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FTSE 350: A tough time to be contrarian

Welcome to our 2016 review of every stock market in the FTSE 350 index
January 28, 2016

“The bears have killed Goldilocks.” If the year continues as it started, this heading on an early January note from forecasters at the Royal Bank of Scotland (RBS) could prove a fitting epitaph to the decline of equity markets that started in summer 2015.

If the RBS view is correct, we are back in 2008 territory. Its analysts project major threats facing the global economy including further problems in China; a continuing commodities slowdown led by the falling oil price; the prospect of deflation; sovereign debt weighing upon growth; and automation destroying jobs. Those in the investor community on social media don’t appear to be entirely convinced by the comparison with 2008; the overall reaction seems to have been ‘it is not as bad as that’. But it may be useful to add a ‘yet’ in there.

While we lack information on how the average private investor has fared in these troubling times for growth assets, we have a proxy: the average performance of open-ended UK equity funds. It is not pretty. According to investment data provider Morningstar, these funds delivered an average total loss of 9.1 per cent in the year to 20 January. Investors may have been better in a tracker fund. Over the same period, the total return on the FTSE All-Share was minus 4.8 per cent.

Unsurprisingly, any business with a high exposure to the market has been hammered. Take the asset managers as a case in point. Our optimism for these stocks over the course of last year was driven by an increase in appetite from investors that have struggled to get their required return from their fixed-income holdings. Much talk of the ‘bondification’ of equities and prospects of further quantitative easing on the continent buoying European bourses looked to be a tonic for further growth for all but those exposed to emerging markets.

But as we have seen, the positive impact of this demand for asset managers has been completely outweighed by the hit on the funds they manage,and thus their fees, by falling markets. And the murky outlook is making investors nervous of even the highest-quality operators. Take a company of long-term pedigree such as Schroders Asset Management. As a manager heavily exposed to growth asset classes, particularly equities, it has been harshly treated over this turbulent period. The shares are trading on a consensus blended forward ratio of price to earnings that is less than 14, against a five-year average of around 15 (source: Bloomberg).

Admittedly, this is a tough call. When it comes to commodity stocks, we were doubtful a year ago that it would pay to call the bottom. This has been proved right, and then some, with industrial metals and miners taking the worst of the worsening global slowdown, which has been driven by falling of demand in China. Meanwhile, we stuck to our belief that housebuilders would be encouraged by an improving domestic economy, and have been proved correct – housebuilders and construction companies have been among the best-performing sectors over the past year. With the supply in the market continuing to be dwarfed by demand, and a political party in government that is wedded to home ownership it is hard to see this changing. The big question there is the high valuation for the sector, and whether companies can continue to grow as fast as expected.

Is there anything new under the sun? A theme that has plenty of momentum yet is that of defence and security. That can mean data security, staving off the next cyber threat. It can also mean security in the traditional sense: terror attacks closer and closer to home as well as deepening instability in the Middle East have focused policymakers’ minds on their need to protect their citizens. As always, there are winners and losers among UK corporates. The taps have been loosened for defence spending. But tour operators have been hit by scenes of British holidaymakers being massacred on North African beaches. One investment theme in 2016 could be identifying those companies that will prosper in an unstable world.