June: Bloom or Gloom?

Investment Notes

Despite the increasing concerns of a Greek default and the additional volatility this has brought to most world markets, we believe that there is more global bloom than gloom; this note explains why current portfolio allocations should be maintained with company shares and commercial property predominating over cash and bonds. There is much to be optimistic about for global company shares; economic growth remains robust, companies are reporting good profits improvements and corporate takeover activity is increasing.

The surprisingly decisive General Election result has given UK investors a firmer foundation from which to reassess market prospects for the remainder of 2015. We have been recommending heavy allocations in the UK stock market for some time, and our confidence has been reinforced by the election result; company directors have an extra spring in their step knowing they will not have to deal with a business-unfriendly Labour Government, and the housing market came back to life the moment the English electoral map turned Tory-blue. Smaller-sized UK companies appear best placed to benefit from this outcome, and having lagged the broader market over the last year, we expect them to outperform the leading index of 100 UK companies in the year ahead. We are also optimistic about the prospects for UK commercial property where increasing rental growth is being driven by an upturn in tenant demand, providing stronger income returns to investors; lower volatility UK property funds also have excellent diversification attributes when combined with more variable company share funds.

We are becoming increasingly confident that a European economic recovery is underway – the fact that France grew faster than the US, UK and Germany in the first quarter of 2015 is one indication that economies are on the mend in much of the Eurozone. Given that forward looking business surveys indicate that the recovery should be sustained, and the European Central Bank’s Quantitative Easing programme should continue to provide support, we will consider increasing allocations in Europe when there is more clarity on the outlook for Greece. There is a rising probability that the country fails to reach a satisfactory agreement with the IMF and EU; the consequences of a Greek debt default and/or departure from the euro make the risk/reward balance of European stock markets currently less attractive than that of other regions.

We have been and remain optimistic about Japanese company shares for nearly three years, as we expected the strong economic stimulus provided by the Bank of Japan to bring deflation to an end and the Government’s corporate reform programme to increase companies’ profitability. This has benefitted portfolios, particularly as the recommendations have been to select funds protected against the declining yen, by hedging back to sterling. We are towards the end of the main annual company results season in Japan, and the stock market is continuing to rise as dividend and share buy-back announcements surprise on the upside; we expect the bull market in Japan to remain while investors continue to be pleasantly surprised by companies’ response to their Government’s exhortations. A heavy allocation to Japan also aids portfolio balance, as many of the issues driving higher Japanese share prices are unrelated to global economic growth, thereby making the market somewhat uncorrelated to other world stock markets.

It would be hard to be optimistic on company shares unless the world’s two largest economies, the US and China, were expanding and supporting global growth. While the US economy had a weak start to the year, due to temporary factors such as adverse weather and a port strike on the West Coast, it is now showing renewed signs of strength though without the inflationary pressures, which would require a material rise in interest rates. Even though we are confident that the American economy will continue to grow in 2015, we have a modest allocation to the US, given that company shares appear reasonably well valued. In China, while the rate of economic expansion is likely to be slower in 2015 than in 2014, the local growth rate should still exceed those of developed economies. Markets have been encouraged by Chinese interest rate cuts, which are designed to ensure the Government’s growth targets will be met; this has been supportive of our heavy allocation to company shares in the Asia Pacific region.

When the economic outlook is favourable and markets are taking comfort from loose monetary policy, there is always a danger of complacency. However, the sharp losses witnessed in Western government bonds over the last two months (where yields have risen from very low levels), together with explicit warnings from Federal Reserve Chair Janet Yellen about the valuation of stock markets, has caused investors to reflect on the risks in their portfolios. This reality check, together with a lack of general market euphoria, provides us comfort that it is appropriate to retain a heavy allocation to company shares. As legendary investor Sir John Templeton observed, “bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria”; our current view is that we are in the “grow on scepticism” phase. Meanwhile, we are recommending appropriately balanced portfolios with protective allocations to index-linked gilts and UK commercial property to protect against any unexpected surprises.

To discuss this note or any other matter, please contact Nick Fletcher on 020 3696 6801, or any member of the London Wall Partners investment team on 020 3696 6805.