So far this year the return of volatility thanks to uncertainty surrounding the quantitative tightening process, geopolitical issues and a slowing global economy has led to some dispersion in the market.
Indeed, some fund managers have been caught out by a range of unanticipated issues in markets.
One of the worst affected areas has been the emerging markets, which has been struck by concerns over a potential trade war between the US and China and the strengthening dollar.
As such, the IA Global Emerging Markets sector has been the worst performer of 2018, with the average fund down by 5.97 per cent.
Meanwhile, the average IA Global Emerging Market Bond and IA Asia Pacific Excluding Japan funds have lost 4.7 per cent and 1.8 per cent respectively.
Conversely, technology stocks have continued to outperform for yet another half-year, with the IA Technology & Telecommunications sector.
Performance of sectors in H1 2018
Source: FE Analytics
With sector dispersion coming back this year, choosing which can outperform and which to avoid has become more important for investors. Below, FE Trustnet asks fund managers where they are most bullish on for the second half of the year.
Emerging markets
We start with the most disappointing region from the first half of the year – emerging markets – where Seven Investment Management’s Peter Sleep said the possibility of a trade war has perhaps created an opportunity among equities in the region.
The senior portfolio manager said that the threat has “created an opportunity for those prepared to bet on president Donald Trump’s pragmatic side in cutting a deal with the Chinese – something he has already done with the Koreans and is in the process of doing with his neighbours and Canada and Mexico”.
As a result of recent falls, emerging market equities are cheap, priced at 12.5x earnings compared with the S&P 500 priced at 23x earnings.
While there is extra risk associated with emerging markets, there is the potential to invest in some of the fastest growing countries in the world like China, South Korea, India and Brazil, he said.
“You may also get an investment in one well-known market phenomenon known to market professionals as mean reversion, which in plain language means, what goes down often bounces back. Usually. That can be a powerful friend when you are trying to guess what will happen in the next six months,” Sleep added.
Within the emerging markets, Ewan Thompson, manager of the Neptune Emerging Markets fund, said Russia is a market where valuations remain particularly low and sentiment poor.
Indeed, the market is on a price-to-earnings multiple (P/E) of 5x and has a dividend yield of 5 per cent. It has underperformed the wider emerging markets index over the past five years by 27.03 percentage points.
“Russia is naturally well placed as oil prices sit at elevated levels, with the budget in surplus above $55 per barrel – the lowest amongst the major producers – and FX reserves rising,” Thompson said
“Moreover, Russia exhibits resilience, with very low external debt and strong current account and fiscal position.”
Performance of indices over 5yrs
Source: FE Analytics
He added that policy direction is attractive following the crisis-management period of 2014-15, with fiscal policy such as investment in public infrastructure boosting growth.
Andrew Harman, senior portfolio manager of multi-asset solutions at First State Investments, said it is not just equities in the region that look attractive.
“Companies operating within emerging markets are experiencing robust earnings growth and benefit from structural growth factors such as urbanisation and demographic trends,” he said.
“The ‘original sin’ of large foreign currency denominated debt is largely gone – with a few notable exceptions – which we believe lowers their vulnerability relative to previous crisis in those regions.”
As such, emerging market credit continues to offer relatively good risk-reward, having underperformed so far this year.
With global trade increasing and commodity prices underpinning expansion, the higher yields justify the higher volatility, he said.
“We continue to allocate our duration exposure to emerging market bonds, both hard and local currency,” Harman added.
Japanese companies
Jon Gumpel, manager of the IFSL Brooks Macdonald Defensive Capital fund, said this year will be tricky for investors generally and is not so bullish about the outlook for equity markets.
“We think the remainder of this year is going to be difficult, with massing ongoing uncertainties and QT [quantitative tightening] draining global liquidity, so we don’t like equities generally,” he explained.
However, if you were to back an equity market, Gumpel said Japan would be his choice as it houses some of the best global companies that should be sheltered from a trade war, has a supportive government, a cheap and risk-off currency, and reasonable valuations.
In the first half of the year, the Japanese market, as represented by the Nikkei 225, was one of the better performers, up 2.1 per cent in sterling terms.
“Having decreased exposure to Japan earlier this year we are considering going back in with a yen-denominated Nikkei index structured note to sit alongside the Sony convertible bond and deeply-discounted Softbank equity positions,” he said.
UK smaller companies
FE Alpha Manager Ken Wotton said with Brexit just around the corner and ever-increasing speculation around the possibility of a ‘no deal’ leaving position, investing in smaller companies could provide good opportunities during the second half of the year.
The manager of the LF Livingbridge UK Multi Cap Income and UK Micro Cap funds said this is because these companies “can display more attractive valuations compared to larger-cap peers and are potentially well-positioned to mitigate any headwinds as Brexit uncertainties mount”.
Performance of indices over 1yr
Source: FE Analytics
“Due to their size they can often be quite nimble, and it may be easier for them to react at pace to the risks and opportunities going on around them,” he added.
Wotton highlighted that many of these growing companies also operate in less cyclical areas of the market, which can give management teams more control over their own destiny.
“Small- and micro-cap companies often fall under the radar, but it is our belief that investors patient enough to unearth hidden gems in this space will be rewarded in this late stage of the extended equity bull run,” he said.
Indeed, this is an area we considered last week and on Thursday asked fund pickers for their favoured fund to play the asset class.
European high yield bonds
Jon Jonsson, manager of the NB Global Bond Absolute Return Fund, said European high yield debt is a good bet for the second half of the year within the credit space.
The absolute return manager said large moves in the spread widening of the asset class has been the opposite of that in the US which has remained flat.
“European high yield should deliver stable returns in what we expect will be an increasingly volatile global environment,” the Neuberger Berman manager said.
“The European high yield market offers a much higher proportion of BB-rated bonds (72 per cent) and much less CCC paper (4 per cent) relative to other developed high yield markets, and exposure to commodity issuers remains very low at 5 per cent.”
He noted that the eurozone rate outlook is likely to remain more accommodative than that in the US as inflation remains below the European Central Bank’s (ECB) target.
“Despite improving dynamics and stronger economic activity, the ECB seems unlikely to hike its policy rate in the next 12 months,” Jonsson said.
“Meanwhile, current hedging costs make European high yield issues attractive to US and Asian investors looking to diversify their existing non-investment grade holdings. All in all, we expect the demand for European high yield paper to remain strong in 2018.”
Oil stocks
Elsewhere, Ashburton Global Energy fund manager Richard Robinson said the outlook for oil prices should remain strong following its collapse in 2014.
Performance of index over 5yrs
Source: FE Analytics
“We are rapidly heading towards a new reality of undersupply and low storage levels – far from the environment of a market drowning in oil that was evident just a few years ago,” he said.
Last year, the world discovered the least amount of oil since the 1930s despite supply-side risk increasing as a result of a lack of expenditure from oil companies and increasing political volatility in oil-producing nations, such as Venezuela, Angola and Iran.
This comes at a time when spare capacity has shrunk to levels only seen once in the last 20 years on a ‘days of forward cover’ basis.
“With the positive outlook for the oil price unfolding over the next few years, integrated oil companies are beginning to show significant cash balances and industry reserve replacement ratios appear increasingly challenged post 2020, a problem that needs addressing now,” Robinson said.
“As a result, we believe capex [capital expenditure] in the offshore space is poised to move higher, driven by a fundamentally well supported, stronger oil price over the foreseeable future.”