Extreme investor sentiment towards the UK, the return of stock selection and a rebound in Chinese equities are some of the factors that are likely to affect returns over the course of 2019, according to a panel of investors from Investec Asset Management.
With the new year less than a month away, Investec Asset Management’s John Stopford, Alastair Mundy, Blake Hutchings, Greg Kuhnert and Therese Niklasson have highlighted five themes that they think investors need to pay attention to.
Below, we explore these five themes in more detail.
Stock selection to come into its own
John Stopford, head of multi-asset income and manager of Investec Diversified Income, starts us off by noting that 2019 is expected to be another challenging year for markets. A decade into the post-crisis bull run, valuations are no longer as attractive as they once were and potential catalysts for a market drawdown are mounting.
Performance of indices over 10yrs
Source: FE Analytics
Stopford said a variety of leading indicators appear to be showing that a recession is on the cards for late 2020 while monetary policy – which has pushed up asset prices for the past 10 years – is becoming less accommodative as rates rise and quantitative easing is scaled back.
“The case for adopting a steadily more defensive posture in portfolios is, therefore, pretty clear but the timing of a bear market remains highly uncertain. If the global economic expansion still has a year or more to run, then equity markets can go on to make new highs before they peak,” Stopford said.
He said equity call options still look cheap in a historical context and provide a way to participate if the rally continues while protecting the downside. He added that a sensible strategy might be to sell equity futures to hedge some physical equity exposure and then buy out of the money calls to benefit if the bull market carries on.
Stopford also argued US president Trump’s policies and the resulting growth divergence with the rest of the world remain dollar supportive. However, the Japanese yen stands out as being “significantly cheap” and offering naturally defensive qualities if equities come under pressure, thanks to Japan’s status as an international creditor.
“There are selective value opportunities in many areas and a bottom-up security driven approach looks increasingly relevant at this stage of the market cycle. A focus on attractively valued holdings with attractive yields supported by sustainable cashflows should help to underpin returns in a difficult market environment,” the manager concluded.
China’s inclusion and transformation in the year of the Earth Pig
Chinese equities have been volatile in 2018 on the back of the US/Sino trade spat and tightening domestic liquidity, but Investec All China Equity manager Greg Kuhnert argued that the long-term investment case for the country “remains clear”.
“We’d caution against ignoring China’s ongoing transformation, which is being driven by government reform and ongoing innovation in the economy,” Kuhnert added. “This transformation addresses many of the concerns investors have and supports the development of the equity market over the long term. China’s transformation, based on reform and technical innovation, continues unabated.”
The manager said the correction in Chinese equities could be seen as a stock-picking opportunity on a valuation basis although he is reluctant to call the bottom of the market until there is evidence of positive surprises on corporate earnings.
“Clearly the Chinese equity market entails short- to medium-term risks, most significantly policy execution and the growing tension between China and its trade partners, particularly the US,” he concluded.
“However over the long term, we believe a consistent investment strategy focusing on high conviction ideas, selected using a bottom-up approach, is the best way to provide long-term risk-adjusted returns to our investors and we remain broadly fully invested in our portfolio as there are abundant opportunities that can be found in a dynamic market environment like China.”
Looking through Brexit – extreme investor sentiment points to pricing anomalies
Alastair Mundy, head of value at Investec Asset Management, said: “We fear the market may lose confidence in central bankers and their bag of tricks over the next cycle.
“In this environment, those assets which have been most supported by easy money over the last decade become the most vulnerable and those which have been most out of favour become more attractive. In this transition stage there is a good chance that asset volatility could increase significantly.”
As a result, Mundy said his Investec UK Special Situations fund and Temple Bar Investment Trust remain defensively positioned in both equities and bonds while using precious metals (both bullion and shares) to protect against the tail risks of a return to quantitative easing or higher-than-expected inflation.
Performance of indices over 3yrs
Source: FE Analytics
The manager added that he does not take a view on the outcome of the UK’s negotiations to leave the UK, although he noted that pricing anomalies often occur when investor sentiment reaches the “extreme” levels that are being seen towards the UK.
His approach is designed to look through short-term issues such as Brexit and concentrate on finding opportunities where he can pay a low price for companies can generate profits through the cycle; the “Brexit paralysis” has given him chance to build holdings in stocks such as Royal Bank of Scotland and Barclays.
“2019 is likely to be the ‘moment of truth’ where we will see clearly which asset classes have become the most distorted over the last decade,” Mundy said.
“Looking further afield we see many more opportunities in emerging markets, Europe (including the UK) and Japan than we do in the US. UK and emerging market equities appear particularly attractive to us, owing to their recent weakness.”
Opportunity knocks amid uncertainty for quality capital-light, cash-generative businesses
Blake Hutchins, manager of the Investec UK Equity Income and Investec Global Quality Equity Income funds, is another investor expecting 2019 to be a difficult year but added that opportunities can still be found in companies that able to generate cash and reinvest it at rates of return well in excess of their cost of capital, supporting future growth in cashflows and dividends.
“Going into 2019 against this uncertain backdrop, we believe it will be important for equity income investors to focus on companies that largely control their dividend-paying ability. Investors cannot rely solely on the fortunes of external factors, such as commodity prices, interest rates, or the economy, to sustain dividend growth,” he explained.
“As quality investors, we focus on capital-light, cash-generative businesses that are typically underpinned by structural growth. These companies can sustainably return a proportion of their growing cashflows to investors as dividends and re-invest the remainder for future dividend growth. Most of these businesses have continued to grow their dividends. Prudent stock selection will be required to separate the good from the unsustainable in terms of income.”
Hutchins draws attention to the UK, where Brexit outcome, a weak consumer environment, political infighting, sterling volatility and poor business investment is holding back sentiment. He argued that larger multinational companies with globally diversified revenue streams will be best placed to deal with the domestic political and economic challenges as well as any risks to sterling.
“As we look forward to 2019, we see a continued shift back in favour of more resilient quality stocks with sustainable business and financial models, reliable cashflow and dividend growth drivers, strong balance sheets, and lower sensitivity to the economic and market cycle,” the manager said.
Performance of funds vs index over 10yrs
Source: FE Analytics
An evolving and expanding ESG focus with significant milestones in the year ahead
Therese Niklasson, global head of environmental social governance at Investec Asset Management, made the case that responsible investing has “gone mainstream” as the investment community places an ever higher emphasis on environmental, social and governance (ESG).
“There has been a surge in the quality and depth of ESG-related investment products, as well as reporting by companies and industry. Regulators and policymakers are strengthening their messaging and focusing on more long-term sustainable capital markets,” she said.
“ESG in emerging markets also continues to evolve, with China leading the way in some regards, and continuous efforts around environmental legislation. Efforts to avoid ‘runaway’ climate change are stepping up and the investment community has come under increasing pressure to demonstrate action.”
ESG milestones over the coming years include including the UN Sustainable Development Goals (SDGs), post-2020 Biodiversity Framework and COP26 in 2020. “Progress is mixed, but hope prevails,” Niklasson said.