There’s a lot of anxiety unfurling in the markets at the moment, with fears ricocheting between several concerns which combine into a towering wall of worry. 
These include the slowdown in China’s growth rate and the fragility of its financial system, with the risk that a sharp devaluation of the Yuan could export a deflationary tsunami around the globe.
There is the rout in oil, gas and industrial commodity prices, which while being beneficial for some economies also weighs on the UK’s FTSE 100 and is raising the prospect of defaults in US high yield bonds.
Plus there are Concerns about the solvency of European banks and uncertainty around the UK’s forthcoming “Brexit” referendum.
Performance of indices in 2016
Source: FE Analytics
It wasn’t that long ago when we were concerned that markets had grown too complacent about risk, in the belief that central banks would always step in to the rescue.
What has been a game-changer in recent months has been a growing sense that central banks are no longer in control of the situation, so very rapidly bearishness has moved into ascendancy.
While we went into 2016 with a cautious outlook, and believe the current volatility could continue for some time, we also believe that recent declines make for a far more attractive entry point for long-term investors.
No one knows how long this current turmoil will continue but history suggests that markets tend to overshoot on both the way up and the way down. We may be reaching a point of capitulation where the exodus out of equities is herd-like rather than driven by fundamental factors.
“For truly long term investors, it is important not to get blown off course by the short term white noise of weekly market moves but instead to focus on building a robust, well diversified portfolio that will stand the test of time.
“For those concerned about the sharp swings in markets, a sensible strategy is to drip feed their cash in over a period of weeks or months.”
Here are a number of areas that investors might consider this ISA season:
Put absolute return funds on the agenda
In volatile markets, absolute return funds should be high up investor’s radars to both help reduce overall portfolio volatility and enable them to back managers who can utilise a wider set of tools to deliver returns.
For investors looking for a strategy aimed at generating positive returns that are not dependent on general market movements, we favour multi-strategy targeted absolute return funds – though a positive return is not guaranteed.
Here, one of the funds that we rate highly is the Invesco Perpetual Global Targeted Returns. The fund is an umbrella for a plethora of underlying strategies that invest across equities, bond markets, currencies and interest rates and as such provides a diversified “one stop shop” approach to absolute return investing.
A second idea in the absolute return space, but which is less focused on reducing volatility per se but instead uses both long and short positions in UK and European companies to access a wider range of money making opportunities, is the FP Argonaut Absolute Return fund.
The team focuses on companies which they believe have the capacity to deliver earnings surprises compared to the consensus view, whether in a positive or negative way.
The ability to “short sell” companies means the fund manager seeks to generate returns from companies that they believe will disappoint, as well as those that will do well. For example, the fund has a short position in Standard Chartered, a bank with a high exposure to Asia and Emerging Markets, regions which are facing negative headwinds.
The team at Argonaut see the potential for disappointing loan growth and an increase in bad loan provisions because of the deteriorating conditions in Asia.
For equity investment consider Europe
While we think the year could remain a volatile one for equities, Europe is our preferred equity market at the moment as the policy environment remains very supportive for shares.
The European Central Bank has adopted negative interest rates and is already engaged in a QE stimulus programme which it may well accelerate. Furthermore, low energy prices are also a positive for Western Europe, as a net importer of oil and gas.
Performance of fund versus sector and index over 10yrs
Source: FE Analytics
The Threadneedle European Select fund has long been one of our top picks and has quite a defensive style, with a focus on high quality businesses.
In uncertain times back big brands
With the global growth outlook weakening, there’s a strong case for focusing on high quality brands, as these business typically command loyalty that can prove resilient through the economic cycle and which provides a high barrier to competition.
One fund that has exposure to such companies is the Fundsmith Equity fund, managed by Terry Smith, one of the most colourful and pugnacious characters in the City. His approach is very much a long-term buy-and-hold one, backing a concentrated portfolio of growth companies which have the ability to sustain high rates of return on capital employed.
The fund is split between the US, the UK and Europe and offers investors exposure to giant consumer brands like Dr. Pepper Snapple, Pepsico, Imperial Tobacco and Microsoft.
Play a defensive game in the UK
Many British investors naturally gravitate to UK funds, but the road ahead could be rocky, with the upcoming Brexit vote generating uncertainty.
This is most likely to be felt in sterling, which has already weakened in recent times, and in Foreign Direct Investment, but don’t forget that the UK equity market is very international in nature and not particularly reflective of the domestic economy at all.
Ironically a weaker pound could help massage UK-listed company dividend pay-outs for sterling investors, as many UK-listed firms earn most of their revenues outside of the UK.
As overseas earnings are translated back into sterling dividends, this could help mask weaker underlying dividend growth. However, it is vital to be selective and avoid potential dividend landmines, as dividend cover has weakened in a number of sectors, so it is vital to avoid stocks which could face cuts.
One fund that pursues a very selective approach is the Standard Life UK Equity Income Unconstrained fund.
For growth investors, a strong defensive choice is the JOHCM UK Opportunities fund, managed by John Wood. The fund is a concentrated portfolio of 25 very high quality large and mid-cap companies, with predictable and growing cash flow streams.
Performance of fund versus sector and index since launch
Source: FE Analytics
Wood has a strong emphasis on protecting capital and is prepared to hold a considerable proportion of the fund in cash, when he feels cautious on markets and valuations. He entered 2016 with 18.8 per cent of the fund in cash and is in a great position to snap up companies that meet his strict quality criteria which have been indiscriminately marked down by falling markets.
Could Asia/emerging markets be the “wild card”?
We’ve been particularly cautious on Asia and Emerging Markets for a long time now, as they have faced significant headwinds both from the slowdown in China but also as the dollar strengthened in expectations of a US rate hiking cycle which has made the costs of servicing dollar denominated debt, very painful.
Yet we may now be nearing a point where so much negativity is priced in, that these markets could be the “wild card” for 2016, for bargain hunters.
While these markets have looked “cheap” for some time, we think that market expectations of a normal US rate hiking cycle are rapidly evaporating and there is even a chance of further easing. A weakening Dollar will provide a relief to these markets but set against this is the risk of a further deterioration in China and a deeper devaluation of its currency.
Investors tempted to make a contrarian call on Asia, might therefore consider a fund such as Stewart Investors Asia Pacific Leaders, which has very little exposure to mainland China (1.3 per cent) and instead has put its chips on the India table (23 per cent).
Jason Hollands is managing director of business and communications at Tilney Bestinvest. All the views expressed above are his own and shouldn’t be taken as investment advice.
