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  • Market Review

     

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    Market review

     

    Following an eventful second quarter, the third quarter of 2016 proved to be a much calmer and, ultimately, a constructive period for financial markets with the only real volatility occurring around central bank activity during September

    Following an eventful second quarter, the third quarter of 2016 proved to be a much calmer and, ultimately, a constructive period for financial markets with the only real volatility occurring around central bank activity during September. Most assets performed well with equities leading the way among Growth assets. Asian ex Japan equities were the stand-out performer with emerging market equities close behind. Japanese equities rebounded strongly from their fall in the second quarter despite a mild strengthening of the yen. The export-reliant larger cap UK equities benefited from continued sterling weakness. European and US equities were the relative laggards with returns of almost 5% and 4% respectively demonstrating the extent of equity market strength over the period.

    High yield bonds saw another good quarter of performance with spreads tightening further, while emerging market debt (both local and hard currency) continued to rally. Property securities in the UK saw a partial bounce back following their difficult second quarter, and European property also saw a positive quarter. Oil retraced most of its decline following Opec’s decision to cut supply for the first time in eight years although still ended down. Within Defensive assets, once again over the quarter we saw record low yields for 10 year developed market government bonds in the UK, US, Japan and Germany, although they all retraced somewhat by the time the quarter ended. The US dollar depreciated against most developed and emerging currencies, while the Japanese yen appreciated against most G10 currencies. Within Uncorrelated assets, gold traded within a range but was marginally negative over the period.

    At a glance - our asset class views

    -- - o + ++
    Equities
    North America  
    Europe ex UK  
    UK  
    Japan  
    Asia ex Japan  
    Emerging markets  
    -- - o + ++
    Government Bonds
    North America  
    Europe ex UK  
    UK  
    Japan  
    EM Hard Currency  
    EM Local Currency  
    IG corporate bonds  
    HY corporate bonds  
    -- - o + ++
    Currencies
    US dollar  
    Euro  
    Sterling  
    Japanese Yen  
    Asia ex Japan  
    Emerging Markets  

      View for the coming 6 to 12 months* Previous quarter's view

    *Views of Investec Asset Management’s Multi-Asset team and reflect preferences within respective asset class. As at 30.09.16.

    Key themes for coming 6-12 months

    • Overdone fears of recession – we believe markets have overreacted to the fear of a recession and have positioned ourselves accordingly. We do, however, acknowledge the probability has risen.
    • Rates lower for longer – interest rate expectations have eased further and while we expect rates to stay lower for longer, we look to exploit any overreactions in market sentiment through careful duration management.
    • Resurgent Emerging Markets – after struggling with weaker fundamentals and adjusting to slower growth paths, the outlook for some emerging markets now looks more constructive again.
  • A letter from your PM



    Monetary policy and the law of unintended consequences.

    - A letter from Philip Saunders

    Philip Saunders

    Many of the central bankers who met in Wyoming for the annual Jackson Hole symposium in August this year must by now be keenly aware of the impotence of monetary policy in addressing the challenge of persistently weak growth rates. Interest rates are near zero and despite additional bells and whistles, nominal GDP growth in the key developed economies has been stubbornly unresponsive. Neo- Keynesian faith in the effectiveness of these unorthodox monetary policies is waning and there are signs of a dawning realisation that the policies being pursued may have become part of the problem. The extreme unconventional monetary measures would appear to be undermining future financial stability by mispricing credit risk and asset prices in general and encouraging wasteful and unproductive capital allocation by corporates. Larger listed US companies have bought back their shares with gusto whilst curtailing capital investment. Uneconomic capacity persists because of low debt service costs and the poor use of capital historically. By keeping marginal capacity afloat, central banks are contributing to the very deflationary forces that they are seeking to reverse. Rates of return on assets are chronically low and productivity weak. Massive cash flow-sapping debt overhangs have actually increased not reduced. Flat yield curves damage the ability of banks to restore their balance sheets organically and generally undermine the financial infrastructure. The unorthodox policies of central banks are arguably failing to achieve macro-economic stability and are damaging the soundness of financial systems by encouraging wasteful loans and the mispricing of collateral (assets pledged to a lender to secure repayment) by lenders. Finally, the resulting asset price inflation aggravates social inequality and encourages political instability.

    To be fair, the Federal Reserve (Fed) Board of Governors clearly recognises the desirability of normalising interest rates and that unconventional monetary policy is not limitless in scope. Debt purchases have been ‘tapered’ and official interest rates have been increased, albeit very modestly. However, policies being pursued by other major central banks, such as the European Central Bank, the Bank of Japan and the Bank of China, are exerting a countervailing force, keeping US and indeed global long term interest rates too low.

    So what happens next? Government impatience with the low rate of growth and the failure of monetary policy to deliver more acceptable growth outcomes, is likely to result in a renewed emphasis on fiscal intervention (such as tax cuts), despite high levels of existing debt. Indeed we are already witnessing this in Japan and China. Some recovery across developing economies should also help the current economic expansion to persist but, at best, the Fed’s path to normalisation may slowly succeed in returning official interest rates to 2%, or zero in real terms. However, even though debt service costs are cheap, fiscal expansion (government spending in excess of revenues) would continue to aggravate the long term problem which is centred on excessive debt and capital misallocation in a time of secular disinflation. Add to this the bubbles in real estate that have built up over the last two decades and it is little wonder that investors remain cautious – as evidenced by high cash levels – even though such caution may appear excessive given current levels of growth. However, notwithstanding the longer term issues of yet more borrowing, a more balanced fiscal and monetary policy mix should result in less distorted interest rates and yield curves. We might even be surprised by the degree to which growth has been held back by these excessively low rates.

    Philip Saunders
    Co-head of Multi Asset Growth

  • Equities

    Equities

    -- - o + ++
    Equities
    North America  
    Europe ex UK  
    UK  
    Japan  
    Asia ex Japan  
    Emerging markets  
    We continue to retain a constructive outlook on emerging market equities

    North America

    -- - o + ++
    North America  

    US equities continue to offer high quality, but we have scaled back our conviction from the previous quarter. Valuations are increasingly looking stretched and underlying economic growth is lacklustre. There is uncertainty surrounding the upcoming presidential election which is likely to cause bouts of volatility.

    As such, we have a preference for high returning companies with earnings visibility that are cheap given their cash generation abilities.

    Europe ex UK

    -- - o + ++
    Europe ex UK  

    There is no one area in European equities which we have identified as compelling in our process. While valuations are relatively attractive, poor company fundamentals and a lack of meaningful momentum overwhelm the investment case.

    More generally, while the European Central Bank (ECB) remains accommodative, the direction of travel is less clear with potential talk of reducing asset purchases and less of an emphasis on engineering a weaker currency.

    UK

    -- - o + ++
    UK  

    We remain neutral on the prospects for UK equities, where returns continue to be driven by conflicting factors. On one side, the market remains underpinned by monetary easing, while sterling weakness should continue to provide support for the FTSE 100 which is dominated by companies with overseas assets and earnings.

    However, the uncertainty associated with Brexit is likely to continue to act as a headwind, and it is also important to note that valuations are starting to look somewhat stretched.

    Japan

    -- - o + ++
    Japan  

    Japanese equities remain one of our core themes. Valuations remain attractive and fundamentally there are strong buyback trends which help to underpin the market.

    It is also interesting to note that the correlation between the yen and equity performance does not seem as pronounced as has previously been the case and yen strength over the quarter was not enough to derail the rally.

    Asia ex Japan

    -- - o + ++
    Asia ex Japan  

    Like many other emerging markets, Asian equities are attractive from a valuation perspective. However, the fundamentals are weak and have failed to show material signs of turning a corner like in other regions.

    In China, we do still find an attractive case for names who stand to benefit from its move towards a consumer led economy – the theme of ‘new China’. This is being driven by an expanding and wealthier middle class population.

    Emerging markets

    -- - o + ++
    Emerging markets  

    We continue to retain a constructive outlook on emerging market equities. The optically cheap valuations are now firmly supported by a meaningful improvement in fundamentals and positive price momentum in an asset class which has come under pressure in recent years.

    Our preferences remain in Europe, the Middle East, Africa and Latin America, particularly against a backdrop of more challenging valuations in many developed markets.

      View for the coming 6 to 12 months* Previous quarter's view

  • Bonds

    Bonds

    -- - o + ++
    Government Bonds
    North America  
    Europe ex UK  
    UK  
    Japan  
    EM Hard Currency  
    EM Local Currency  
    IG corporate bonds  
    HY corporate bonds  
    UK bonds are our least favoured of the major economies, despite the Bank of England’s quantitative easing programme

    North America

    -- - o + ++
    North America  

    Our neutral view on US Treasuries reflects our opinion that they are close to fair value given the market’s expectations of future interest rates.

    We expect them to continue to ebb and flow within a range on economic data releases and US Federal Reserve (Fed) rhetoric. However, unless trend growth or inflation pick up sharply, or we see an aggressive post-election fiscal easing, we do not expect US government bonds to sell off sharply.

    Europe ex UK

    -- - o + ++
    Europe ex UK  

    Core euro-zone government bonds remain well supported by high unemployment and low core inflation, with an ECB which is very aware of both these dynamics.

    Outside of the euro-zone, we favour Czech Republic government bonds which offer an attractive yield and should be supported by central bank easing once the floor, a lower limit on the euro-koruna exchange rate, is removed.

    UK

    -- - o + ++
    UK  

    Our scorecards are flagging the UK gilt market as one of the most expensive and so UK bonds are our least favoured of the major economies, despite the Bank of England’s quantitative easing programme.

    With inflation likely to rise sharply following the fall in sterling, heightened uncertainty around the medium-term impact of Brexit and a large budget deficit to fund, we expect yields to drift higher.

    Japan

    -- - o + ++
    Japan  

    Japanese Government Bond (JGB) prices are largely dominated, and arguably distorted, by the Bank of Japan’s (BoJ) actions which means this market should be treated opportunistically and with caution.

    The BoJ has had a habit of underwhelming markets which has resulted in a JGB sell-off, particularly as the limits of its monetary stimulus came under scrutiny. However, recent measures such as direct yield caps (another form of monetary easing) continue to underpin the market.

    Emerging Markets Hard Currency

    -- - o + ++
    Emerging Markets Hard Currency  

    The emerging market complex has benefited from a degree of stabilisation in commodity prices and a more dovish Fed. Hard currency debt also benefits from relatively limited supply.

    However, with yields having rallied quite meaningfully, valuations are less attractive than they were at the beginning of the year. Yields do still look attractive relative to high yield once adjusting for leverage and projected default rates.

    Emerging Markets Local Currency

    -- - o + ++
    Emerging Markets Local Currency  

    Like hard currency debt, sentiment around local currency debt has improved considerably which is again attributable to stable commodity prices and a more dovish Fed. Additionally, we are more constructive around the prospect for emerging market currencies.

    Overall, growth surprises have stabilised and appear relatively positive when compared to developed markets. As ever with these markets, selectivity remains crucial and we retain a preference for the higher quality end of the spectrum.

    Investment Grade

    -- - o + ++
    Investment Grade corporate bonds  

    Investment grade corporate bond markets are underpinned by central bank support. This is particularly clear in Europe where the ECB is buying investment grade bonds, while the pace of Fed tightening remains uncertain.

    In a strong quarter for the asset class, valuations are starting to look more stretched and further yield spread compression could well start becoming more challenged.

    High Yield

    -- - o + ++
    High Yield corporate bonds  

    Like investment grade markets, the high yield market also stands to benefit from central bank support. The high yield space, particularly in the US, has also benefited from the stabilisation in the oil price as both Opec and Russia have shown a greater willingness to cap supply.

    While the fundamental case remains intact, valuations are starting to look more stretched, particularly after another strong quarter. Like equity markets, a risk-off environment could see a shorter-term correction.

      View for the coming 6 to 12 months* Previous quarter's view

  • Currencies

    Currencies

    -- - o + ++
    Currencies
    US dollar  
    Euro  
    Sterling  
    Japanese Yen  
    Asia ex Japan  
    Emerging Markets  
    Despite the rally this year, emerging market currencies still appear relatively cheap given the prolonged sell-off in the years preceding

    US Dollar

    -- - o + ++
    US dollar  

    The US dollar offers a relatively attractive yield and even though the Fed is still expected to raise interest rates, the economy, on balance, is slowly recovering. The fundamental background, therefore, remains supportive for the dollar, despite the economy perhaps not growing as fast as some might have expected.

    On the other hand, it is close to fair value on our scorecards, while market price behaviour suggests it is simply range bound.

    Euro

    -- - o + ++
    Euro  

    While the euro has been fairly resilient recently, we believe the fundamental backdrop suggests further downside for the currency.

    The ECB is still looking to ensure the currency remains cheap; there are questions over the medium-term future of the European Union and yields are deeply negative. Valuation appears fairly valued, neither supportive nor a headwind.

    Japanese Yen

    -- - o + ++
    Japanese Yen  

    We increasingly favour the yen over the short term because the currency still appears cheap and the economy is reasonably robust.

    It also seems the willingness of the Bank of Japan to cut interest rates further into negative territory is diminishing, with more of a focus on ‘Yield Curve Control’ in order to promote easy monetary policy. We would argue that this could be perceived as a step back from quantitative easing and as such, supportive of the yen. However, the longerterm structural issues with Japan mean that we only have a neutral view.

    Sterling

    -- - o + ++
    Sterling  

    The uncertainty from Brexit remains a dark cloud over the UK economy, especially as negotiations with the European Union look set to start in earnest in early 2017.

    A weaker sterling remains the mechanism through which the economy can rebalance. We therefore expect further downside in the currency and a dovish Bank of England to remain proactive in cutting interest rates further if sentiment deteriorates.

    Asia ex Japan

    -- - o + ++
    Asia ex Japan  

    Asian currencies still look particularly vulnerable to further downside. China is devaluing its currency, global growth is lacklustre and many Asian economies are at the peak of their financial cycles.

    We expect these headwinds to be offset with easier monetary policy and as such, weakening currencies.

    Emerging Markets

    -- - o + ++
    Emerging Markets  

    Despite the rally this year, emerging market currencies still appear relatively cheap given the prolonged sell-off in the years preceding.

    Selectivity is again crucial and we are focusing on those positions where we see both strong fundamentals and attractive valuations. It is important to note that many of these economies are still adjusting to a structurally slower growth path and hence caution is warranted. The stabilisation of commodity prices can continue to be a strong tailwind.

      View for the coming 6 to 12 months* Previous quarter's view

Important information

The information discusses general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market forecasts presented herein reflect our judgment as at the date shown and are subject to change without notice. These forecasts will be affected by changes in interest rates, general market conditions and other political, social and economic developments. There can be no assurance that these forecasts will be achieved. Past performance should not be taken as a guide to the future, losses may be made. Data is not audited. Investment involves risks: Investors are not certain to make profits. Where index performance is shown, this is for illustrative purposes only. You cannot invest directly in an index. Investec Asset Management does not provide legal and tax advice. The information contained in this document is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This communication is provided for general information only and is not an invitation to make an investment nor does it constitute an offer for sale. This is not a recommendation to buy, sell or hold a particular security. No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided. The securities or investment products mentioned in this document may not have been registered in any jurisdiction. In South Africa, Investec Asset Management is an authorised financial services provider.