The fourth quarter was positive overall for equities but there were reasonable differentials between the various countries and regions. Relative economic growth levels, interest rate expectations and inflation continue to be key performance drivers.
Despite ongoing concerns about its valuation level, the US equity market continues to lead the way with companies continuing to generate good earnings and the shale gas revolution has reduced companies’ energy costs. The overall market valuation is higher than the other major markets but as long as companies continue to perform well then there is the potential for market outperformance to continue, but companies that miss earnings/profits expectations have been, and are likely to continue to be, hit hard. This creates a good environment for stock selection. Interest rates are highly likely to be raised in 2015 but this should start at a very slow pace.
Interest rate rises are also on the agenda in the UK but the timescale for the first rise continues to be pushed out further, more recently due to the significant fall in energy prices. This in turn should be positive for the UK consumer but will not be reflected in the very short-term. The equity market looks fair value with dividend stocks likely to continue performing well, should interest rates stay at current levels. Mid-caps again outperformed in 2014 but if economic growth begins to slow in 2015 larger companies may come more into favour. How Europe performs will also influence economic and market performance due to the trading relationship.
The European equity market looks cheap from a valuation perspective but equity market movements are likely to be highly dependent on the success, or otherwise, of monetary (Mario Draghi and the ECB) and fiscal (individual countries) policies. These need to stimulate economic growth from currently very low levels and generate an increase in inflation and create greater confidence within Europe as a whole. Such policies may lead to a weakening of the Euro, so some form of currency hedging may be appropriate.
Asian and Emerging Market equities look attractively valued both on an absolute and relative basis but with different countries at different stages of reform and development it remains important to be selective in choosing which stocks, sectors, countries and currencies to invest in. Historically, good active managers have been able to add significant value in these regions due to their individualistic nature and the multitude of markets and companies available to invest in and we see no reason for this to change.
The performance of fixed income markets in 2014 has surprised many investors with the ‘safe haven’ developed government bond markets in particular performing much better than expected given that, as the start of 2014, most investors expected UK and US interest rates to have increased at least once by now. Long-dated assets have particularly benefited. Whether this can continue remains the subject of much debate but with rate rises now likely in 2015, especially in the US, albeit on gradual basis, government bonds should not perform to the same level in 2015. They may continue to hold their own in the short-term but it is likely that volatility will continue as markets try to digest every piece of economic and policy news. Conventional fixed income strategies are likely to struggle over the next couple of years with flexibility likely to be the key to generating decent returns. Overall, government bond and high quality credit markets are not overly attractive and the spread (extra yield over government bonds) available from the high yield market is offering less value with liquidity also becoming an increasing issue. We continue to favour strategic / absolute return strategies where managers can use a variety of techniques (duration, currency, yield curve etc.) plus their stock picking skills to generate superior returns.