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Prepare for inflation and protectionism

Where fund managers are pinning their hopes for outperformance in the coming year
January 5, 2017

The investment outlook for 2017 seems broadly to be a choice between inflation stoked by expansionary fiscal policy or stubborn secular stagnation due to the rise of protectionist politics and the crumbling of trade agreements, which could hobble world commerce. Whichever force you think will be more powerful, should determine the mix between growth- and income-producing assets in your portfolio.

The rise of inflation is already evident in the UK and the drop in sterling is starting to exacerbate this trend by making the cost of imported goods higher. Chancellor Philip Hammond’s Autumn Statement also struck a fiscally expansive tone with its £23bn investment fund. And there’s every chance of inflation in the US, too, with President-elect Donald Trump pledging a domestic infrastructure spending splurge.

Add in rises in the oil price – or at least a floor given the positive noises from the recent Organization of the Petroleum Exporting Countries (Opec) meeting – and there could be a significant shift in the types of stocks that could fare well and those that might lose their lustre. On the other hand, if Mr Trump pulls up the drawbridge and the UK finds itself trading in no man’s land after unsuccessful Brexit negotiations, the global economy could suffer.

 

Cyclical switch

A characteristic of UK markets in 2016 was the continued march of stocks with earnings deemed to be less volatile and that were judged to be less cyclical, or economically sensitive. The perception is that they will continue to produce the goods almost no matter what the economic environment.

But the re-emergence of inflation could change all that, according to Fidelity UK equity fund manager Alex Wright, and the performance of so-called defensive and cyclical stocks could rotate. “I think the gap in valuations [between defensive and cyclical stocks], which has widened over the past three years, could be poised to narrow significantly as investors position themselves for a Trump presidency,” he said. “Whether Trump manages to achieve his stated 4 per cent GDP growth target is anyone’s guess. But we can be sure that if he gets even part of the way there it will be accompanied by higher inflation rates than we have become accustomed to.”

Mr Wright said the types of stocks set to perform well in this more inflationary environment were “very different to the ‘bond proxies’ that had led the market since the financial crisis”.

Between 8 November, the day of the US election, and 30 November, tobacco, the most expensive sector of the market, dropped 2.8 per cent, while banks, the cheapest sector, rose 3.8 per cent. “Of course, this is an extremely short-term observation, and time will tell how much further this reversion has to run,” Mr Wright said. “However, given the extreme starting point, I believe there could be further outperformance ahead for the cheapest parts of the market.”

 

Income focus

If the aforementioned expansionary policies don’t work and global growth remains relatively stagnant, income will remain a key component for investors’ portfolios.

Deutsche Asset Management chief investment officer Stefan Kreuzkamp said he would expect “yields only in the mid single figures right across all asset classes”. Given that he is “not pinning our hopes for economic growth and capital market returns very high for 2017”, he is looking towards good dividend payers and selected high-yield bonds, as well as alternative infrastructure and real estate investments.

Darius McDermott, managing director of Chelsea Financial Services, agrees that investors should consider the latter asset classes for 2017. “Infrastructure is a sector that has recently come to the fore as government policy around the world has begun to shift from monetary to fiscal stimulus,” he said. “Many projects are backed by governments and long in tenure, making the sector less volatile than the wider market. Yield can also be found. I like VT UK Infrastructure Income (GB00BYVB3M28) and First State Global Listed Infrastructure (IE00BK8FXL82).”

Many property-related stocks also have strong well-covered yields, including Berkeley Group (BKG), which also recently proposed a share buyback scheme, Custodian Reit (CREI) and Regional Reit (RGL). There’s also a burgeoning trend of build-to-rent, which housebuilders including Telford Homes (TEF) are getting in on. Such work is less risky for housebuilders as the projects are funded by pension funds and there are no sales and marketing costs needed to fill the properties. This should help support their dividend payouts.

But it isn’t all easy on income street. It will be increasingly important for investors to scrutinise dividend payers as research published in October last year showed almost half (48) of FTSE 100 companies had forecast earnings that covered their dividends by less than two times for 2016. Not only this, the 10 stocks with the highest dividend yield in 2016 all had earnings that covered their dividend by less than two times. This could put some pressure on some of the market’s favoured dividend stocks if market conditions prove too turbulent.

 

Tentative bond

It isn’t only the equities market that could face upheaval, though. M&G Investments’ head of fixed interest, Jim Leaviss, said Mr Trump’s pledged infrastructure policy, potential protectionism and repatriation of immigrant workers created a “cocktail that adds up to increased government borrowing and firmer inflation prospects”.

“Against such a busy scenario, governments that borrow too much typically watch their bond yield curves steepen, as we saw from the US Treasury market’s behaviour in the weeks following the election result,” he said. Mr Leaviss noted that increased borrowing today by consumers and governments is “merely stealing growth from the future”.

“For bond markets, this could lead to a renewed focus on the creditworthiness of government bonds, the traditional ‘risk-free’ asset, resulting in higher yields in the not-too-distant future.”

John Stopford, head of multi-asset income at Investec Asset Management, agreed that investors were beginning to look towards fiscal policy as having a greater role, but said it was “too soon to look for a decisive inflection point” in bond yields.

“Central banks will be cautious about changing direction given the risk of derailing the economic recovery, and fiscal policy is hard to expand quickly,” he said. “Fiscal expansion may also be limited in some countries by debt levels, and requires a level of co-ordination that will challenge most governments.”

Mr Stopford said government bond yields would “remain largely rangebound” with fair value only “modestly above current yield levels”. “A structural increase in yields will require either a rise in trend growth, a rise in trend inflation or a clearer change in the direction and mix of policy,” he said. “None of these are likely to happen quickly, but we may now be at the end of a 35-year bull market for government bonds.”

 

 

Safe as houses

Given the prognosis for bonds – or at least government debt – investors may well be looking to other assets to protect them from inflation.

Justin Curlow, an investment strategist at Axa Investment Managers, said the fund management house is bullish on an allocation towards more defensive, income-focused strategies. “Following seven years of expansion, global property markets are firmly entrenched in the mature phase of the cycle” he said. “In this context, property returns are shifting from being capital-growth-driven, stemming from falling capital rates and property yields, towards income-driven.”

Mr Curlow predicted an adjustment phase in property given the late stage of the cycle, and said the best quality properties tend to outperform immediately following a downturn. “This is the time in the cycle when tenants have a clear upper hand in leasing negotiations and, as a result, landlords owning the best-located properties with the highest specifications stand the best chance of maintaining occupancy and the all-important resilient income stream,” he said.

So property investors should “place a premium on prime assets, which are likely to outperform during a downturn, and avoid secondary property altogether”.

 

Emerging markets: more resilient than you might think

Those with investments in emerging market asset classes may be worried about the ramifications of a switch in western monetary policy on those holdings. The fear predominantly focuses on currencies, which can weaken against the dollar as the greenback tends to strengthen when interest rates rise.

But Ross Teverson, manager of Jupiter Global Emerging Markets fund, says a US rate hike has been priced in and there have already been “some large adjustments for a number of emerging market currencies” which have improved their export competitiveness.

“And emerging market equities have actually outperformed developed market equities in a number of previous rate hike cycles and it may be a mistake to assume that higher US rates are a threat to the asset class,” he added.

Mr Teverson added that many investors remained underweight to the asset class, which could mean a flow into the sector should performance hold up, something he was seeing evidence of.

“The problem in recent years has been that, despite positive long-term changes, earnings for the asset class as a whole have disappointed,” he said.

“But this is changing. The current year should prove to be the first since 2013 when emerging market equities deliver a year-on-year increase in aggregate earnings per share and this trend of earnings growth looks likely to persist through 2017.”

Michael Hasenstab, chief investment officer of Templeton Global Macro, said many emerging markets were now more resilient to rising US rates thanks to improved external reserves, better current account balances and lower US-dollar liabilities.“During periods of short-term uncertainty, markets tend to overplay the potential US policy factors and under-recognise the more important domestic factors within the countries,” he said. “We expect those valuations to revert toward their underlying fundamentals over the longer term as markets more accurately assess their actual value.”

Mr Hasenstab cited local currency bonds in Mexico, Brazil, Argentina, Colombia, Indonesia and Malaysia as undervalued.

 

Left field

It can be hard to think against the consensus, but each year Saxo Bank produces a list of 10 “outrageous predictions”. The ones that caught our eye were: the Shanghai Composite index hitting 5,000; Brexit never happens; and Italian banks becoming the best-performing equity asset.