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Top 100 Funds: manager outlooks for equities and bonds

We canvas 15 managers of IC Top 100 Funds to get a broad picture of investor prospects for 2016.
December 18, 2015 and Leonora Walters

We canvassed the views of 15 managers of IC Top 100 Funds to see what they can see in store for equity and bond investors in 2016.

The global picture: Mixed

Iain Stewart, Newton Real Return Fund (GB00B8GG4B61)

Despite continued bullishness about US economic prospects, expectations for global GDP growth continue to fall, with the Organisation for Economic Co-operation and Development (OECD) the latest to cut its expectations for 2015-16. The biggest downward revisions are in the developing world, and among commodity and energy exporters. Some economies, such as Canada's, are already in recession, and interest-rate policy globally remains biased towards cutting rates rather than any kind of normalisation.

Growth in cash flows and profits is also decelerating and credit investors are demanding a wider spread over government bonds. Given the scale of the credit expansion in this cycle, we should expect to see a sharp rise in the number of defaults up from extremely low levels in recent years.

A backdrop of falling commodity prices is a positive for western consumers, and it should help bolster disposable incomes at the lower end of the scale. The problem is that sharp and broadly based falls in commodity prices have in the past been associated with economic and financial market stress, and it is hard to see why this time should be different.

If current trends prevail, it is likely the focus will turn to more stimulus rather than a lift-off in interest rates. The question would then be what form further programmes would take and how markets would react. Can bad economic news continue in perpetuity to be considered good news for investors in growth assets if it involves more stimulus?

Our contention is that hidden risks are real and rising, that a cautious positioning is warranted, and we do not think that this is the right time to chase risk assets on the upside.

Over the past 12 months the net equity weight has been reduced and cash levels are being kept high, not least until alternative investments are identified that provide an adequate risk/reward profile, but also because cash dampens volatility. Gold also remains an essential insurance, despite the deflationary backdrop.

 

Bruce Stout, Murray International Trust (MYI)

The main area of disappointment next year will be earnings and dividends: with weak inflation it is hard to grow the top line and companies have been focusing on cutting costs. But there is only so much of this you can do and at some point you either grow your top line or suffer an earnings decline.

The UK dividend coverage rating looks poor because of the market structure and overseas earnings are being negatively impacted by the strength of Sterling. Earnings in the UK and Europe could be hit.

To address this we are seeking as much diversification as possible in our portfolio. Diversification has not necessarily worked recently because of the propensity of the markets to become narrower, so we try to counteract this by owning different businesses, in different sectors in different countries.

We look for aspects of a business which might be able to maintain a competitive advantage. For example, Asur (ASURB:MEX), which operates airports in Mexico, has been the beneficiary of the weak peso and has continued to deliver regardless of the economic backdrop.

Unilever Indonesia (UNVR:JKT) is more dependent on rising consumption than macro themes.

Swedish listed Atlas Copco (ATCO A:STO) continues to be a very well run engineering business with lots of recurring revenues.

However, it is difficult to find good value at sensible prices, and difficult to see where expectations of profitability will be surpassed.

The tough economic environment looks set to continue with too much debt, negative bond yields, and no real returns for savers who are also not helped by wage growth. The main risk is still deflation: pricing certainty for many companies is non existent. There is far too much excess capacity relative to global demand because quantitative easing has distorted the global environment. Companies that would have gone bankrupt are still alive and if rates move higher debt servicing costs will become more onerous.

 

Andrew Bell, Witan Investment Trust (WTAN)

The principal opportunities probably lie in the areas most universally spurned in 2015: mining, emerging markets and growth markets in South-East Asia impacted by adverse sentiment on Chinese growth.

In developed economies consumer demand is likely to be sustained by the prolonged fall in fuel prices, so some of the industrial and consumer spending stocks held back by earnings disappointments in 2015 now make sense. The benefits to consumers may become more apparent in 2016, as growth broadens out.

Investors seem to have overdone the gloom on growth and a pick-up in the pace of growth is likely in 2016. Monetary policy remains a tail-wind and the slow-point of growth in mid-2015 has passed.

Although our central expectation is for moderate single-digit returns from equities, the surprise might be on the upside, although investors must be realistic about valuations. Currency weakness in Japan and Europe will help sustain corporate profit estimates, while the headwind caused by the UK's high weighting in resource sectors should abate. So profit momentum, as well as relative valuations, suggest a shift from US leadership in equity returns to better prospects in other developed economies - as well as emerging markets if you are contrarian. Given the variation in pricing power between sectors, as well as the shifts in competitiveness from currency moves stock selection will be important, rather than expecting across the board rises in market indices.

The principal risk, although it appears unlikely, is that anaemic global growth morphs into recession. Apart from emerging economies where valuations appear quite cheap equities are rationally priced, given structurally low interest rates, but they would be vulnerable to the earnings downgrades that accompany a recession.

China's economic transition towards more consumer-led growth could prove bumpy but investors appear more discerning about this than in summer 2015.

 

UK equities: Challenged

Mark Barnett, Perpetual Income and Growth Investment Trust (PLI)

The near-term outlook for the UK stock market as we approach 2016 appears challenged. We have seen a good recovery from the post-crisis low in 2009 and from the eurozone crisis in 2011, but the progress of corporate earnings in aggregate has been disappointing and questions remain over earnings growth potential in 2016 and beyond.

As always, there is a significant polarity of potential outcomes within the market depending on industry factors, individual competitive advantage and outright mispricing of certain equities. I feel the market will continue to reward visibility of earnings and cash flow, so I am looking to my holdings in such areas as tobacco, support services, fixed-line telecoms and life insurance to demonstrate these characteristics.

2016 will be an important year for pharmaceuticals, where I am significantly invested, and I am hoping for further progress on new drug development from major holdings in AstraZeneca (AZN) and Roche (RO:SWX) , as well as from the smaller companies in my portfolios.

The debate over Brexit (British exit from the European Union) will be fully underway during 2016. There could be some nervousness in the market as a whole and, in particular, financial stocks. I do not hold any mainstream banks, but have a strong presence in other financials such as real estate investment trusts (Reits), insurance, and specialist groups such as Provident Financial (PFG) and London Stock Exchange (LSE). So buying opportunities could arise in this scenario.

On the recovery side, the oil market is widely expected to tighten by mid-2016 as demand appears to be robust while supply growth is being curtailed. Although notoriously difficult to predict, this will be relevant not just to my holding in BP (BP.) but to other energy related stocks including Centrica (CNA), Drax (DRX) and SSE (SSE), all of which have been affected by price weakness across the whole energy complex.

 

Richard Watts, Old Mutual UK Mid Cap Fund R Acc (GB00B1XG9482)

If we get an 8 to 8.5 per cent total return off the FTSE 250 next year (as we expect), we will need to do better with our fund. So with a low growth environment - we expect the UK economy to grow at 2 per cent to 2.5 per cent next year - we are targeting stocks that offer structural growth, ones that are growing their earnings more quickly than the stock market.

Examples we like include Just Eat (JE.), Auto Trader (AUTO) and Paysafe Group (PAYS) because they are growing their earnings rapidly. These are more highly rated but if they keep on consistently churning out this kind of earnings growth they will out-perform.

We also like stocks which can give attractive cash returns such as greetings card retailer Card Factory (CARD). If you include its special dividends, this company offers a dividend yield of 6 to 7 per cent versus the UK average of 3.5 to 4 per cent, and it is capable of growing its dividend stream by 10 per cent a year. 10 per cent growth plus its yield equals a high teens total return against about 8 per cent for the FTSE 250.

Other shares we like include Pets at Home (PETS), Barratt Developments (BDEV) and Taylor Wimpey (TW.), as these are stocks that give you very attractive returns. Big Yellow (BYG) also offers growth with a decent dividend yield.

China and emerging markets are slowing, and the UK economy has come through its peak of gross domestic product (GDP) growth, meaning we are in a moderate global growth environment. So these stocks look as attractive as 12 months ago - despite strong performance."

Job Curtis, The City of London Investment Trust (CTY)

UK housebuilders should continue to benefit from strong demand for new homes. The UK has not been building enough homes in recent years and there is massive latent demand from those who rent but want to buy their own homes. Interest rates are likely to remain relatively low and so help affordability.

House builders such as Taylor Wimpey (TW.), Persimmon (PSN) and Berkeley Group (BKG), which are all in the FTSE 100 Index of largest companies, have land banks of over five years and are well placed to meet demand. They have committed to generous dividend distribution policies and yield around 5 per cent.

Banks could be interesting after many years of underperformance, in particular, Lloyds (LLOY) which has resumed paying dividends. It has also significantly rebuilt its capital position so could increase its dividend. The Government's sell-off of its remaining stake in Lloyds could also be an attractive opportunity for private investors.

The weakness of oil and other commodities is likely to continue to have an adverse effect on oil and mining companies, and companies which supply them with goods and services. Dividend cuts are likely for some companies in this area of the market so stock selection is very important. The strongest companies will survive and recover in time.

There is likely to be a small increase in interest rates in 2016 in the UK and US, but I would regard such an increase as a normalisation of economic conditions and a healthy sign. The Europe referendum, however, is likely to take place in the autumn of 2016 and could inject some volatility into UK markets.

The UK equity market is yielding around 3.6 per cent so I think a return of 10 per cent, including income, is achievable given likely trend growth in the UK and US economies, and continuing recovery in Europe.

 

European equities: pockets of opportunity

John Bennett, Henderson European Focus (GB00B54J0L85)

Developed markets are trapped by public indebtedness meaning interest rates are likely to remain at ultra-low levels to ease the burden, and I am less positive than I was this time last year. While Europe may still appear to offer better value relative than the US and emerging markets, we believe the corporate earnings cycle has peaked and 2016 will bring more profit warnings.

Slowing growth in emerging markets is resulting in the dumping of cheaply supplied products - raw materials, components and manufactured goods - from China and Asia more widely into Europe. This will erode pricing power for a broad swathe of manufacturing companies leading to a multi-year bear market in capital goods, which will leave the opportunity set for investors somewhat diminished.

This late in the economic cycle there are not a lot of bargains out there. European equity investors need to be more careful than ever with what they are buying. Simply buying the index through an exchange traded fund (ETF) or otherwise will likely lead to disappointing returns when the market eventually punishes overvalued growth stocks.

That said, there are a few pockets of opportunity, especially within domestically focused European stocks. We continue to look for companies operating in industries that are well placed to benefit from positive change and pharmaceuticals is still our favourite theme after more than five years.

The sector suffered in October as concerns mounted that the industry's ability to command pricing power was under threat from electioneering US politicians. We believe that the cash flow prospects of our key holdings in this industry will not be altered by the current debate, though are preparing for a noisy year ahead. It remains the case that genuinely differentiated drugs which address unmet needs will command pricing power, so we retain our considerable overweight positions in the sector.

 

Sam Cosh, European Assets Trust (EAT)

The market has done well for a long time from very low levels in 2010 when you could buy Europe at 10x earnings. Those were very cyclically low earnings and you had a large margin of safety. It's harder to make that argument now.

Europe has just not seen any profit recovery from the depths of recession and that's in contrast to areas like the US. The bull argument for Europe is that if you do get profit recovery, the current valuation metrics are based on cyclically low earnings, so will look more attractive. But that scenario is assuming profit growth and you have to rely on profit recovery coming through to be bullish about European markets.

We've been in a world driven by emerging market growth where people have had high expectations of anything exposed to emerging markets. Now that has massively disappointed and we are seeing profit pressure in emerging market exposed companies.

The DAX in particular, a very internationally exposed index, has really disappointed and the domestic outlook is improving but from a very low base. The market leadership is moving away from international towards domestic growth in Europe.

You've got to be sanguine about the fact that European equities have performed well. The bearish scenario is if you don't get profit growth coming through and you get a situation where the global economy is let down by emerging markets and Europe cannot escape it. That's not our central scenario however. You still get a dividend yield of 3.5 per cent in Europe baked by strong balance sheets and cyclically low earnings. Given how difficult it is to find yield that will continue to be appealing.

QE will also help the portfolio next year by attracting money to Europe. With the UK and the US moving in the other direction it will help drive liquidity to those areas. Mario Draghi has said he is keen to drive inflation which will be a very accommodative environment for equities. But I think probably the best thing you can say about Europe is that everything else looks far more unattractive.

 

US equities: slower growth

Angel Agudo, Fidelity American Special Situations (GB00B89ST706)

The US economy remains in good shape and should continue to improve at a moderate pace until the end of the year. Growth is likely to be supported by labour market progress - albeit at a slower rate, a consumption rebound helped by an improvement in wages, the strength of the services sector, and improving activity in housing and construction-related sectors.

Structural drivers of the US economy include its innovative business environment and shale gas, which provides lower cost and greater energy independence. Going into 2016, consumption-led growth and innovation will be two of the key factors that could help the US economy continue on its growth path.

A move towards an interest rate normalisation appears warranted as the US economy is expanding at a moderate pace and unemployment levels are close to the theoretical natural rate. But interest rate normalisation would exert greater pressure on companies to employ capital discipline and necessitate an increasingly cautious investment approach.

With the return of market volatility and subsequent correction in stocks, I am finding more interesting opportunities than a year ago. While the correction has further limited downside the strong fundamentals of these stocks offers significant upside. There have been some downward revisions of earnings growth recently. S&P 500 companies are expected to have almost zero earnings growth for 2015. Moreover, growing wages and interest rate pressures, combined with the strong US dollar, could weaken margins in some sectors. However, some companies will perform better than others.

I continue to look for companies that are undervalued, either because they are out of favour or little value is given to their recovery potential. I also focus on companies' potential downside risk, and place great importance on balance sheet strength and the resilience of corporate business models.

 

Japan equities: modest recovery

Andrew Rose, Schroder Tokyo (GB00B4SZR818)

Japan has been economically disappointing but now looks to be making a modest recovery driven by domestic demand, so the backdrop will be more reasonable in 2016.

Equity valuations are reasonable, while the trend for better corporate governance and looking after shareholders is in place. Supply and demand are reasonably supportive, for example, domestic pension funds are increasing their equity weightings. Japanese private investors' asset allocations are very skewed to deflation but there are some signs they may be moving. The recent initial public offering (IPO) by the Japanese post office following a privatisation was mainly taken up by private domestic investors. They are interested in equities if they involve a reasonable yield.

The biggest risks are external. The outlook is reasonably good for corporate profits but these have been leveraged to the global cycle which for some sectors has been negative. These include steel, machinery and commodity price sensitive areas which have had downward revisions to their profits outlook.

But overall the outlook for profits is good and some exporters have benefited from the weak currency, while domestic growth has also helped. What happens to the currency is key, though we have probably seen the bulk of Yen weakness and it will probably not weaken much more from here.

Areas of the market which did well this year have been very much where there has been steady domestic demand, for example, retail, food, telecoms and construction. Some of the worst areas have been machinery and autos, so the best value is probably in cyclical sectors such as these, and commodity price sensitive names.

 

Asian equities: cheap

Hugh Young, Aberdeen Asian Smaller Companies (AAS)

There are pockets of growth that have shown resilience against the broader regional slowdown. There are no hard and fast rules but we've found some of these, for example, in the private and service sectors. Some Asian companies are paying out more in dividends to their shareholders, and some enhance shareholder returns with share buybacks funded from cash reserves. Negative investor sentiment towards emerging markets has punished shares indiscriminately. This means Asian share prices are cheap on both a historical and relative valuation basis, although there is great variation between individual markets.

An anticipated rise in US interest rates will cause market volatility. This is likely to trigger further capital flight to safer dollar-denominated assets and will lead to Asian currencies weakening against the US dollar. Another cause of volatility will be China's slowdown. Investors need to be convinced that policymakers are still in control of this process and China has the financial firepower to avert a hard landing.

There are no quick fixes and volatility linked to the US Federal Reserve's rate-hike will most likely cause share prices to fall in the short term. Almost certainly, share prices will overshoot the levels they should be trading at based on earnings alone, which is good because that will present new buying opportunities.

The so-called normalisation of US central bank policy is a good thing because quantitative easing is the single biggest cause of asset price distortion today. Therefore, a Federal Reserve rate hike is something we welcome because, over the long run, higher interest rates will eliminate these market distortions - a very good thing for value investors.

 

Chinese equities: significant change

Dale Nicholls, Fidelity China Special Situations (FCSS)

China has great potential but has been brought down by short-term macroeconomic concerns. The pace of reforms has been disappointing in 2015, and with some actions such as currency devaluation, timing and communication could have been better. But China's move towards a more flexible currency is a long term positive.

An overall path to liberalisation remains, even if progress is slower than expected in areas such as state owned enterprise reforms, together with backward steps such as stock market intervention. There is potential for positive surprises and this prevalent sentiment creates opportunities in areas such as 'A' shares (Chinese mainland listed shares, where I am finding some strong large-cap businesses at reasonable prices.

A significant change is underway in China: it continues to grow at a better pace than the developed world and personal consumption is likely to outpace this rate of growth as the economy transitions towards a consumer-led market. Change is being driven by increasing penetration of the internet, particularly as a vehicle to reach previously untapped markets. For instance, while traditional retail networks are still to establish a rural footprint in China, e-commerce has already ensured that both goods and services are now accessible to a wider rural and middle class audience.

As people get wealthier, demand for better quality goods and services is also on the rise in areas such as health care and education. This is creating several opportunities for the fund.

There are fewer reasons to worry about the Chinese property market considering overall affordability trends - recent interest rate cuts only help this and the Chinese consumer balance sheet is in good shape. However, I remain concerned about corporate balance sheets where debt has grown substantially, and banks as I think the full extent of their non-performing loans is not fully recognised.

 

Emerging markets equities: currency weakness

Omar Negyal, JPMorgan Global Emerging Markets Income Trust (JEMI)

Firstly, emerging markets (EM) overall look relatively cheap compared with history. The market is trading on around 1.4x price to book today. We've had periods of euphoria in the past where it's been at 3x book and crisis lows at near 1x book but we think quite a lot is priced in to valuations today. Secondly there's been significant currency weakness that's happened in EM in the last few years and some currencies do look exceptionally cheap, for example the Brazilian real and the rouble.

For valuations to rise, either on a price to book basis or in terms of currencies, we need to see more clarity around the Chinese economic trajectory. We have seen stimulus from the Chinese government and are likely to see better numbers from China in the near term. Stabilising global growth would be helpful for EM too as well as some clarity over the US Federal Reserve policy on interest rates.

In the longer term we really need to see some earnings recovery. Valuations will only re-rate substantially if we get EM earnings recovery and so far we haven't seen any particular signs of that happening.

The areas where there are opportunities include Taiwan, particularly the technology companies, those are the companies generation good returns on capital we think have good dividend qualities and have been able to demonstrate they can produce cash flow over time.

Brazil is also interesting because there is a lot of pessimism. The currency has sold off dramatically this year and it's probably the cheapest currency in EM today. It is also a natural area for dividend investors because there is a mandatory 25 per cent dividend pay out.

There's a broad opportunity set for emerging market dividend paying companies. I can think of many hundreds of companies which generate at least a reasonable amount of yield where valuations have improved because EM have grown cheaper, so it's balancing act between the fact that valuations have improved and things have gotten cheaper versus the reality that the fundamentals are challenging.

 

Bonds: no return to normal?

John Pattullo, Henderson Diversified Income (HDIV)

We have remained patient throughout the year, running higher cash positions that can be used opportunistically. But we are more positive than this time last year and think we can achieve a higher return next year.

As we approach 2016 there are higher bond yields compared with the same time last year - higher compensation for default risks. We also expect to see better value emerging and more interesting credits in the market, so there should be more opportunity in the next 12 months.

Two major investment themes will dominate the credit markets in the coming year. The most important continues to be the credit cycle. The industrial cycle is at quite a late stage, particularly in the US, but in Europe it remains sanguine. European corporates remain more conservative and less levered than their US counterparts, and selected industrial high yield names are attractive. Europe appears to offer some good opportunities and should be supported by the accommodative monetary policy being pursued by the European Central Bank, which should hold interest rates low in Europe for some time.

The second big investment theme is the ongoing reregulation of the banking industry. This has already resulted in healthier banks in the UK, US and Switzerland, and is independent of credit and the industrial cycles.

We remain true to our long-held strategy of sensible lending to large, non-cyclical businesses with reasons to exist. These entities typically have relatively reliable earnings and a moderate amount of debt on their balance sheets, which gives them the ability to pay a reasonable coupon.

This approach will continue to pay the carry (yield), which continues to be a core part of our strategy.

 

Ariel Bezalel, Jupiter Strategic Bond Fund (GB00B4T6SD53)

Commentators have been itching to call the top of the great bond bull market, which has seen prices march steadily upwards since the 1980s. They point to improving economic conditions in developed economies, a healthier US labour market and a long-awaited normalisation of interest rate policy, after many years of low rates and quantitative easing. It has also been suggested that bonds have simply entered a bubble which must eventually burst.

Far from being at the start of a great normalisation, we believe that interest rates are likely to remain low for a long time. We think the ability of central banks to raise rates will be limited in an environment where high debt levels and aging populations in much of the developed world continue to act as impediments to economic growth. The development of new, disruptive technologies represents another headwind to global inflation. So we expect any tightening of global monetary conditions to be gradual and that longer-dated bonds, which are particularly sensitive to changes in interest rates, will continue to perform well.

In the short term the risk of a policy error by the Federal Reserve (the US central bank) has increased. Senior officials are determined to start raising rates and it seems the Federal Reserve is looking to atone for its failure to begin normalising monetary policy earlier, before the imbalances in the global financial system became so pronounced. That window has now closed, and the Federal Reserve may eventually regret raising rates in December, especially as the slowdown in global trade appears to be affecting US manufacturing. This US economic recovery is built on shaky foundations.

In challenging economic conditions, governments with sound finances and control over their printing presses should prove resilient in the event of further deflationary shocks.