Grin and bear it
Rising commodity prices have supported bulls, but the bears are getting louder, says Paul Farrow
Fears over growth in Europe and the US, combined with the eurozone crisis and impending interest rate rises, are unnerving fund managers.
Only a net 10 per cent of investors expect stronger global economic growth in the next year, down from 58 per cent in February according to the latest Merrill Lynch Fund Management survey of 294 fund managers worldwide.
Expectations for Europe are worse, with a net 8 per cent of respondents now expecting that growth will slow, against a net 32 per cent forecasting it would improve just two months ago.
It is the first time that growth expectations on Europe have turned negative since July 2010.
Managers have also trimmed exposure to equities and commodities, while adding to cash and bond holdings slightly. Risk aversion is more evident in strong sector rotation into more defensive areas, such as consumer staples and pharmaceuticals, and out of more volatile and growth-dependent sectors, such as energy and materials.
“A risk for investors is that pessimism on Europe now looks to be overdone, particularly in light of strong recent GDP data,” says Gary Baker, head of European Equities strategy at BofA Merrill Lynch Global Research.
In this bracing and uncertain economic environment, dependability deserves a much higher rating
Expectations for corporate profits have seen a similar downturn in recent months. Only a net 9 per cent of fund managers are looking for profits to improve over the coming year.
Prominent fund manager Neil Woodford at Invesco Perpetual has been bearish about the global economy for some time and his opinion hasn’t changed. He still believes that the economic environment is “very challenging” and that it is likely to remain so for some years to come.
“I think some of the expectations that are embedded in the market in terms of earnings progression from some parts of the market that we are not exposed to are very optimistic, and that the stock market will struggle to deliver the earning expectations that are now embedded in many share prices,” he says.
Woodford continues to hold big positions in pharmaceuticals - it’s a sector that makes up 25 per cent of his Income fund. He is also big on tobacco.
It is not just their defensive nature that makes these sectors an attractive option - valuations are too. “These sectors are delivering growth in earnings, cash flow and dividends; these are all very important in terms of what one looks for from an investment,” added Woodford. “Over the past 25 years the tobacco sector has produced total returns of about 9,200 per cent - the best performing sector by a country mile.”
Part of the reason the sector is structurally undervalued, says Woodford, is because it is a structurally unpopular sector. “It continues to be unpopular; it continues to be subject to tighter regulation and increasing excise duty. But the tobacco sector has, through focus and good management, but largely through the inherently attractive cash generation characteristics, been able to produce very attractive returns to investors, and should continue to do so despite the headwinds that it continues to see.”
Over the past 25 years the tobacco sector has produced total returns of about 9,200 per cent - the best performing sector by a country mile
While Woodford’s positioning has been well trailed for sometime, other UK-based fund managers are moving in to tap into the large cap defensive stocks.
According to a new S&P Fund Services report, many equity income fund managers are typically positioning their portfolios with an increased focus on earnings quality and sustainability, and companies that are capable of delivering sustainable revenue and cashflow growth in weaker economic conditions.
For some this has led to a cut back in some of the more economically sensitive areas of the market, and into more defensive areas further up the cap scale.
The report highlights that Aviva’s Chris Murphy for one has been trimming positions in select industrials, which he feels are operating at peak margins or earnings forecasts getting ahead of themselves.
Meanwhile Threadneedle’s Richard Colwell and Leigh Harrison also started to reduce exposure to some of their smaller industrial names. In their place, they have been adding to large-caps, in particular the more defensive names such as GlaxoSmithKline, Unilever and Morrisons, which
Bill Mott, the highly regarded manager of the PSigma Income fund, is also looking to reliable stocks for the road ahead. He says: “In this bracing and uncertain economic environment, dependability deserves a much higher rating.”
Mott says that he firmly believes that pharmaceuticals offer this dependability and they are currently greatly undervalued offering an outstanding opportunity particularly on a risk return basis.
“I am as excited about the current situation as I was in March 2000 at the end of the technology bubble,” he says. “The defensive, high yields, economically insensitive qualities of pharmaceuticals have been over looked. There are offering a better yield than 10-year Government bonds.
They represent outstanding opportunities on a total return basis and they could well do what tobacco has done over the past five to ten years.”
The strategy is already paying dividends for many, with typical defensive areas of the FTSE delivering the biggest gains. Within the FTSE All-Share index, however, tobacco and telecommunications have returned 38.8 per cent and 37.5 per cent in the last 12 months, compared with mining on 29.7 per cent.
Whilst there’s money to be made in any bubble, the doubling up of inflationary risks means the consequences of mistiming commodities is too expensive for most pension schemes to countenance a major position
Utilities gained 26.9 per cent, compared with 25.7 per cent for industrials, while healthcare and beverages grew 19.5 per cent, compared with 12.1 per cent for oil and gas producers.
Other fund managers are going a step further by cutting their exposure to equities, rather than adopting defensive positions. For example, John Ventre, who manages more than £2bn of investors’ money at Skandia, has trimmed his equity exposure - echoing the adage ’sell in May go away until St. Leger Day’.
“The summer is traditionally not where the best returns lie for equity investors. I wouldn’t always advocate selling in May and going away, but there are a number of risks out there that make me think it’s the right strategy this year,” he says.
Mr Ventre’s concerns lie in US volatility, and this could have ramifications for global stock markets.
“It’s possible that there will be much more significant budget cuts in the US than the market is expecting,” he says. “The US consumer is trapped in the doldrums, with confidence suppressed by high unemployment, a high oil price and a depressed housing market. A sustained high oil price is in danger of creating demand destruction, slowing global economic growth.
“I don’t see a big upside for developed equity markets over the next few months. I think that we will be better able to take advantage of the opportunities that these risks are likely to create over the coming months if we keep some powder dry.”
Whether the stock market is at a tipping point could be heavily influenced by commodity shares, which are directly linked to global economic growth, particularly in the bigger emerging markets such as China.
Commodities have enjoyed a steady rise since the credit crunch but there are thoughts that valuations have become stretched. Goldman Sachs, for instance, recently advised clients to close its profitable “CCCP” play, which involved investing in a basket of crude oil, copper, cotton, platinum and soybeans.
Prices have already started to rock. Base metals, according to Dow Jones-UBS indices, which peaked this year have fallen 11 per cent this year.
Patrick Bloomfield, Partner, Hymans Robertson LLP, says: “The nightmare scenario for pension schemes would be a period of stagflation following the end of the commodities run.
Stagflation is like kryptonite for DB pension schemes, as pension payments increase whilst assets remain static.
“Whilst there’s money to be made in any bubble, the doubling up of inflationary risks means the consequences of mistiming commodities is too expensive for most pension schemes to countenance a major position.
That said, almost every pension scheme has either direct or indirect exposure to commodities, so the aftershocks will be felt to some extent.”
Indeed, although getting direct exposure to commodities would have been difficult within a DC environment, indirect exposure will have been gained via investing in emerging market equities, which has seen a marked increase in use over the last few years.
“The knock-on effect to DC schemes (whichever direction commodities may move in) is likely to be more indirect, through the general impact any large swings in these sectors would have on the overall market,” says Lee Smythe, managing director at Smythe & Walter. “This is as a result of most schemes (except maybe for those GPP’s with a wide external fund choice) not providing access to a specific commodity or technology funds.”
However, there are also those fund managers who while running a more diverse “UK equity” or other regional funds, will have a conviction about particular sectors and will has a result have differing weightings to commodity, so calling the movement in these sectors correctly could see a wide variance in overall returns for funds of a more general nature.
“This also indicates the inherent danger to investors of not necessarily knowing what their fund managers are investing in, as some investors may be happy with the concept of “UK equities” in general, but may not be so happy if they knew that a large proportion of this was invested in what they may perceive to be riskier areas,” adds Smythe.
Jonathan Parker, funds strategy director, Zurich UK Life says that any “conscious” desire by trustees and members of corporate DC pension schemes to benefit from the rise in commodity prices has been limited - it has had infrequent requests to add specialist sector funds like JPM Natural Resources or BlackRock Gold and General.
“Most trustees, employers and advisers still take a long-term view when constructing DC investment strategies and try to avoid the latest hot asset class,” he says. “A number of diversified growth funds have some exposure to commodities, but again, we have not seen a noticeable increase in allocations to this asset class.
Uncertainty for pension funds has been an underlying theme ever since Lehman Brothers went to the wall in 2008 and the DC industry has been making progress in addressing the concerns of trustees and plan sponsors. Asset allocation has become the buzz phrase, with diversification the key to keeping employee members’ concerns over short-term volatility at bay.
“We see a realisation from trustees and plan sponsors that members are unhappy with the volatility they have been exposed to over the last few years,” says Daniel Smith, director of DC business development at Fidelity. “There has been a move away from global equities as the growth component of a default to a more multi-asset strategy, which includes; property, commodities, equities and fixed income. Plan members want funds where asset allocation is dynamically managed to take account of changing markets in an uncertain world.”
The FTSE has treaded water around the 5,600-6,000 mark since the autumn. The bears, and there have been a many for some time, have still to be judged correct. It is why many consultants remain unfazed by the uncertainty because they still believe that over the long-term equities is a good place to be.
They argue that pension investment is long-term and short-term volatility should not influence decisions for DC members with many years to retirement. There has been nothing that has occurred that is sufficiently different to change their view and, as equities have out- performed other asset classes historically, they expect this to remain so in the future.
Colin Robertson, head of global asset allocation at Aon Hewitt, says: “We are not negative on equities, even though the big issue is whether corporate profits will be as big as consensus expects. Although cautious, we expect equity markets to be stable in a range.”
Roberston’s concerns lie elsewhere. “Where there is real mis-pricing is in the gilt market - now they are overpriced,” he says..