx 50 index. As at 31 October 2015.
30
Jan 14
Jan 15
Outlook 2016: European Equities
In both the fixed income and equity markets, ‘quality, safe’ assets have seen a period
of strong outperformance to the extent that the defensives versus cyclicals are back to
levels seen through the eurozone crisis. Corporate bond yield spreads have significantly
widened versus government debt despite the global deflationary pressures. These moves
indicate nervousness across markets that the global economy may be entering a more
difficult period. We would agree that the global economic outlook is more uncertain but
the extreme moves we have seen in ‘growth versus value’ have opened up valuation
anomalies as indicated by the chart on price/book value below.
Rory Bateman,
Head of UK and
European Equities
Rory joined Schroders in April 2008
and is Head of the UK and European
Equity Team. His responsibilities now
include co-managing Pan European
Equity portfolios, including Schroder
ISF European Large Cap, and
management of the other portfolio
managers and European research
analysts. Prior to joining Schroders,
Rory spent 12 years at Goldman
Sachs Asset Management where
he was the portfolio manager for
Continental European Equities for
eight years. In addition, Rory has
12 years of experience as an analyst
covering numerous sectors across
the European market.
“The export market is
clearly suffering but overall
the data suggest to us that
the eurozone economy
has momentum...”
World Growth vs Value return1
Price to tangible book value2
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
84
0.60
0.55
0.50
0.45
0.40
0.35
0.30
0.25
0.20
97 99 01 03 05 07 09 11 13
MSCI Value vs MSCI Growth Average
-1 Standard Deviation
-2 Standard Deviation
+1 Standard Deviation
+2 Standard Deviation
88
92
96
00
04
08
12
MSCI World Value vs. MSCI World Growth
1
2
Thomson DataStream. As at 31 October 2015.
Schroders, Bloomberg. As at 31 October 2015.
Eurozone recovery has momentum
From an economic perspective we are confident that the eurozone recovery will continue
through 2016 despite the emerging market turmoil witnessed during the late summer.
The export market is clearly suffering but overall the data suggest to us that the eurozone
economy has momentum in its recovery phase driven by domestic demand, credit
expansion and consumption growth. It’s worth noting that services and construction make
up 75% of German GDP and these areas of the economy are performing well. The same
can be said for other large eurozone member countries.
Eurozone growth showing
better momentum1
Credit cycle2
4%
4%
3%
3%
2%
2%
1%
1%
0%
0%
-1%
-1%
-2%
1
2
2010 2011 2012
GDP growth, Y/Y
BNB survey*
2013 2014 2015
PMI, EZ Composite*
-2%
Net balances
% change y/y
50
5
40
4
30
3
20
2
10
1
0
0
-10
-1
-20
-2
-30
-3
-40
-4
Q1 Q3 Q1 03 Q1 Q3 Q1 Q3 Q1
03 04 06 07 09 10 12 13 15
Eurozone Bank Lending Survey:
Expected credit demand next quarter (lhs)
Euro area retail sales (rhs)
Thomson DataStream, Markit, Schroders Economics Group. As at 23 September 2015.
Thomson DataStream. As at 30 September 2015.
The eurozone can also count on the ongoing support offered by the European Central
Bank’s (ECB) quantitative easing (QE) programme. Recent surveys from businesses and
consumers show that QE is having a positive effect on credit growth which is crucial if
economic expansion is to be maintained. Additionally, ongoing QE will help keep the euro
under pressure, especially if the US Federal Reserve does decide to raise interest rates.
There could be more easing on the way in the eurozone: Mario Draghi recently warned
that global forces may have a negative impact on GDP growth and suggested that further
measures could be announced imminently. In summary, we see a positive outlook which
is likely to be enhanced if the ECB takes further policy action.
The views and opinions contained herein are those of Rory Bateman, Head of UK and European Equities, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds.
31
12
Outlook 2016:
Global Bonds
Bob Jolly, Head of Global Macro
Throughout 2015, market turbulence made for choppy waters
for investors to navigate. Central bank policy forecasts grew
increasingly unreliable. Global manufacturing and trade
slowed as emerging market growth – particularly in China –
continued to weaken. Commodity prices also struggled, and
currency markets only added to the wider volatility, as the US
dollar’s strength persisted and China devalued its currency.
– Central banks, which remain highly
influential in market movements, have
grown overly concerned with the
international and market ramifications
of their decisions. This means that
potential policy errors are growing
more likely.
– Lacking clarity in the course of central
bank policy decisions, we expect
fixed income (bond) markets to be
increasingly volatile.
– Overall, we expect the environment
to be better suited to smaller, tactical
trades than large-scale strategic
positions in the coming year.
“The global economy
should remain resilient
over 2016, but global
markets may be a very
different story.”
32
This has left a great deal of uncertainty for markets in 2016.
We believe that underlying economic stability will endure,
but that the shadow cast by central banks will remain large.
Overall, we expect the environment to be better suited to
smaller, tactical trades than large-scale strategic positions in
the coming year.
Is the Fed overcomplicating things?
The US economy is fundamentally in good shape. Manufacturing is certainly feeling the
pinch from lingering excess capacity and weakening external demand, but strength is
persistent elsewhere. The labour market is strong, the US consumer is active and there
is even some evidence of wage growth building. Our concern is that the Federal Reserve
(Fed) seems increasingly preoccupied with international developments – chiefly those in
emerging markets – in setting its policy terms. This muddled reaction function has left
investors twitchy, and is likely to trigger significant market distortion in 2016 until greater
clarity is restored.
We still expect that the Fed will embark on its hiking cycle, possibly by the end of 2015,
and would caution that short-dated Treasuries do not look ready for the move. We
expect that as investors reassess the level of interest rate compensation offered by this
portion of the market, prices are likely to cool off. Longer dated Treasuries – those in the
10-year bracket and beyond – look better supported. We expect institutional investors –
particularly pension schemes – to lend sustainable demand to this part of the yield curve
as these schemes look to de-risk.
UK policy set to echo the US
The US is not the only market susceptible to an overbearing central bank. In the UK, the
growth outlook is similar. The stronger consumer sector is helping to sustain momentum
even as deterioration in global trade impinges on the UK’s manufacturing sector. As in the
US, short-dated gilts look more sensitive to the end of ultra-accommodative monetary
policy and prices are likely to ease back as interest rate risk is reassessed. We do believe
Outlook 2016: Global Bonds
that the first rate rise from the Bank of England (BoE) is further away than in the US, but
we also believe that the gap between rate moves is probably smaller than the market
appreciates. Once the Fed moves, we anticipate that the BoE will shift its rhetoric,
becoming increasingly hawkish to prepare markets for the tightening cycle ahead.
This time, the ECB is taking no chances
The European Central Bank (ECB) has responded to the increased downside risk to
global growth by stating more clearly that it will be proactive in challenging any resurgence
of deflation. The market has responded positively already. The exact policy measures
that the ECB intends to use are not yet quite so clear, but we expect the deposit rate to
be lowered again, and that the existing asset purchase scheme – currently running at a
rate of €60 billion-a-month – will be extended either in term, pace, or both. The effect
of the extended policy support would mean euro government bond valuations, already
at historic highs, are likely to remain well supported. The euro is likely to weaken further
against major currencies.
Bob Jolly,
CFA – Head of Global Macro
Bob joined the Schroders fixed
income team in September 2011,
as Head of Global Macro. Prior to
joining Schroders, Bob worked for
UBS Global Asset Management,
where he was Head of Currency, UK
Fixed Income and Global Sovereign.
Before UBS, Bob spent two years
with SEI Investments, developing
customised solutions for institutional
pension fund clients. The majority of
Bob’s investment career was spent at
Gartmore Investment Management.
He is a CFA charter holder.
“Our concern is that the
Federal Reserve seems
increasingly preoccupied
with international
developments – particularly
those in emerging markets –
in setting its policy terms.”
Tread carefully in corporate bond markets
Corporate bond markets may offer a degree of shelter from the murky policy environment.
In the US, the stream of investment grade supply has been torrential in 2015. Overseas
demand has remained strong, but the extent of the supply has still pushed yield spreads
outwards. We believe that pockets of value have now emerged in the energy sector, as well
as more generally in financials. Euro investment grade corporate markets have also grown
cheaper during the year. Although the region continues to expand, inflation and growth
remain fragile, and the market has also had the Greek debt crisis and several negative
issuer-specific developments to contend with. However, we have always been of the view
that with market stress often comes value. On a selective basis, opportunities are available.
High yield corporate bonds are even less exposed to policy changes, and as with
investment grade bonds, the volatility and risk aversion of the third quarter has reset
valuations to the point that certain areas look attractive. Commodity-sensitive sectors,
particularly in the US, represent a range of prospects, provided the appropriate level of
research has been undertaken.
China’s new normal
The key question then, is that if central banks are altering course (or not, as the case may
be) due to China’s gloomy outlook, just how weak is the world’s second largest economy?
China is clearly committed to the transition from its prevailing export and infrastructure-led
growth model, to one of domestic consumption and service provision. We believe that
China’s political will and policy tools are sufficient to support the economy as it traverses
from one set of drivers to another. Furthermore, urbanisation and productivity enhancement
are not over as growth themes, and will continue to contribute as the multi-decade transition
unfolds. That said, while the process is set to continue, uncertainties remain regarding the
timing and pace of the transition, as well as how China’s currency policy will develop.
China’s official growth targets remain ambitious and misses on GDP figures are, as a
rule, detrimental to risk appetite. Further, the risks associated with elevated debt levels,
as well as a mounting deflationary threat, may spill over to the rest of the world. Finally,
China’s surprise devaluation of its currency this year has resulted in concerns about the
magnitude and timing of any future devaluations.
Be cautious of bold trades
The global economy should remain resilient over 2016, but global markets may be a very
different story. Investors continue to focus intently on central bank moves, given how
integral they were in shoring up the financial system in the wake of the financial crisis.
As such, until central bank decisions are less clouded by external factors, we believe
investors should be wary of taking large-scale directional positions.
The views and opinions contained herein are those of Bob Jolly, Head of Global Macro, and may not necessarily represent views expressed or reflected in other Schroders
communications, strategies or funds.
33
13
Outlook 2016:
Global Corporate Bonds
Rick Rezek, Co-Fund Manager, US Fixed Income
We expect corporate bonds to outperform government bonds
in 2016 although investors should brace themselves for
periods of heightened volatility.
The themes driving risk assets globally have shifted dramatically over the course of
2015 and should continue to do so next year. However, we believe that corporate bond
markets should generate positive excess returns versus government bonds over the next
twelve months, albeit with periods of extreme price volatility. In our view, the following key
themes will have a significant impact on credit markets globally:
– Growth should remain modest by historical standards for major developed economies
– Developed economies are likely
to see low levels of growth,
but central bank divergence
could result in volatility.
– We believe US dollar credit
markets offer attractive valuations
and we see bank and finance
sectors as representing lower
risk than the broader market.
– Amid a challenging environment,
research will be crucial for uncovering
attractively-valued opportunities.
“We do not believe that
a tightening cycle by the
Federal Reserve will result
in an adverse reaction by
risk assets.”
– Divergence in central bank policies will be a source of volatility. Importantly, we do not
believe that a tightening cycle by the Federal Reserve (Fed) will result in an adverse
reaction by risk assets
– Emerging market economies will remain in the headlines. Despite the situation in China,
we expect the trend of economic activity in many emerging economies to stabilize and
even improve as we progress through the year
– Corporate credit fundamentals vary by region and industry but should broadly remain
stable. The credit cycle is much further advanced in the US than in Europe or the UK,
but we do not see deteriorating fundamentals triggering a dramatic re-pricing of
risk globally
– The supply of bond issuance, which has been a major contributor to wider credit
spreads during 2015, primarily in the US, should abate somewhat and become more
supportive for valuations.
2015 has sown the seeds for a volatile 2016
China, and the potential contagion from its economic slowdown, has been and continues
to be a major issue which must be confronted by investors. In spite of the initiation of a
quantitative easing (QE) programme by the European Central Bank (ECB) late last year,
the economic picture in the eurozone remains rather fragile. The persistent Greek drama,
a refugee crisis not seen on the continent since the Second World War, multiple terrorist
incidents and even a reassertion of more “nationalistic” tendencies all pose long-term
challenges to Europe’s political union. Not to be outdone, the US has also embarked on
the presidential election season which promises to add further volatility to markets.
Fortunately, these events have yet to shake the confidence of businesses or consumers.
However, we are vigilant of catalysts that could lead to a change in sentiment and will
continue to focus on these and future developments that may impact credit markets
in 2016.
34
Outlook 2016: Global Corporate Bonds
US dollar markets
Looking to 2016, we believe that US dollar credit markets offer attractive valuations, and
the economic picture continues to be among the best of the developed economies.
We see the bank and finance sectors as representing lower risk than the broader market.
In the energy sector, we also believe a number of companies in the investment grade
universe – those with attractive assets and fairly good balance sheets – are currently
valued as high yield credits.
We spent much of 2015 very cautious of emerging market debt, both sovereign and
corporate, but this caution has receded in recent weeks. We see higher quality sovereign
credits as offering a more attractive risk-reward profile than emerging market
corporate bonds.
Rick Rezek, Co-Fund Manager,
US Fixed Income
Rick joined Schroders in 2013 when
we acquired a stake in STW Fixed
Income Management, where he was
a Portfolio Manager, joining them in
2002. Rick has previously held fund
management positions at several
firms including Loomis Sayles and
Wells Fargo Bank IM. He has an
MBA from DePaul University and a
BS from St. John’s University.
“We anticipate that the
coming year will be
another opportunity
for us to capitalize on
market dislocations.”
Finally, US high yield bonds have become more compelling during the last three months
of 2015. While we have generally avoided the energy and basic materials sectors – which
we perceive to have significant default risks in the coming year – we look more favourably
upon higher quality issuers.
Euro bond markets
The euro denominated corporate bond market looks to be among the more challenging
of the major markets to decipher as we enter 2016. While the ECB’s QE programme
is arguably supportive of risk assets in the eurozone, much of this appears to be fully
reflected in valuations. Frankly, it is very difficult to be overly enthusiastic about a broad
market that yields well below 1.5%.
Sterling markets
Similar to the US, the underlying economic fundamentals in the UK are reasonably sound,
and valuations are more attractive than those in the euro denominated markets. Sterling
corporate bond markets often pose challenges in terms of liquidity, but on balance we
believe that some exposure could be warranted.
Research remains essential
2016 should prove to be an interesting year for global credit markets as we continue to
digest the events of the past year and their impact on the overall fixed income landscape.
As we enter the year, the Fed has embarked on its first rate hiking cycle in over a decade.
China will try to find its footing, while oil attempts to rebound after reaching a low not seen
since the financial crisis.
There will certainly be many significant decisions to be made and we anticipate that the
coming year will be another opportunity for us to capitalize on market dislocations. While
price volatility will undoubtedly be with us for the foreseeable future, we are confident that
opportunities exist and that, with research, investors can uncover specific industries and
issuers that offer attractive value amid this challenging credit environment.
The views and opinions contained herein are those of Rick Rezek, Co-Fund Manager, US Fixed Income, and may not necessarily represent views expressed or reflected in other
Schroders communications, strategies or funds.
35
14
Outlook 2016:
Global Equities
Alex Tedder, Head of Global Equities
Alex Tedder discusses how an uncertain macroeconomic
backdrop means that a focus on company-specific drivers
that can deliver earnings surprise, is the best way to
navigate 2016.
In aggregate the backdrop for equities is challenging and the macroeconomic
environment is highly uncertain. Low interest rates reflect massive quantitative easing
by central banks around the world, artificially boosting many asset prices and creating
a potentially dangerous situation when rates start to rise. Significant currency distortion,
weak commodity prices, slowing growth in China and mixed economic data in Europe
and the US have added to the uncertainty. For equities, this has meant low absolute
returns and increased volatility.
– The global macroeconomic
environment is highly uncertain
heading into 2016. Our
approach remains the same:
a focus on bottom-up drivers
of return in our search for
unanticipated earnings growth.
– Technology is evolving at an
unprecedented rate and disrupting
an array of industries, providing
a wide range of investment
opportunities, as well as serious
challenges in legacy industries.
– We generally prefer service companies
over those in the manufacturing
sector, given more resilient pricing
power and stronger growth.
– Those firms that are able to reduce
costs and strengthen balance sheets,
particularly in highly competitive
industries faced with overcapacity,
will be rewarded in 2016.
36
It is therefore particularly relevant to take a selective approach to investing, focusing on
those companies that can deliver unanticipated earnings growth despite the uncertain
environment. We see a number of different dynamics at play that have the potential to
surprise the market in 2016.
Disruptive technology driving rapid change
Technology is evolving at an unprecedented rate and new business models leveraging
increased connectivity, particularly in the mobile space, are threatening to reshape
industry dynamics in a number of different areas. Firms such as Amazon, Google,
Facebook, Alibaba and Tencent are already household names in their respective end
markets. The revenue and market capitalisation of these companies already rank amongst
the largest in the world.
However, the number of industries facing disruption is increasing rapidly and now extends
well beyond the immediate e-commerce, social media and handset space. Disruptive
technology is shaking up traditional industries such as autos (Tesla, Uber), apparel and
food retail (Yoox, Zalando, Just Eat, GrubHub), hospitality (Priceline, Expedia, TripAdvisor,
Airbnb) and recruitment (LinkedIn). Other industries that are about to experience
significant disruption include healthcare and banking. We are focused on finding
opportunities where the market has either overlooked or underestimated companies’
potential to disrupt.
Service firms preferred for their pricing power
The global economy is likely to be characterised by ongoing deflationary pressure in 2016.
A lack of pricing power is already evident in the traded goods sector where competitive
pressures and overcapacity make for a challenging pricing environment. By contrast, the
services sector has been able to maintain pricing power, given a lack of tradability in many
areas. The divergence between manufacturing deflation and services inflation naturally
informs a bias towards service companies in our portfolios heading into 2016.
Outlook 2016: Global Equities
We still find some attractive opportunities among those manufacturing firms with a
substantial component of high margin recurring revenue, such as maintenance providers
and parts suppliers. These types of companies should prove more resilient to any decline
in capital investment spending, particularly in industries that benefited from the capital
spending boom in China over the last 10 years.
Saving profits with “self-help”
We are seeing evidence that companies in challenged sectors, such as industrials,
energy and mining, are taking steps to support earnings and we expect this to be a
key feature of 2016. There is an increasing focus on “self-help”, as companies seek to
restructure by reducing costs and strengthening balance sheets in order to weather the
uncertain demand and pricing environment. For example, firms like diversified miner
BHP Billiton and oil and gas major Royal Dutch Shell have committed to substantial cost
reductions and lower capital spending in the face of sharp declines in commodity prices
and revenues.
Alex Tedder,
Head of Global Equities
Alex re-joined Schroders in July 2014
as Head of Global Equities, having
commenced his investment career at
Schroders in 1990 with responsibility
for promoting European Equity
mandates alongside Schroders’
Private Equity operation. In 1994
he moved to Deutsche Asset
Management Ltd, where he worked
in various capacities including
Managing Director and Head of
International Equities/Portfolio
Manager. He was lead manager of
the Deutsche International Select
Equity Fund (MGINX) from inception
in May 1995. He also previously
served as co-manager of DWS
International Fund, DWS Worldwide
2004 Fund, Deutsche Global Select
Equity Fund and Dean Witter
European Growth Fund. Alex re-joins
Schroders from American Century
Investments in New York, where
he worked from 2006 as Senior
Vice President and Senior Portfolio
Manager (Global and Non-US
Large Cap Strategies). He was lead
manager of the American Century
International Growth Fund (TWIEX)
from July 2006 to March 2014.
In the industrials sector, earnings have been hurt by the combination of softer economic
growth and excess inventories. However, inventories are now at levels such that
even a modest upturn in end demand should translate into better profitability. Firms
that have been able to reduce costs should show significant operating leverage even
with a moderate uptick in revenue. Companies behind the curve in terms of expense
management are likely to be de-rated.
A focus on innovation
Regardless of industry, however, we continue to focus on innovation as a driver of returns
in 2016. Our emphasis is on companies that are committed to finding new, interesting
and sustainable ways in which to grow their businesses, but whose efforts have not yet
been fully recognised by the market.
For example, in the healthcare sector, firms continue to gain insight into disease
processes and are continuing to develop a variety of new treatments to improve mortality.
Despite a more challenging regulatory backdrop, we expect the sector to continue to
experience strong pricing power for therapeutical innovations.
Another example is the food and beverage sector where firms have to differentiate
their products and services to command pricing power in a highly competitive industry.
Starbucks is a case in point where management is intent on finding innovative ways to
improve the customer experience (such as the introduction of mobile payments) to sustain
customer traffic and support average spend.
Looking for earnings surprise
As we have highlighted, the economic backdrop remains highly uncertain and we
cannot predict with any accuracy what will happen in the global economy, markets,
commodities or currencies in 2016. The best approach in our view, is therefore to focus
on developments at the company level, to identify individual companies that can deliver
earnings surprise and outperform in an uncertain and challenging environment.
The views and opinions contained herein are those of Alex Tedder, Head of Global Equities, and may not necessarily represent views expressed or reflected in other communications,
strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Past
performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may
not get back the amounts originally invested.
37
15
Outlook 2016:
Global High Yield
Wes Sparks, Lead Fund Manager, Global High Yield
Continuing volatility and an elevated risk premium mean that
high yield bond returns could be in the mid single-digit range
in 2016, but we expect this performance to be attractive
relative to many other fixed income alternatives.
2016 will likely be another year when returns in the high yield bond sector are ‘coupon light’
(i.e. total returns are lower than the coupons on offer). Under our base case scenario, we
expect a total return in the range of 4–5% for the global high yield index in 20161. Returns
should be better for active managers and investors, who are able to take advantage of what
we see as the likely continuing divergence of returns across issuers and industries.
– We believe active investors will be
better equipped to navigate what
looks like a volatile year ahead for
high yield bonds.
– Defaults may rise, but should be
clustered around a handful of
industries. The market is also already
pricing in a higher probability of default
for a larger portion of the index.
– Sentiment surrounding the energy
sector and emerging markets is
almost universally negative just now.
Investor decisions on when to add
exposure to these areas could be
crucial in 2016.
“Perhaps the most
important strategic calls
in 2016 will surround the
decisions about when to
add exposure in energy
and emerging markets.”
Positive technical factors – such as modest supply, an uptick in demand, light dealer
inventories, high cash balances at mutual funds, and more conservative positioning
among high yield investors after the market correction in the second half of 2015 – could
lead to a market bounce in the first half of 2016. Several possible positive catalysts could
emerge which would trigger a shift in sentiment and spark renewed investing interest by
pension funds, insurance companies, and mutual fund investors.
The brunt of any rise in the default rate is likely to be weighted towards the end of 2016,
which provides a time horizon for the high yield bond market to bounce back from what
we considered to be somewhat oversold levels as 2015 came to a close.
Over the past two to three months, high yield strategists and investors have increased
their expectations for defaults for 2016. It is difficult to assess with absolute precision
what the implied default rate is based on current market valuations – whether using yields
or spreads for high yield bonds – because there have been changes in two variables at
the same time. Expectations for defaults in 2016, and the risk premium demanded by
investors have both risen in recent months.
Indeed, a good portion of the recent widening of spreads in the high yield bond market
represents this wider risk premium. This partially reflects the investor belief that they need
a higher ‘illiquidity risk premium’ in order to be enticed to invest, since press coverage on
the topic of poor and diminishing liquidity in corporate bond markets has been so high.
Referencing the Barclays Global High Yield ex-CMBS ex-EMG 2% Issuer Capped Bond Index
1
38
Outlook 2016: Global High Yield
Default rates to rise but not as much as currently feared
Defaults should rise in 2016, but only moderately from the currently low level of defaults.
Defaults should be clustered in a handful of industries – primarily in metals & mining
and energy, as well as in retail and media – where the market is already pricing in a high
probability of default for a number of issuers. The distressed debt ratio has risen after the
late 2015 selloff; so the market is already pricing in a high probability of default for a larger
portion of the index.
We believe that the global high yield market now looks relatively cheap after the spread
widening during the second half of 2015. High yield valuations appear to be relatively
cheap in several ways:
Wesley Sparks,
Head of US Credit Strategies
& Lead Manager, Schroder ISF
Global High Yield
Wesley Sparks has been with
Schroders for 15 years. Wesley began
his career in 1988 at Goldman Sachs
as an analyst. From 1994 he held
portfolio manager positions at three
asset management firms before joining
Schroders in 2000. In total, he has 26
years of investment experience. Wes
is a CFA charter holder and also holds
a Masters in Business Administration
(MBA) from the Wharton School
in Pennsylvania and a BA from
Northwestern University.
– Relative to the high yield market’s own valuations during historically analogous periods
(at similar points in the credit cycle in past cycles, etc.)
– Relative to other asset classes: Versus investment grade credit, for investors who have
the risk tolerance to bear greater potential volatility; versus emerging markets; versus
government bonds; and versus cash & cash equivalents
– Relative to predicted valuations from fundamentally-based forecasting models
– Relative to our sense of the severity of potential further downside risk, and relative to
the probability of positive catalysts emerging which could improve valuations over the
course of the coming year.
Watch for key signposts as market conditions change during 2016
Rather than fixate on a total return forecast for the entire year, we believe that investors
should instead focus on various signposts along the way to indicate whether the riskreward profile of the high yield asset class is attractive or not. As was highlighted clearly
in 2015, the market can rally for several months at a pace that is unsustainable for the full
year. The market can also become oversold. We believe that key market trends to monitor
include the following:
– The pace of M&A activity: We expect that acquisition activity will remain elevated and
that many high yield companies will continue to benefit from larger, higher-rated issuers
pursuing strategic mergers as they seek growth opportunities
– The trajectory of oil and natural gas prices: We expect a recovery in oil prices to be delayed
until the second half of 2016, given recent shale production and oil supply data
“Investors currently
expect fewer rate hikes
in 2016 than the Fed itself
is projecting.”
– The pace of fallen angels: We expect the pace of investment grade companies being
downgraded to high yield to rise, particularly in troubled sectors, versus rising stars.
We also expect the pace of distressed debt exchanges and defaults to increase
– The pace and mix of supply: We expect gross new issuance will likely be slightly lower
in 2016 than in 2015 and may be split between refinancing activity and M&A financing,
with very little for financing highly levered buyouts
– Demand reversals: Extremes in mutual fund flows can often be contrarian signals as
widespread mutual fund redemptions are often concurrent with market corrections
– The pace of Federal Reserve (Fed) rate hikes: Investors currently expect fewer rate
hikes in 2016 than the Fed itself is projecting
– Changes in the strength of regional economic growth across the Americas,
Asia and Europe.
39
Outlook 2016: Global High Yield
Many of the themes that we expect to dominate in 2016 are similar to those in 2015,
but perhaps the most important strategic calls in 2016 will surround the decisions about
when to add exposure in energy and emerging markets, as sentiment about both market
segments is nearly universally negative as the year begins yet valuations backed up
materially in late 2015.
High yield bonds could provide positive returns even as the Fed hikes rates
The Fed raised the Fed funds rate by 25 bps in December, representing the first rate hike
in more than nine years by the US central bank. Many investors hold the view that fixed
income returns will inherently be negative during a period when the Fed is raising shortterm rates, but an analysis of the three most recent Fed rate hiking cycles shows that this
is not the case.
In fact, an analysis of the past three rate hike cycles shows that high yield bonds can
produce positive returns over a six month or 12-month horizon after the Fed first raises
the Fed funds rate. High yield can also outperform other fixed income asset classes,
such as Treasuries and investment grade corporate bonds. This was especially the case
during the 2004–2006 rate hike cycle but was also generally the case in the 1994–95 and
1999–2000 rate hike cycles.
We believe that prospective returns in corporate bonds markets in 2016 could be much
better than recent performance, and better than the bearish consensus view that seems
to have developed over the past couple of months.
While many uncertainties remain as 2016 begins, the risk premium embedded in high
yield valuations is high. There are several signposts that we will be monitoring in the
market to potentially become more constructive as the year progresses. Fundamental
research and active risk management in the face of changing market conditions will
continue to be key to outperformance.
The views and opinions contained herein are those of Wesley Sparks, Lead Fund Manager, Global High Yield, and may not necessarily represent views expressed or reflected in
other communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation
to buy or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up
and investors may not get back the amounts originally invested.
40
16
Outlook 2016:
Global Real Estate Securities
Hugo Machin, Co-Head of Global Real Estate Securities
Market commentators often refer to the ‘wall of worry’,
and from the media alone it would be easy to believe that
Armageddon is around the corner. Indeed, the world appears
to be in a state of perpetual crisis, but is this because it is
true, or because pessimism sells newspapers?
Looking to 2016, our view is of a calmer real estate horizon than many would have you
believe. While we recognise that risks are out there for real estate investors, we aim to
quantify those risks; using the data and the facts available to make informed decisions. If
2015 has shown us anything, it is that the world isn’t perfect. We do expect some squalls
from financial markets, but we don’t see evidence of a storm on the horizon.
– Although there may be periods of
turbulence in 2016, we believe
some market commentators are
overly pessimistic.
– Low interest rates, regulatory
changes and dwindling supply are
all supportive of the asset class.
– Investors should focus on assets
with pricing power, which should
be better suited to a tighter global
policy environment.
“If your assets lack pricing
power, the tighter policy
environment could pose a
serious challenge.”
Fair wind
There are a number of reasons why we don’t think we are heading into a stormy
2016. The first is that interest rates remain very low. This means that finance costs and
borrowing ratios should remain stable for companies with solid balance sheets. Secondly,
banks simply won’t lend to speculative real estate development any more. Recent
changes in the regulatory backdrop mean that the ‘cost’ of regulatory capital is exorbitant.
The days of property developers risking other people’s money for self-enrichment
are gone.
The knock-on effect is that less development means less new space. Less new space
means more stable, or even growing, rents. Demand for space – especially in higher
barrier markets – is sufficient for the right companies to build considerable ‘pricing
power’. Our view has long been that real estate is a commodity much like any other. If it is
desirable, people will pay. We aim to invest in companies that own assets where
people want to work, live, eat and shop as this is integral to defending your capital in
turbulent markets.
Grey clouds
Not all real estate is created equally. The assets that most concern us are ones that lack
this pricing power. These are assets that we describe as ‘commoditised’. Essentially, if
there are plenty of them to go round, why should an occupier pay more for a building
when a cheaper rent can be found next door? You need to give occupiers a reason to
pay rents.
The elephant in the room for investors in all asset types seems to be the prospect of
higher interest rates. Real estate is no different. The edging up of interest rates traditionally
signals that inflation and growth are back in the financial system. If your real estate assets
have pricing power, higher rents can offset higher borrowing costs. If however, your assets
lack pricing power, the tighter policy environment could pose a serious challenge.
41
Outlook 2016: Global Real Estate Securities
In our view, exposure to commoditised real estate in inappropriate structures – where the
fund is traded daily but the underlying assets are not – could provide the single biggest
headache to real estate investors in the medium-term. If rates go up or the economy
falters, then commoditised assets do not generate the rent growth to drive them through
the storm.
Choose carefully
We cannot say with any certainty what the next year will bring. However, we are
reasonably optimistic about how the real estate companies we invest in will fare. Pricing
power and a lack of new supply should bode well for positive returns. Where we are
concerned is the impact of rates and shifting market dynamics on ‘bog standard’ real
estate assets.
Hugo Machin,
Co-Head of Global Real
Estate Securities
Hugo joined Schroders in July 2014
as fund manager for Global Real
Estate Securities, with over 15 years
of real estate experience. Prior to
joining Schroders, Hugo was Head of
European Listed Real Estate at AMP
Capital where he was responsible
for setting up the London office for
the AMP Global Property Securities
Fund. Hugo has also worked at
ING Investment Management in
Sydney and Welcome Trust. Hugo is
a Member of the EPRA Report and
Accounts Committee. He holds a
BA (Hons) in English Literature from
Durham University, a MSc in Real
Estate Finance and Investment from
Reading University and a Diploma in
Cross Border Valuation from Oxford
Said Business School.
“We do expect some squalls
from financial markets, but
we don’t see evidence of a
storm on the horizon.”
The views and opinions contained herein are those of Hugo Machin, Co-Head of Global Real Estate Securities, and may not necessarily represent views expressed or reflected
in other Schroders communications, strategies or funds.
42
17
Outlook 2016:
Greater China Equities
Louisa Lo, Head of Greater China Equities
Against a backdrop of sluggish economic growth and
anaemic earnings, the importance of bottom-up stock
selection becomes even more imperative for 2016.
Although Chinese GDP growth broadly held steady at the 6.5–7% level in 2015, the real
economy paints a much weaker picture as various indicators have pointed to increasing
sluggishness. Despite this, China’s A-share market, fuelled by record margin lending and
expectations of continued support by the Chinese government, saw an extraordinary
run-up that began in Q4 2014 and culminated in a spectacular collapse in share prices
halfway through 2015 as the unwinding of these margin trades sparked a heavy sell-off.
– A ‘two-speed economy’ in China
has emerged in a number of
areas, including the contrasting
fortunes of the private sector and
state-owned enterprises (SOEs).
– The continued liberalisation of
China’s financial markets should
open up further opportunities in the
investable China stock universe.
– Amidst sluggish economic
growth and anaemic earnings,
the importance of bottom-up
stock selection becomes
even more imperative.
Back in May, we wrote about our concerns over unsustainable valuations in Chinese
A-share markets and discussed our thoughts on navigating volatile markets amidst a
slowing economy. We have always maintained the view that there continue to be longterm, bottom-up opportunities in China, as reflected in our investment strategy.
China’s two-speed economy
Although recent data for China have been soft, the services sector of the economy is
generally in far better health but the pick-up is not sufficient to offset the slowdown in
the manufacturing sector. Consumer demand has been hit hard by the anti-corruption
campaign, across luxury and even consumer staple products, and for both local and
multinational players. The pace of fixed-asset investments, which previously functioned
as a counter-cyclical tool, has also shown signs of deceleration on the back of slower
property starts and a lack of incentives for local governments to do fiscal stimulus.
Figure 1: China Industrial Output, Investment and Retail Sales – % YoY
35
30
25
20
15
10
5
0
May
05
May
06
May
07
Retail Sales
May
08
May
09
May
10
May
11
Industrial Output
May
12
May
13
May
14
May
15
Fixed Asset Investment
Source: MSCI, IBES, Rimes, Morgan Stanley Research, October 2015.
Perhaps one of the most relevant divergences, at least for investors, has been the differing
fortunes of the private sector and state-owned enterprises (SOEs). The former have seen
43
Outlook 2016: Greater China Equities
growing sales and net profits, with a notable example being some of the large players in
the internet sector, while SOEs such as banks, industrial companies and oil companies
have seen declining profits on the back of weak economies and commodity prices.
The private sector/SOE divide is set against the broader divergence between the
manufacturing and services sector in China (i.e. the secondary and tertiary industries
respectively, illustrated in figure 2). Continued weakness in manufacturing data for
China has persisted but the consumer services sector maintains a healthy rate of
growth, incrementally making up a larger share of GDP growth. This is part of a
long-term transition that many feel is necessary for the Chinese economy to obtain
sustainable growth.
Figure 2: China GDP composition – Tertiary Industry versus Secondary Industry
Louisa Lo,
Head of Greater China Equities
Louisa Lo has 22 years’ investment
experience, with 19 years at
Schroders. She is currently the
Deputy Head of Asia ex Japan
Equities team and responsible for
the overall aspects of the Greater
China Equities business, based
in Hong Kong. She is a specialist
fund manager for Greater China
mandates and lead manager of the
Schroder ISF Taiwanese Equity.
Prior to joining Schroders, she spent
three years working as a research
analyst with two securities firms,
focusing on Asian electronics stocks.
She is a CFA charterholder and
has a Master’s degree in Applied
Finance, Macquarie University.
% share of total GDP, 4-quarter moving average
50
48
Secondary industry
46
44
Tertiary industry
42
40
01
03
05
07
09
11
13
15
Source: NBS, JP Morgan, November 2015.
Mixed record on reforms
Reform and restructuring have long been heralded as the key for the Chinese government
to enhance corporate efficiency and optimise resource allocation. However, the reform
initiatives have so far disappointed, especially amongst big SOEs. In contrast, some
progress has been made amongst smaller SOEs given a higher level of flexibility to
change and reform. Going into 2016, the government is likely to further encourage
overseas mergers and acquisitions, especially in the much-needed technology sector.
However, some of these deals may not enhance earnings and require close monitoring.
Continued liberalisation of financial markets
Where we have seen the greatest progress has been in financial market liberalisation.
The renminbi’s (RMB) recent inclusion in the Special Drawing Rights (SDR) basket is
a notable milestone for the RMB’s internationalisation.
Furthermore, the continued liberalisation of the stockmarkets, first through the
Shanghai-Hong Kong Stock Connect and to be followed by a similar upcoming scheme
for Shenzhen, should open up further opportunities in the investable China stock universe.
In addition, index provider MSCI’s recent inclusion of the China-based ADRs (US-listed)
companies to its MSCI China and MSCI Emerging Markets indices, due to be completed
by May/June next year, should have a more profound impact on the development
of China’s market. This rebalancing will also better reflect the reality of China’s ‘new
economy’, where education, internet, e-commerce, travel and consumer names are all
playing a larger part in growth.
Valuations see bad news priced in
Valuations in Chinese markets, as represented by the MSCI China index, are trading
at levels seen in the past few crises, including the Global Financial Crisis in 2008, with
the trailing price-to-book (PB) ratio close to 1.1x. We believe a lot of the bad news has
already been reflected in share prices. Market liquidity should remain supportive as the
deflationary environment allows for further monetary stimulus measures such as RRR/
interest rate cuts.
44
Outlook 2016: Greater China Equities
Figure 3: MSCI China valuation in terms of P/B
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
Sep
05
Sep
06
Sep
07
Sep
08
Sep
09
Sep
10
MSCI China Trailing PB
Average
Sep
11
Sep
12
Sep
13
Sep
14
Sep
15
MSCI China ex. Banks Trailing PB
Avg.+1Stdev
Source: Datastream and Citi Research, September 2015.
“We focus on investing
in companies that have
sustainable business
models and strong
cash flows, for example
in the service sectors
such as internet, tourism
and education.”
Potential risks for Greater China markets?
The potential risks for China include policy mistakes by the Chinese government, earnings
risks for corporates on the back of weak top line growth in a deflationary environment
and a further increase in non-performing loans (NPLs) in the banking system. Although
restructuring may continue to exert pressure on the economy in the near term, we do not
foresee a major systemic collapse in the financial system.
Another key risk for the China/Hong Kong market will be the US Federal Reserve’s
timetable for interest rate hikes, while the unwinding of the US dollar carry trade will
dampen investor risk appetite and put pressure on Asian markets.
As for Taiwan, the political headwinds of a presidential election scheduled for next year,
where the opposition Democratic Progressive Party (DPP) is expected to win, could cause
uncertainty to the cross-strait dialogues given the party’s less engaging relationship with
Beijing. Currently, the market has probably priced in a relatively pragmatic approach of the
DPP towards China.
Where do we see opportunities?
Against the market backdrop of sluggish economic growth and anaemic earnings, the
importance of bottom-up stock selection becomes even more imperative. We remain
focused on investing in companies that have sustainable business models and strong
cash flows.
China – maintain overweight in consumption/service stocks
We continue to be overweight in the consumer/service sectors including internet, tourism
and education on the back of our positive long-term outlook for consumption demand in
China. We have also selectively invested in companies that can benefit from supportive
government policies, including railway equipment, environmental protection and
renewable/alternative energy stocks. On the other hand, we continue to remain cautious
of the banking sector given the rising asset quality risk and declining net interest margins.
Meanwhile, we are broadly underweight oil and commodities stocks.
45
Outlook 2016: Greater China Equities
Hong Kong – favour more traditional Hong Kong names
The sluggish Chinese economy and the continued drop in tourists from mainland China is
having a knock-on impact on Hong Kong retail sales that has been a key driver for Hong
Kong economic growth in the past few years. Despite the more subdued outlook for the
local economy in the near term, we continue to see good value in more domestic names
including commercial property investors, diversified regional and global conglomerates,
regional insurers and selective manufacturing exporters, on a longer-term view. Balance
sheets are typically very conservative, franchises robust, dividends supportive and
management quality is well known to investors.
Taiwan – political headwinds and the technology product cycle
After a major earnings upgrade in 2014 led by Apple’s iPhone 6 new product cycle, we
are struggling to see another visible catalyst to drive the re-rating of the technology sector,
especially after the lukewarm reception to the iPhone 6S. Looking ahead, the prospects
of old economy stocks (such as materials and banks) remain lacklustre where selective
technology companies and telcos still offer investors with attractive valuations and decent
dividend support.
China A-shares – slowly bottom fishing
China’s A-share market has witnessed a major short-term correction, as expected in Q3
2015. The market is expected to range-trade in the near term as liquidity remains buoyant
and margin positions have declined to a more reasonable level. Although market upside
is capped by the government stock overhang, some of the better quality names have
become more attractive after the recent correction whilst valuations of many small/mid
cap stocks remain excessive. Within our broad Greater China strategy, we took profit in
most A-shares in Q2 and will selectively buy into this market on further weakness.
The views and opinions contained herein are those of Louisa Lo, Head of Greater China Equities, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy
or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and
investors may not get back the amounts originally invested.
46
18
Outlook 2016:
Japanese Equities
Shogo Maeda, Head of Japanese Equities
The Japanese equity market has seen optimistic economic
forecasts continue to be scaled down as the year has
progressed, but it has still managed to post gains over 10%
year-to-date in what has been a challenging environment.
Although the Japanese economy has entered a technical
recession after negative growth in the third quarter, the
headline numbers have disguised the fact that a broad-based
economic improvement is underway in Japan.
– Growth has been weaker-thanexpected but overall the trend for
Japanese economy remains positive.
– Improving corporate earnings and
governance will provide support for
Japanese stock prices.
– We continue to adhere strictly to our
bottom-up stockpicking approach and
focus on sustainable mid- to long-term
earnings growth and valuation.
“Japanese companies’
earnings have been growing
at a solid pace and are still
expected to rack up positive
year-on-year growth for the
current fiscal year.”
There have been a number of factors that have contributed to the continued solid
long-term outlook for Japanese equities. It has also been encouraging to see that the
previously strong correlation between the Japanese yen’s weakness and rising stock
prices has started to subside. Significant challenges for the Japanese economy remain in
the short- to medium-term and the slowdown in Asian growth, in particular, has weighed
on investor sentiment, reflecting the contribution to Japan’s external trade.
The economy: heading in the right direction
Investors have been closely watching short-term data releases in Japan but, in general,
we believe Japan’s economy is heading in the right direction. Although recent inflation
data have been weaker-than-expected and far below the Bank of Japan’s (BoJ) 2%
target, Japan does seem to have achieved a sustainable exit from deflation.
The labour market remains tight, with the unemployment rate at 3.1% – the lowest in
20 years. Growth in real wages is rising and recent talk of a hike in the minimum wage
should provide a further boost to consumer confidence. In addition, we should remain
cognisant of the fact that inflation data have been held down by lower oil prices and
slower growth in China. The direction of the economy remains positive, despite the fact
that progress is happening at a slower-than-expected pace.
Looking further ahead, there is a potential obstacle to growth from the next planned
increase in consumption tax from 8% to 10%, due to be implemented in April 2017. If this
goes ahead as planned it will, at best, cause additional short-term disruption to economic
data and, at worst, could create another period of contraction for the economy for one
or two quarters afterwards. While we expect a smaller impact this time around for the
economy, it will be worth monitoring closely for its potential ramifications.
Some signs of policy progress
A lot of controversy has surrounded Japanese Prime Minister Abe’s eponymous
‘Abenomics’ programme and whether it is having the desired effect on the economy.
The much-touted ‘three arrows’ have so far failed to impress investors due to a perceived
47
Outlook 2016: Japanese Equities
lack of policy reform initiatives. However, one area where Mr Abe can justifiably claim
credit is in pushing through the Trans-Pacific Partnership (TPP) trade agreement that
encompasses 12 Pacific Rim countries including Japan and the US. Covering about
40% of global GDP, this agreement could bring enormous benefits, although the market
has yet to fully digest what these might be and we remain realistic on the timetable for
ratification, especially given potential hurdles in the US. Mr Abe has also made substantial
progress in cutting the corporate tax rate, which is likely to be lowered again next year to
below 30% from the current rate of 32%.
For the BoJ, the weaker-than-expected inflation numbers have restricted its policy
options. Although Governor Kuroda remains upbeat, at least officially, it is clear the BoJ’s
original target of 2% inflation is virtually unobtainable. As a result, there is mounting
speculation about further easing moves by the bank and the central bank’s credibility
remains in the spotlight.
Shogo Maeda,
Head of Japanese Equities
Shogo Maeda is Head of Japanese
Equities, based in Tokyo, and joined
Schroders in January 2006. He has
previously worked at Goldman Sachs
Asset Management, where he was
Head of Japanese Equities, before
becoming Managing Director and
Chief Investment Officer for Asia
Pacific equity fund management.
Shogo is a CFA Charterholder and
has a Masters in International Affairs
from the School of International
Affairs, Columbia University. He
also has a BA in Economics
from Wesleyan University.
Improving corporate earnings and governance
Domestically, Japanese companies’ earnings have been growing at a solid pace. Despite
the weaker global picture, earnings are still expected to rack up positive year-on-year
growth for the current fiscal year. Although expectations have had to be scaled back
slightly, growth has been well-balanced and dependency on the external global economy
is now lower.
On the corporate governance front, the greater pressure being exerted by shareholders
on management is beginning to pay off. The introduction earlier this year of the Corporate
Governance Code is, without doubt, a positive long-term development in Japan and
is another success story for Mr Abe. Changes already underway include better board
structures which will ultimately lead to improved accountability and more efficient
allocation of capital, all of which should benefit shareholders. This trend of improving
governance is unlikely to be reversed and we are already seeing the positive effects of this
change via increased dividends and share buybacks by Japanese companies. We have
stepped up our own efforts to engage with company management with a focus list of
companies and have seen encouraging results.
Sticking to the fundamentals
Although growth data have been weaker than anticipated, the overall trend for the
Japanese economy remains positive. In an environment of low growth and low inflation,
we see the Japanese market being supported by firm corporate earnings growth and
growing returns to shareholders. Furthermore, the price-to-earnings multiple of the
Topix benchmark (based on forward earnings) is still at a reasonable level of 15–16
times. We feel that lower global economic growth has been sufficiently discounted in
share prices and in some cases the negative impact from China’s slowdown may have
been overestimated.
As always, we continue to remain disciplined and strictly adhere to our bottom-up
stockpicking approach, leveraging our in-house fundamental research platform on
the ground.
The views and opinions contained herein are those of Shogo Maeda, Head of Japanese Equities, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy
or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and
investors may not get back the amounts originally invested.
48
19
Outlook 2016:
Multi-Asset
Johanna Kyrklund, Head of Multi-Asset Investments
After years of liquidity-driven markets, investment trends look
tired and we expect muted returns in 2016. Cyclical assets
present the main source of potential ‘pent up returns’ and
could be a wild card for investors.
Many 2015 themes remain in place
Looking into 2016, we thought about ‘cutting and pasting’ from our 2015 outlook when
we said:
– The US continues to lead the recovery but growth momentum elsewhere is weak. As
such, we favour assets that can cope with subdued levels of growth
– Many of the economic trends that
prevailed in 2015 look set to remain
in place in 2016 with global growth
reliant on central bank activity.
– Our return expectations are lower as
quantitative easing has inflated the
prices of the assets we have liked
and the trends look tired – we prefer
to be patient at these levels, reduce
risk and wait for better opportunities.
– Value is most apparent in the
more cyclical areas of markets –
potential catalysts for unlocking
this value would be strongerthan-expected economic growth
or a weaker US dollar.
“Generally our outlook
is more muted than in
previous years, reflecting
the fact that quantitative
easing has inflated the
prices of the assets we
have liked.”
– Equities performance is likely to remain narrow; we prefer those areas of the market
where corporate earnings trends are most well-established
– The outlook appears tough for commodities although there could be opportunities after
recent steep price falls.
Certainly economic data would suggest more of the same; measures of manufacturing
activity remain subdued and global GDP growth remains stuck around 2.5% with the US
being the main bright spot. We remain focused on developed economy growth and have
avoided cyclical assets.
This has been the right call but the challenge we now face is that quantitative easing has
inflated the prices of the assets we have liked and the trends look tired. Accordingly we
have reduced the risk in our portfolios compared to previous years.
Economically-sensitive assets have fallen in value
What would enable us to refresh our portfolios and position for potentially stronger
returns? Certainly assets exposed to the more cyclical areas have fallen significantly in
value; emerging market equities are down 15%, commodities are down 26%, US energy
stocks are down 24% and local emerging market debt has fallen by 15% this year
(Schroders, DataStream, 31 December 2014 to 22 December 2015). This could be a
potential source of ‘pent up returns’ and we see two potential catalysts.
Firstly – the economic ‘pie’ may grow more quickly than is currently expected. Here we
would expect surprises to come from US and European consumption given the fall in the
oil price.
Secondly, the economic ‘pie’ may be sliced differently depending on currency
movements. In recent years, the Europeans and the Japanese have been the winners
of the currency wars. With the Federal Reserve now starting to raise rates it looks like
49
Outlook 2016: Multi-Asset
this trend could continue as higher US rates could support further strength in the US
dollar. However, we do see a scenario where the US dollar could weaken, particularly if
European inflation picks up and the Japanese choose to desist from further quantitative
easing for political reasons.
In summary, it seems to be too late to add to the beneficiaries of quantitative easing and a
bit early to add to the cyclically sensitive assets. Patience is a virtue.
Johanna Kyrklund, Head of
Multi-Asset Investment
Johanna Kyrklund joined
Schroders in March 2007. She is
Head of Multi-Asset Investments
and a member of Schroders’
Global Asset Allocation Committee.
Before joining Schroders, Johanna
specialised in asset allocation
strategies. She has worked at Insight
Investment and Deutsche Asset
Management. Johanna is a CFA
Charterholder and has a Degree in
Philosophy, Politics and Economics
from Oxford University.
“The economic ‘pie’
may grow more
quickly than is currently
expected. Here we
would expect surprises
to come from US and
European consumption.”
The views and opinions contained herein are those of Johanna Kyrklund, Head of Multi-Asset Investment, and may not necessarily represent views expressed or reflected in other
communications, strategies or funds. Any countries, companies or sectors shown herein are for illustrative purposes only and are not to be considered a recommendation to buy
or sell. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and
investors may not get back the amounts originally invested.
50
20
Outlook 2016:
Multi-Asset Income
Aymeric Forest, Head of Multi-Asset Investments Europe
2015 has been a challenging year for asset prices; however,
following the widening of credit spreads, large swings in
government bond yields and the recent equity sell-off, many
income sources are offering attractive yields again.
Demand for income is still strong
The demand for income remains global and structural, driven by low interest rates and by
an ageing global population.
– Demand for income remains high
and many income sources now offer
attractive yields.
Despite this ongoing demand, the environment has been challenging for income
strategies. First, the appreciation of the dollar is impacting liquidity and some interest
rate sensitive assets. Second, the normalisation of real rates happened as inflation
expectations dropped both in the US and Europe. Real yields are the discount rates of
financial asset prices. If they increase, growth needs to be strong enough to offset this
negative effect.
– Economic cycles are diverging;
active management of regional risks
is required.
So what should we expect going forward? Investors will have to adapt to a fast
changing environment as valuation may not be a sufficient guarantee of a successful
investment strategy.
– High dividend stocks and high yield
bonds offer opportunities.
Regional divergences are more apparent
Global economic cycles are diverging across regions and are expected to continue to do
so in 2016. Recent divergences have been mostly driven by exchange rates and central
banks’ guidance. As such, we favour regional asset classes in Europe and Japan, which
are both supported by loose monetary policies. Europe is now accelerating thanks to a
weaker euro.
“Central banks and real
rates will remain key
drivers in 2016.”
Elsewhere, there are some signs of slowdown in the US manufacturing sectors whilst
emerging economies remain under the stress of a strong dollar and decelerating
Chinese growth. The Federal Reserve (Fed) is expected to raise its key rates. However,
regardless of the timing of the first hike, this cycle is unique and the Fed may lack
room for manoeuvre in the future and could reverse its course of action if imbalances
grow. Typically, tighter monetary policy tends to generate lower expected returns and
this requires investors not only to focus on total return but also on strategies which are
dynamically managed.
For this reason, we expect volatility to normalise higher. Asset prices will be more
dependent on the realisation of growth to deliver future returns, whilst fair-to-expensive
long-term valuation levels may cap equity price appreciation.
51
Outlook 2016: Multi-Asset Income
High dividend stocks and high yield bonds look attractive
In this context, high dividend stocks could offer some defensive characteristics with more
regular and robust cash flows. They have been underperforming for more than two years
versus a standard global equity universe and now offer an attractive entry point.
We are also finding some value in high yielding bonds although security selection matters.
It is our preferred fixed income asset class given the attractive yield and high implied
default rate.
Regarding emerging market assets, we are cautious despite attractive valuation because
of a strong dollar and a low growth environment.
Aymeric Forest,
Head of Multi-Asset
Investments Europe
To conclude, central banks and real rates will remain key drivers in 2016. The first rate
hike by the Fed in the coming months is not likely to be followed by an aggressive
tightening cycle because of the dollar appreciation impacting US exports and of a weak
Chinese growth. Government bonds are therefore unlikely to run out of control but are
unlikely to offer attractive returns. This could benefit actively managed income strategies.
Aymeric joined Schroders in May
2011. His investment career
began in 1996. Aymeric is the
lead manager of Schroder ISF
Global Multi-Asset Income and
responsible for investment on
behalf of European Multi-Asset
clients and complex segregated
mandates. He is also a member
of the Global Asset Allocation
Committee and the Volatility Risk
Premia group leader. Prior to joining
Schroders, Aymeric was Global
Head of Investment Solutions at
BBVA in Madrid, responsible for the
multi-asset products. He was also
Head of Tactical Asset Allocation
quantitative strategies and senior
fund manager at ABN AMRO.
The views and opinions contained herein are those of Aymeric Forest, Head of Multi-Asset Investments Europe, and may not necessarily represent views expressed or reflected
in other communications, strategies or funds.
52
21
Outlook 2016:
Multi-Manager
Marcus Brookes, Head of Multi-Manager
Robin McDonald, Fund Manager
Sometimes these outlooks differ significantly from year to
year. This is not one of those times. Many of our thoughts
from a year ago still stand. Here, we revisit some of these
views as well as introducing a few new ideas.
What we think we know
We devote a lot of our time to assessing risk/reward opportunities. In our view, the
rewards on offer to the Federal Reserve (Fed) and the US economy in keeping interest
rates at zero were exhausted some time ago. The risks, however, particularly in financial
markets, have continued to build.
– Our general view is that almost all
assets are priced for continued
low growth, low inflation and low (if
not negative) real interest rates.
– We expect the trend of US equity
leadership to flip in 2016 and for
international equities to begin
to outperform in both local and
common currency terms.
– We believe cash will become
more desirable over the course
of 2016 as the headwinds
for fixed income intensify.
I’m writing this piece in the second half of November, and as things stand it is anticipated
that the Fed will begin the process of normalising monetary policy at its mid-December
meeting, albeit in exceptionally dovish fashion. So, here are a few things we consider to
be relevant:
– The global economy has not delivered. At the end of 2007, the global stock of
outstanding debt was $142 trillion. Since then the world has added an additional $57
trillion of debt to its balance sheet
– This record debt burden has been encouraged by global central banks and supported
by near zero rates
– Most financial assets have re-rated significantly on the back of near zero rates as it has
encouraged investors to take more risk.
What we believe to be true
Every economic cycle is different and in many ways this one has re-written the rule book.
Undoubtedly, the 2008 financial crisis was deserving of a radical response and in 2009
the US led the world in dramatic fashion, employing aggressive measures to rebuild its
balance sheet. A little over two years ago, in 2013, total net worth of the US household
sector hit a new record high. A reasonable question therefore is whether US rates have
remained unnecessarily low ever since, and what will the consequences ultimately be if
that proves to be the case? Here are a few things we observe:
– A US central bank that is desperate to move away from zero rates without distressing
financial markets
– An international economy trying to digest a stronger US dollar (global GDP growth is
down 5% year-on-year in dollar terms)
53
Outlook 2016: Multi-Manager
– A corporate sector that has engaged in aggressive financial engineering by issuing
huge volumes of low-yielding debt in order to retire massive volumes of equity
– Global bond yields close to record lows
– Global equity markets close to record highs.
Marcus Brookes,
Head of Multi-Manager
Marcus joined Schroders in July
2013 following the acquisition of
Cazenove Capital. Prior to the
acquisition he was the Head of MultiManager at Cazenove Capital, which
he joined in January 2008. During
his career Marcus has held MultiManager linked roles at Gartmore,
Rothschild Asset Management, and
his investment career commenced
in September 1994 when he joined
Friends, Ivory and Sime. Marcus
qualified from University of Stirling
with a MSc. in Investment Analysis.
What we know we don’t know
Sadly, what we know we don’t know with certainty is how financial markets will absorb this
inflection point in US monetary policy. Fortunately, what we can evaluate is how financial
markets are currently priced in a historical context, and broadly what investor expectations
are. This is a decent starting point for making reasonable judgments about the outlook.
Our general view is that almost all assets are priced for continued low growth, low inflation
and low (if not negative) real interest rates. If that’s the outcome – no great shakes. If the
outcome is higher growth and/or particularly higher inflation, then we could see some big
swings in the absolute and relative prices of bonds, equities, currencies and commodities.
We are very much alive to this prospect as we are beginning to observe accelerating
wage growth in a number of economies whose labour markets have tightened
meaningfully. Below are some thoughts on the major asset groups as we enter 2016:
Fixed income and cash
Traditional fixed income tends not to do well in a rising rate environment. Our bias is for
history to repeat itself in this respect considering how low current yields are. If we are
wrong, and longer-term yields fall when the Fed hikes, it would be suggestive of a policy
mis-step, making us more cautious on the economy. Either way, our suspicion is that
weaning investors from such loose policy conditions will not be straightforward, so we
expect bond markets in 2016 to be fairly turbulent.
Corporate credit spreads have widened over the past year suggesting, increased investor
concerns about the potential for credit stress among highly leveraged borrowers. This is
something we’re watching closely as history suggests that credit spreads often narrow
when the Fed begins to raise rates. Importantly, however:
1. The Fed doesn’t usually wait seven years into an economic cycle before raising rates.
Typically the Fed starts normalising one-to-two years into a recovery when earnings
growth is strong.
Robin McDonald, Fund Manager
Robin joined Schroders in July 2013
following the acquisition of Cazenove
Capital. Prior to the acquisition he
was a fund manager at Cazenove
Capital, which he joined in October
2007, responsible for co-managing the
Multi-Manager fund range. Robin has
previously held Multi-Manager linked
roles at Gartmore, Insight Investment
Management and Rothschild Asset
Management. Robin began his
career in September 1999 when he
joined Bank of New York (Europe)
Limited as a Client Relationship
Executive. He is a CFA charterholder.
54
2. A key reason why risky assets have done well this cycle is that investors have been
encouraged to move out along the risk curve. How many investors have unwillingly
bought investment grade credit and high yield this cycle in pursuit of a higher return;
and how many will retreat to less risky assets when the Fed begins normalising?
3. We strongly believe that when this credit cycle ends, the lack of liquidity will be a major
issue. The latest data from the New York Fed shows US corporate debt inventories
amongst primary dealers having turned negative for the first time on record. Until
these markets are properly tested we don’t know how they will cope under such poor
liquidity conditions.
So, although we can be modestly more positive on credit than we were a year ago as the
degree of compensation has theoretically gone up, we have opted to retain a healthy cash
balance across the Multi-Manager portfolios. Cash has been the hot potato asset of the
last seven years. We believe it will become more desirable over the course of 2016 as the
headwinds for fixed income intensify.
Outlook 2016: Multi-Manager
As a final point, 12 months ago we were rather more optimistic than we are today about
the US dollar. Once again, history suggests the dollar tends to peak early into a Fed hiking
cycle. This is contrary to popular wisdom, which suggests that in spite of a 25% rally in
18 months, the dollar remains a one-way bet. We tend to be wary of one-way bets as
invariably they disappoint.
Equities appear richly priced
Our overriding view of the equity market is that it’s richly priced and has dubious internal
dynamics, such as very narrow breadth (i.e. a small number of stocks leading the overall
market higher). This combination doesn’t guarantee it will go down a lot. But nor do we
believe our base case should be that it shoots up a lot either. Of greater curiosity to us at
present is the relative opportunity set that’s emerged within the market.
“We are trying to resist
the urge of becoming too
contrarian too early here.
Being different is often
crucial at turning points,
but can also prove a drag
in the latter stages of a
cycle when momentum
investing typically
works best.”
We expect the trend of US equity leadership to flip in 2016 and for international equities
to begin to outperform in both local and common currency terms. This reflects US
economic, margin and valuation cycles that are more mature than elsewhere. In addition,
Fed tightening is historically not good for US equity valuations. The reason why Fed
tightening cycles haven’t historically assured outright equity weakness is because they
usually get underway early enough in the cycle such that earnings growth effectively
trumps the de-rating that almost always occurs (the tech sector in the late 90s was an
exception). With the level of US profit margins close to record highs and with earnings
growth already having moderated, we ought to be able to garner a greater return
elsewhere. Our preference remains Japan and Europe where the above cycles are earlier
in their evolution.
We consider investor positioning within the equity market to be heavily skewed in favour
of the low growth – low inflation narrative. Yet, with US core inflation just a smidgen below
target at 1.9% and a tight labour market, it may not take much of a spark from wages
for the pendulum to swing away from this crowded group of ‘secular stagnation’ stocks
towards higher inflation beneficiaries. The oil price bottoming around current levels would
clearly be beneficial to this idea as well.
We are trying to resist the urge of becoming too contrarian too early here. Being different
is often crucial at turning points, but can also prove a drag in the latter stages of a cycle
when momentum investing typically works best. As ever we remain disciplined and
patient, but equally open-minded to change.
Blending alternatives
We ask for the same degree of pragmatism from our underlying managers, particularly
those running absolute return funds (one of our alternative asset classes). 2015 has been
a challenging and in many cases frustrating year for even the most experienced investors
we monitor in this space. We have no reason to believe the current higher volatility regime
will not persist into 2016.
It has been the correct decision for us to stand aside of the commodity markets in recent
years. This initially drew some criticism on the basis that we run (amongst other things)
mandates benchmarked against inflation, and commodities are generally considered an
effective inflation hedge. Inflation hasn’t been a risk the market has seen fit to hedge in
recent years. As indicated earlier, we’re mindful that this could change in 2016.
55
Outlook 2016: Multi-Manager
For now, we continue to blend a number of fund managers in the alternatives portfolio
who have historically proven adept at growing capital in weak markets. Sometimes this
has been through contrarian positioning, sometimes through bold directional exposure,
either long or short. Importantly the aggregate views expressed here are always in
harmony with our wider portfolio themes. To summarise, these are to approach the bond
markets with caution, to carry equity risk primarily outside of the US, and within equity
markets to increasingly lean in favour of strategies that will benefit from a shift away from
the low growth – low inflation beneficiaries. These views are expressed through both long
only and long-short strategies.
The views and opinions contained herein are those of Marcus Brookes, Head of Multi-Manager, and Robin McDonald, Fund Manager, and may not necessarily represent views
expressed or reflected in other Schroders communications, strategies or funds.
56
22
Outlook 2016:
UK Commercial Real Estate
Duncan Owen, Global Head of Real Estate
After a strong 2015, we expect performance across different
parts of the real estate sectors to be more polarised in 2016.
2015 has been another good year for UK commercial real estate and unleveraged total
returns are likely to be close to 15%.
Rental recovery
Whilst one of the drivers for another strong year has been a continued favourable fall in
real estate yields, the key difference to 2014 is that this year has also seen a broad-based
recovery in rental values. While Central London offices have led the upswing, several other
cities including Brighton, Bristol, Cambridge, Manchester, Leeds and Oxford have also
seen a significant increase in office rents. Likewise, industrial rents rose in many locations,
boosted by growing demand from on-line retailers and parcel couriers.
– Office and industrial rents are
now rising across the UK, not just
in London.
– The UK is finally seeing a recovery in
productivity, which should support
a steady increase in real disposable
incomes and consumer spending.
– New commercial development remains
at a low point in most markets.
– On balance, given that all the usual
suspects have a good alibi, we think
that capital values are likely to rise in
2016, but at a slower pace than in
2014–2015.
“The best market returns
will be achieved by real
estate which is in the right
city, the right location and
which best suits occupiers’
requirements and maximises
their productivity.”
In contrast however, the retail sector is still adjusting to a world of multi-channel sales. While
there are pockets of rental growth in London and some tourist destinations, most centres
have a significant amount of vacancy and rents were either flat, or fell slightly in 2015.
Top of the cycle?
The outlook for 2016 is already categorised by some commentators asking whether we are
now at the top of the cycle. The income from commercial real estate has historically been
very stable, but capital values have been cyclical (albeit less volatile than equities). However,
capital values have risen by 25% in less than three years so surely, this cannot continue?
This sentiment is understandable, but not necessarily rational. The immediate trigger for
previous downturns has been a recession, which has depressed rents and pushed up real
estate yields as investors have withdrawn from the market and liquidity has dropped. In
addition, commercial real estate has had a habit of contributing to its own downfall, either
through excessive borrowing which inflated prices (e.g. 2005–2007), or because of a boom
in development which left an over-supply of space (e.g. 1988–1990) and falls in rents.
Supportive economic picture
Fortunately, none of the usual suspects appear to yet be evident. Looking at the
economy, the outlook is positive and the consensus is that UK GDP will grow by
2.25–2.50% through 2016–2017. The main reason for being optimistic is that the UK is
finally seeing a recovery in productivity, which should support a steady increase in real
disposable incomes and consumer spending. Furthermore, exporters stand to gain from
faster growth in the rest of the EU, which accounts for 45% of total exports.
Borrowing under control
Similarly, there are few signs of excess borrowing. In general, banks and other lenders
have continued to take a disciplined approach to commercial real estate and although
total loan originations in 2015 are likely to be around £50 billion, they are still well below
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Outlook 2016: UK Commercial Real Estate
the peak of £80–90 billion reached in 2006–2007. Moreover, while the IPD All Property
Index initial income yield is low by historical standards at 5%, it is still comfortably above
the yield on 10-year gilts at 2% and the consensus is that 10-year gilt yields are unlikely to
rise to 3% until at least 2018.
Development low
The final reason for being sanguine is that new commercial development remains at a low
point in most markets. The only grounds for concern being the City of London, where
a number of new offices are due to complete in 2018–2019. Even so, these levels of
development are well below previous cycles. The lack of new development reflects in part
the reluctance of banks to fund speculative schemes and in part the hollowing out of the
development industry during the last financial crisis. Employment in construction is still
10% below its pre-crisis peak. Also, another constraint on development in the commercial
sector is sites being instead used for residential development.
Duncan Owen,
Global Head of Real Estate
Duncan Owen, Global Head of Real
Estate, joined Schroders in January
2012. Duncan was previously CEO
of Invista, having led its creation
and IPO as a newly formed property
fund management business listed in
London. Invista was formed in 2006
from the fund management business
of Insight Investment Management
Limited. He Joined Insight in 2003
following its acquisition of Gatehouse
Investment Management, the real
estate investment management
boutique which he co-founded.
He was the Managing Director of
Insight’s property division and a
main board director at the firm.
Previously he was a director at
LaSalle Investment Management and
a partner at Jones Lang Wootton.
Polarised performance in 2016
On balance, given that all the usual suspects have a good alibi, we think that capital
values are likely to rise in 2016, but at a slower pace than in 2014–2015. We anticipate
that total returns will still be respectable at between 7–9%.
There are, of course, risks around this outlook. One possibility is that 10-year gilt yields
jump more sharply in 2016 than anticipated. A second risk is the EU referendum. If the
UK were to leave, then UK real estate could be hit as various investment banks and
institutions, as well as some manufacturers, switch to continental European locations.
The best market returns will be achieved by real estate which is in the right city, the right
location and which best suits occupiers’ requirements and maximises their productivity.
The outlook from this point in the cycle is therefore set for more polarised performance
across different parts of the real estate sectors.
The views and opinions contained herein are those of Duncan Owen, Global Head of Real Estate, and may not necessarily represent views expressed or reflected in other
Schroders communications, strategies or funds.
58
23
Outlook 2016:
Outlook 2016: US Equities
Matthew Ward, Portfolio Manager, US Equities
A strong employment market and robust consumer
confidence make for a positive outlook for the US, where we
favour domestic exposure and sectors such as technology.
There is little doubt that some of the biggest risks to equity markets last year – depressed
commodity prices, slowing growth in China, and uncertain economic data points in
Europe as well as the US, all accompanied by dollar strength – will affect 2016 as well.
We continue, however, to be constructive about the outlook for US equities, encouraged
predominantly by ongoing strength in the employment market, increased evidence of
rising wages, better household balance sheets, and robust consumer confidence.
– Strong employment market and
robust consumer confidence make
for a positive outlook.
– Active fund management to
differentiate itself against backdrop
of increased volatility.
– We are focused on sectors with
secular expansion potential and prefer
a domestic tilt where necessary.
“We are optimistic about the
prospects for US growth
based on the strength of the
consumer, which ultimately
accounts for two thirds of
the economy.”
“We see continued
investment opportunity in
the technology sector, our
biggest overweight, as cloud
computing usurps traditional
business models.”
Strong consumer to drive US growth
We are optimistic about the prospects for US growth based on the strength of the
consumer, which ultimately accounts for two thirds of the economy. Based on current
activity indicators, we believe the US economy is growing 2–3% annually, roughly in-line
with trend-line GDP growth which, when combined with moderate increases in corporate
profitability, 1–2% stock repurchases, and modest multiple expansion, can provide
attractive equity returns. Other potential positives include an accommodative European
Central Bank and Bank of Japan, China’s ability to engineer modest growth, and potential
for dollar stabilisation and/or reversion in commodity prices/emerging markets driving
greater overall global growth. Offsets include further earnings revisions associated with
those companies more exposed to oil and other commodity prices, emerging markets,
and/or further dollar strength.
Certainly, slowing growth in China, subdued commodity prices, and uncertain economic
data points in Europe and the US could lead to increased levels of volatility. But given
greater levels of dispersion associated with this volatility, this should provide an environment
in which active management could differentiate itself from an asset management industry,
struggling to beat its benchmark over the last five years.
Industry disruption creates secular growth opportunities
We see continued investment opportunity in the technology sector, our biggest overweight,
as cloud computing usurps traditional business models in areas like enterprise resource
planning and human resources. The cloud offers lower total cost of ownership, faster time
to market, and more flexible and user-friendly interfaces. Also, as consumers spend more
time online and on mobile devices, historical means of monetisation and commerce will
give way to newer, disruptive approaches.
A stronger consumer, shopping online
We’re also constructive on the US consumer, emboldened by upward pressure on wages
associated with improving employment and lower gas prices. We believe in e-commerce
over traditional ‘big box’ retailing as selection, price, and convenience drive market-share
gains. Today e-commerce only accounts for 7% of overall retail sales, but it is growing at
a compound annual growth rate of 19% versus 4% for traditional retail. Where traditional
bricks and mortar will continue to prevail is through brand and merchandising and
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Outlook 2016: US Equities
categories that don’t lend themselves to online, and in service. Many of these names will
also benefit from the resurgent consumer, when steady jobs growth over the last two years
begins to manifest itself in improved wages and greater consumer expenditures.
US pharmaceuticals offer hidden value but regulatory uncertainty
tempers enthusiasm
In US pharmaceuticals and biotechnology there are myriad, late-stage drug pipelines
that are undervalued by Wall Street, in lieu of overvalued single-drug franchises that
haven’t shown research and development efficacy and are a focus for competition/
generic substitutes. But our enthusiasm is tempered heading into an election year as the
time of unchallenged pricing in pharmaceuticals is coming to an end. Direct government
intervention is unlikely, but multiples will be constrained.
Matthew Ward,
Portfolio Manager, US Equities
Matthew Ward is a Portfolio Manager
for the Schroder US Large Cap
Strategy and Schroder US All
Cap Strategy. He is also an Equity
Analyst for the US Large Cap team,
responsible for the media, internet,
software and telecommunications
services sectors. Matthew joined
Schroders in 2005 and is based
in the New York office. Prior to
joining Schroders he was an Equity
Analyst at Phoenix-Engemann Asset
Management and was responsible
for covering internet, media, and
cable/DBS. His investment career
commenced in 1995 when he joined
Franklin Resources based in California.
He was an Equity Analyst and his
responsibilities included coverage of
capital goods, electrical equipment,
natural resources and cable/new
media. Matthew has a BA degree in
Economics and English, Georgetown
University and is a CFA charterholder.
Industrials face multiple challenges
As we look at depressed commodities, particularly oil and gas, and at China battling
to shore up weaker growth, it’s difficult to be constructive on industrials, so we are
underweight this sector. Instead, we focus on the secular growth evident in certain
pockets such as environmental/analytics, auto manufacturing, residential construction/
HVAC (heating, ventilation and air conditioning). We’re also watching short-cycle and
inventories intently as signs of dollar stabilisation, commodity, or emerging market
economic growth would really drive positive earnings revisions in the group.
Strong US dollar points to domestic exposure
As interest rate differentials persist, the result of US Federal Reserve monetary policy
tightening versus European and Japanese QE, dollar strength should remain a theme in
2016. Accordingly, we must be mindful of multi-national sales sensitivity in those areas
of the S&P 500 (34% exposure to international overall) which have the highest overseas
sales. These include the technology (roughly 50% exposed to international sales),
materials (45%), and industrials (40%) sectors. In technology, we feel confident that our
stronger secular growth will overwhelm headwinds from dollar strength, while in industrials
and materials the impact to multi-nationals was quite evident in 2015. As such, at the
margin, we’ve tried to emphasise domestic versus international exposure.
Growth should outperform value
Historically, in an environment with modest economic growth, growth stocks tend to
outperform value. We are confident in the prospects for the consumer given strong
monthly jobs data, good housing starts and robust consumer confidence. However wages
and inflation are still fairly muted and the industrial economy is challenged. Against that
backdrop and the resulting 2% or so GDP growth we’d extrapolate, investors should
gravitate to those stocks where growth is more evident. This informs our penchant for
secular growth (via overweights in technology and consumer discretionary and decent
exposure in staples) and is notable in our growth premium to our S&P 500 benchmark.
“As interest rate differentials persist, the result of US
Federal Reserve monetary policy tightening versus
European and Japanese QE, dollar strength should
remain a theme in 2016.”
The views and opinions contained herein are those of Matthew Ward, Portfolio Manager, US Equities, and may not necessarily represent views expressed or reflected in other
Schroders communications, strategies or funds.
60
24
Outlook 2016:
US Multi-Sector Fixed Income
Andrew Chorlton, Head of US Multi-Sector Fixed Income
The market appears confident that Federal Reserve rate
hikes will be gradual in 2016, and we believe this could be
storing up some shocks for the new year.
The Federal Reserve (Fed) is finally on the cusp of increasing interest rates, but despite
the anticipation, market expectations for the future path of rates are extremely benign by
historical standards. This complacency could sow the seeds of an interesting year in
2016 with plenty of potential for surprises. However, we also believe that there are a
number of opportunities.
– Market expectations for the
future path of US interest
rates are extremely benign
by historical standards.
– Corporate bond markets
have endured a challenging
2015 and certain areas now
offer compelling value.
– Municipal bonds have had a very
robust year and may struggle to carry
this momentum into the new year.
“Many commentators have
spent time focusing on the
timing of the Fed ‘lift off’
but probably not enough
on the trajectory of rates
thereafter.”
Credit markets have tested investors over the last year. US corporate bond yield spreads
have continued to widen, and the slightest disappointment on individual names has been
met with intense reactions. Record breaking issuance, declining liquidity and deteriorating
fundamentals have all contributed to a challenging market. However, valuations have
become more attractive and reflect much of the bad news already. Conversely, the US
municipal bond market has been a bastion of strength and stability recently, but looking
ahead to 2016, it is hard to see it maintaining such strong relative performance.
It’s not about the first Fed move; but the second, third, fourth and beyond
Many commentators have spent time focusing on the timing of the Fed ‘lift off’ but
probably not enough on the trajectory of rates thereafter. It is perhaps natural that after
such a prolonged period of ‘zero’ interest rates – and multiple rounds of quantitative
easing around the world – that the first major bank to tighten policy would get such focus.
What really matters is what happens next. The current expectation – of just two 25
basis point (bps) hikes in 2016 – is much more benign than any recent rate hiking
cycle. It predicts that the Fed’s dovish approach will continue even as it raises rates,
and is coupled with fears that the slowdown in the rest of the world will persist. Making
exact forecasts on either the Fed funds rate or 10-year Treasury yields is a fruitless
task. Nevertheless, it does feel that market expectations are one sided. After years
of excessively positive outlooks, the market has been beaten down; resigned to an
extension of low growth with low inflation. Having been wrong for so many years,
one could almost argue the consensus view is no view at all.
Given where we are, any negative economic surprise could delay further rate hikes, but we
believe it is unlikely to reverse or cancel the Fed’s hiking cycle altogether. On the other hand,
any positive surprises to global or domestic growth – and yes, it is possible – could result in
a more material impact on markets, as rate hikes are brought forward and the expectation
of the terminal rate moves above 2%. Inflation could also present a surprise to the market,
which is currently pricing in significantly below-trend inflation for the next ten years.
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Outlook 2016: US Multi-Sector Fixed Income
Corporate bonds are cheaper, but are they cheap enough?
Our strongest held conviction remains the compelling value of US investment grade
corporate bonds. Credit spreads have moved wider over the last 18 months in the face
of record issuance, deteriorating fundamentals and declining liquidity. Current valuations
in BBB-rated issuers have moved to levels consistent with previous recessions and, at
longer maturities, are near 25-year lows. Since the summer we have slowly increased our
exposure to credit and expect to do so as we head into 2016.
One of the key elements of that decision has been the time horizon we are taking.
In this market, credit spreads could go 25 bps in either direction over the next three
months, but as a team we feel confident that taking credit risk could be rewarding over a
12-month horizon. The balance of positioning is crucial in this environment. While we
have reasonable exposure to corporate credit risk, we have enough high quality assets to
enable us to react to any surprises that create investment opportunities.
Andrew Chorlton,
Head of US Multi-Sector
Fixed Income
Andrew Chorlton is the Head of US
Multi-Sector Fixed Income and based
in New York. He joined Schroders
in 2013 following the acquisition of
STW Fixed Income Management,
where he had worked since 2007. At
STW, Andy was Principal, Portfolio
Manager and a member of the
team responsible for managing
Multi-Sector portfolios including
Core, Short and Long Duration and
Tax-Aware strategies. Andy has
also held senior positions at AXA
Investment Managers and Citigroup
Asset Management. Andy is a CFA
charter holder and has a Bachelor of
Social Sciences in Economics and
Spanish, University of Birmingham.
“Given where we are,
any negative economic
surprise could delay further
rate hikes, but we believe
it is unlikely to reverse or
cancel the Fed’s hiking
cycle altogether.”
We favour investment-grade financial and broadly diversified industrial credits, including
some higher quality energy issuers which are at what we consider to be very attractive
valuations. It is our view that the financial sector will continue to benefit from a more
supportive regulatory backdrop and is more immune from the merger (M&A) risk,
which is affecting many industrial sub-sectors.
How will municipal bonds react to a move from the Fed?
There have been two material dislocations in municipals in the last five years. The most
recent was two years ago, when ‘taper tantrum’ fears sent longer dated municipals
to the cheapest levels seen in decades. Municipal bond yields rose rapidly, spreads
between rating grades widened and liquidity evaporated. How times have changed.
As we approach Fed ‘lift off’ the opposite has occurred. Municipals have delivered strong
outperformance relative to other bond markets, despite a plethora of idiosyncratic noise
ranging from the collapse of commodity prices to the well-publicized fiscal malaise in
Puerto Rico. As we look forward to next year, expectations of negative net supply should
support the market. We believe that municipals are fully priced while corporate bonds
are more undervalued.
Is liquidity going to come back?
No; at least not any time soon. However, if investors have a longer-term time horizon, we
think they can demand an attractive ‘liquidity premium’. As portfolio managers and investors
we just have to come to terms with the new liquidity environment and manage accordingly.
2016: A year of firsts
2016 should prove to be an interesting year, and one of firsts. The Fed is embarking on
the first rate hikes since 2006. It is also the first time the Fed has started hiking rates with
a $4.5 trillion balance sheet and the first time they have raised interest rates with real
economic growth running below 2.5%. There will certainly be many significant decisions
to be made and we anticipate 2016 will be another year for capitalizing on market
dislocations. We think that could be good news for those investors with a longer-term
time horizon, as valuations in some areas currently look quite compelling.
The views and opinions contained herein are those of Andy Chorlton, Head of US Multi-Sector Fixed Income, and may not necessarily represent views expressed or reflected in
other Schroders communications, strategies or funds.
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About Schroders
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Source: Schroders, as at 30 September 2015.
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