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Elliott: Why bullish investors need to overhaul their portfolios

18 December 2014

The overwhelming majority of fund managers remain optimistic about equity markets, but the significant falls in October and more recently have caught many off guard.

By Joshua Ausden,

Editor, FE Trustnet

The turbulence in risk assets since early autumn is a sign of things to come, warns deVere international investment strategist Tom Elliott, who expects rising market volatility over the next 12 months as a result of growing political risk and regulatory changes.

While long-term investors who don’t actively manage their portfolios on a regular basis can afford to ride out the volatility, those with a shorter time horizon must act now, he says.

“Investors who are sensitive to market volatility may need to increase their exposure to defensive sectors and stock markets, because stock market volatility is likely to increase in 2015,” he said.

“The uncertainty over the ongoing development of the euro project, and Japan’s use of massive fiscal and monetary expansion to achieve consistent economic growth, represent existing political risks for investors.”

Worries about a break-up in the eurozone have been relatively muted since the crisis peaked in mid-2012, though poor economic data from not only the periphery but France and Germany has recently brought the issue back to light.

The MSCI Greece index fell 23 per cent in three days earlier this month, according to FE data, though the wider MSCI Europe ex UK index has been much more resilient.

Performance of indices over 3yrs

 

Source: FE Analytics

Japanese equities have performed very strongly of late, buoyed by the government’s growing commitment to reflating the economy. However, Elliott fears the unintended consequences of quantitative easing could be damaging.

“2015 may also see some increase in risk coming from other countries,” he continued. “For instance, we may discover if China’s private sector has taken on too much debt. If a wave of defaults from property companies, for example, leads to a banking crisis, will the Chinese government bail them out? What will the impact be on growth?”

“In addition, it should be noted that a weak Russian bear is potentially more dangerous than a strong one, and if export energy prices remain depressed and the economy falls into recession, president Putin may choose to ramp up the rhetoric.”

The fall in the oil price to below $60 a barrel has been the biggest contributor to the recent weakness in global equity markets, with the FTSE All Share and MSCI AC World indices down 8.29 and 4.94 per cent respectively over the past 11 days.


Performance of indices since 5 Dec 


 
Source: FE Analytics

However, the country most likely to experience a rise in political risk is the UK, according to Elliott, as voters and investors make sense of the rise of both UKIP and the SNP.

“The spring general election may well result in a minority government that seeks allies on a policy-by-policy basis, or another coalition government. Neither promises stability,” he said.

As well as rising political risk, Elliott highlights evolving regulatory changes as a reason to be nervous.

“A wave of post-credit crunch financial sector regulation, most notably the American 2010 Dodd-Frank Act, has caused investment banks to allocate less capital to market making, in both stock and bond markets,” he explained.

“As a result financial markets have become less liquid and, as the October ‘flash crash’ demonstrated, more susceptible to panics.”

“The high yield bond sector looks most vulnerable to this problem, even when the run-up to the credit crunch liquidity was thin. Rolling over debt for high yield issuers may become expensive, negatively affecting earnings and their stock valuation.”

“In light of both the pressing geo-political factors and the changing regulatory landscapes, it would be prudent for many investors to reassess their risk appetite for 2015,” he finished.

A number of fund managers share Elliott’s concerns. Contrarian star manager Alastair Mundy, who heads up the Investec UK Special Situations fund, says the number of headwinds facing risk assets is rising.

“We see a number of concerns around the world. These concerns range from geo-political worries to fairly disappointing earnings growth for companies worldwide, and, of course, the end of quantitative easing in the US,” he said.

“All of these factors suggest that equity valuations should not be as high as they are.”

Mundy, who has been cautiously positioned for time with an above average cash weighting, says defensive assets should be in high demand.

“So, what do we need if we think equity valuations are going to fall? We need some complementary assets such as gold, gold equities, Norwegian krone, cash and index-linked bonds, both US and UK,” he said.

“We cannot be absolutely positive that these complementary assets will rise if equity markets fall significantly, but we are hoping that they will dampen volatility if equity markets become more volatile.”

FE Alpha Manager Neil Woodford, who runs the CF Woodford Equity Income portfolio, thinks the recent turbulence in risk assets has been deserved. He thinks bonds are more realistically priced than equities, though thinks certain sectors still offer value – namely pharma and tobacco.

“The robustness of developed world equity markets does not appear consistent with the price action in sovereign bond markets, where falling yields seem to suggest growing concern about the economic outlook and, in particular, fears of deflation across the developed world,” he said.



Source: Woodford Investment Management


“We feel more sympathetic to the view of the world implied by the bond market’s behaviour. In the short term, this makes us feel slightly nervous about the outlook for the UK stock market but we continue to believe the portfolio is appropriately positioned for a challenging future, both near term and, most importantly, long term.”

Even Old Mutual UK Alpha’s Richard Buxton, who believes we are in the midst of a longer-term bull market, is cautious in the near term. He thinks uncertainty over the general election will hold back markets initially, though anticipates a more positive year overall. 

“I firmly believe that 2015 could be a year of two halves for the UK equity market. While the market is likely to be stuck in a narrow trading range for the first half of the year, there are some significant tailwinds that should propel it higher post-election,” he said.

In an article next week, FE Trustnet will highlight some of the different vehicles available for investors wishing to weatherproof their portfolio from the headwinds mentioned above. 

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