Data suggests that the global economy is finally on the road to recovery after the financial crash: the FTSE has breached 6,800, the All Share has more than doubled over five years and tail-risks such as the eurozone crisis appear to be diminishing.
This has meant many of the more cautiously positioned funds, such as CF Miton Special Situations, Troy Trojan and the Capital Gearing Investment Trust, have struggled recently in relative terms.
Performance of funds vs index over 5yrs
Source: FE Analytics
However, before you ditch the more cautious elements of your portfolio and go all out in equities, the experts explain why it is important not to get too carried away.
1. You don’t want all your funds to move together
The most important reason not to sell out of defensives, according to Rowan Dartington’s Tim Cockerill (pictured), is because you don't want to put all of your eggs in one basket.
“My approach has always been that you don’t want all your funds doing the same thing,” he said.
“With everyone predicting what will happen this month, next month or next year, a left-field event can come along and those predictions can go out of the window. If that were to happen, you don’t want a portfolio completely geared for a bull run.”
“For me, you want to skew a portfolio for your best case scenario. Even if that is very positive, you want defensive funds just in case you’re wrong,” Cockerill added.
He says there are numerous macro-economic headwinds that have the ability to de-rail the currently euphoric sentiment.
2. Earnings growth is desperately needed
The first of these would be seen if earnings growth fails to live up to expectations. There is no doubt that developed market equities have had a stellar run of late; however, sceptics say the rally is unsustainable as it has been fuelled by cheap money and speculation.
They say that while the prices of shares have re-rated, underlying company earnings growth has remained subdued – which in turn has led to expansion of multiples.
Richard Curling, manager of the Jupiter Fund of Investment Trusts, is one of the people worried about slow earnings growth.
“Markets have obviously had a very good run. However, nearly all of those gains have been due to re-ratings instead of earnings growth. We badly need it, as otherwise equities look optically expensive.”
Curling does, however, think that company earnings will increase throughout the year and so he is bullish on equities.
On the other hand, there are a number of high-profile fund managers who think that instead of expecting earnings growth, most bulls are just hoping for it. Take Alastair Mundy, manager of the Investec UK Special Situations fund, for example.
“I think the market is being incredibly short-sighted in believing earnings growth can grow significantly from here, especially as profit growth has been so strong in recent years,” Mundy said.
“Similarly, it seems unlikely that valuations can grow significantly as they near all-time highs.”
“So the market seems to be willing to ignore history in favour of the weight of money argument or in favour of an 'it’ll all be different this time' argument. This could be right, but it hasn’t got a great track record.”
3. QE hasn’t finished yet
Quantitative easing has undoubtedly helped equity markets as investors have been forced out of cash and bonds into higher risk assets.
Ed Smith, global strategist at Canaccord Genuity, says that although the Federal Reserve has already begun to taper its asset-purchasing programme, whether or not the market can be successfully weaned off the stimulus will be the most important question this year.
“We think that one of the biggest risks for this year is that the pace of QE tapering comes through faster than the market expects,” he said.
“Even more than that, we expect equity returns to be meagre at best in the face of the deceleration of QE.”
“The rally has been largely driven by QE and if you were to plot the expansion of the Fed’s balance sheet against the performance of the S&P 500, you will see it is incredibly correlated.”
Like Mundy and Curling, Smith says that as QE is withdrawn, earnings growth will need to come through. He says his base case scenario is that markets move sideways for the next three to six months as QE is reduced, but will end the year in a better position as company earnings improve.
However, he says this is by no means a certainty.
“The big risk to that is if the reduction of QE is accelerated.”
“Each year the Federal Open Market Committee undergoes a rotation of its voting governors. This year, two of the most dovish, or pro-QE, have lost their vote, while two hawks, who are staunchly negative on QE, will take their place. When there are only 12 voters, that is a big shift.”
4. China and the eurozone are still a concern
While the economic slowdown in China and the eurozone’s ongoing issues have been a prominent concern for investors over the last few years, Smith says those worries seem to have been swept under the rug as sentiment has turned positive.
“This year is going to be about earnings growth and where we will see that isn’t going to happen is where economic growth is below trend. That isn’t going to be China and Europe,” he said.
Smith says that although he doesn’t foresee a doomsday scenario in China, he expects sentiment to remain low towards the world’s second-largest economy.
“The authorities are trying to rein in their shadow banking situation as part of their new commitment to improve their financial services industry,” Smith said.
“Non-bank loans have been growing at about 40 per cent year-on-year, and the Chinese government doesn’t want that as it doesn’t want over-investment or high leverage. These changes are going to cause a problem for the Chinese market, especially as it is very sensitive to liquidity.”
Europe has been one of the surprise packages recently. Buoyed on by positive rhetoric from the ECB, a stabilisation in the economy and extremely low equity prices, European markets have surged over the past year.
Performance of index over 1yr
Source: FE Analytics
However, as UBS’s Joshua McCallum recently told FE Trustnet, investors cannot afford to be overly bullish on Europe.
“The first stage of the crisis was about stabilising the debt trajectory and that has been achieved, but the second stage where debt needs to fall is still to come. Handling the impact on the economy will be a severe challenge,” he said.
5. Don’t get carried away by the UK recovery
Investors can’t become complacent with the state of the UK economy either, according to Tim Cockerill. He says that although the data is encouraging, the UK is still not out of the woods yet.
“We have seen recently that PPI claims accounted for 1 per cent of GDP here in the UK. They are a one-off, so when you take that stimulus out of the market then that could have a damaging effect,” he said.
Ed Smith agrees, but thinks there are other pressing issues as well.
“One of the other issues is that in the first half of last year there was a lot of non-bank loans, from the likes of the payday lenders, and in the second part of the year there was a pick-up in credit card loans.”
“While taking on debt is not always bad, it is when you think of the usurious level of interest charged by payday lenders and certain credit cards. It’s certainly the case where you spend today and forever pay tomorrow.”
“Because of that, we think that in the second part of the year, the UK domestic trade – which has been very popular – could well falter,” he added.