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Global economic scene spells time for investment review

Market volatility is forecast to be higher in 2015. With this in mind, Joel Beebe suggests SMSF investors should revisit their portfolio as strategies that have worked in the past may no longer be viable.

This year is already shaping up to be a very different year for investors compared to the relatively smooth ride enjoyed over the course of 2014.

At Wingate, we expect a higher level of volatility for the next 12 months compared to the past year, and a lower level of base returns from most asset classes.

This expectation was underscored by United States Federal Reserve chairwoman Janet Yellen’s comments in November last year, where she talked about monetary policy needing to normalise, and stated “this normalisation could lead to some heightened financial volatility”.

What this suggests is the calm, tranquil and almost riskless markets we’ve witnessed globally over the past two to three years are expected to become more volatile and more uncertain.

A taste of what may lie ahead was evidenced towards the end of 2014. In both October and December the equity market fell 5 per cent intra-month before recovering most, if not all, of its losses by the end of the month. These volatile periods highlight the pace at which investor sentiment can shift on a global scale.

Following several years of relatively calm markets, the transition to a more ‘normal’ market environment is well underway. In particular, we do not expect the equity market’s 25 per cent annual return over the past three years to be repeated in 2015.

In 2015, investors, and especially SMSF investors, should focus more on alternative sources of return (that is, income or dividends), not just returns that are capital gains related.

Given the backdrop of weak economic growth in most major economies, investors should not rely on the recent trend of higher earnings and higher valuations delivering capital gains.

With increased volatility coming back into the market it will pay to be more discerning.

Both the US and Europe face difficult conditions over the next year, though the outlook for the US economy appears brighter than that of Europe.

The most recent reporting season in the US was quite interesting – earnings growth was between 4 per cent and 8 per cent, but sales growth year-on-year was close to 0 per cent.

This indicates the ongoing focus on cost-cutting, efficiency drives, margin enhancement and share buy-backs is supporting the earnings picture, but revenue growth is difficult. We don’t see that changing dramatically moving forward.

While the US equity market will have some level of support, especially as consumers benefit from lower oil prices, we regard the earnings expectations of about 7 per cent to 10 per cent as being quite challenged in that environment.

The US market significantly outperformed Europe again in 2014, and it is not difficult to see why. The aggregate earnings of S&P 500 constituents have exceeded their pre-global financial crisis high by over 15 per cent, while the top 500 European companies are around 15 per cent below 2007 levels.

Somewhat concerning is that market forecasts have earnings from this group of European companies growing over 10 per cent a year for the next two years.

While a lower euro will help, it does appear optimistic given current fundamentals and risks. Germany’s prescriptive medicine for southern Europe can hardly be considered a success, albeit some much needed improvement has occurred.

The fact that six years after the global financial crisis Europe’s future is as unpromising and uncertain as ever casts doubts on whether a solution for realistically delivering growth is practicably achievable.

We believe Europe will continue to have various issues that will prevent significant economic expansion and sales growth, and there is the potential for some of the issues that many thought had faded away, such as Greece’s exit from the eurozone, to raise their heads yet again.

On the bright side, a ‘Grexit’ does not appear to be as big an issue as it was considered three or four years ago. At that time, any thought of a country leaving the eurozone was a huge shock and no one knew, or had ever considered, how it would work.

But the world has had three years to insulate itself from the effects of such an exit, and the impact is likely to be much smaller than previously feared.

Turning to Asia, it is evident China’s growth rate is slowing. The Chinese government will do what it can to fix this slowdown, but in our view the days of exceptionally high growth are over.

This isn’t necessarily a bad thing, as elements of its recent rapid growth could have been considered too fast and unsustainable.

Australian investors are already seeing the side-effects of China’s slowing growth via lower iron ore prices and a decline in the Australian dollar.

Importantly, for SMSF investors this is a trend we expect to continue in 2015, so investors should review their portfolios to ensure an appropriate balance of Australian and international investments.  Japan also faces challenges and we don’t regard it as an attractive source of opportunity.

We have been reluctant to invest in Japan for quite some time due to relatively weak corporate governance and a declining and ageing population.
Japan has also struggled to emerge from a no-inflation and, almost, no-growth scenario.

After a promising start, it is our view Abenomics has been a failure, with the country falling back into recession. A delay in the sales tax increase and a surprise injection of cash into the economy indicate a government in panic mode.

These issues combined with a weakening yen suggest to us that better opportunities exist elsewhere.

The end of the Federal Reserve’s quantitative easing (QE) program will also have an impact on markets.

The first QE initiative in 2009 resulted in volatility becoming much lower.

However, the end of QE has taken away some of that support and may result in a higher level of volatility (as higher interest rates typically lead to greater volatility).

We noted signs of this in the fourth quarter of 2014 and anticipate more during the course of 2015.

Energy and healthcare are two sectors we are following closely in 2015 (see breakout boxes).

So what does this all mean for investors? As always, they need to consider their options carefully, and decisions should only be made after a great deal of thought and with long-term investment objectives firmly in mind.

But markets are changing and this means that what may have worked for investors in the past, may no longer be suitable.

Health

We see good opportunities in US healthcare stocks following the introduction of Obamacare.

Healthcare costs represent about 18 per cent of US gross domestic product (GDP) (compared to 10 per cent of GDP in Australia) and are increasing steadily year on year. We believe it is unsustainable for this trend to continue.

A heightened focus on costs by governments and private insurers has seen healthcare service providers increase profitability by lowering costs throughout the patient life cycle, whether it is via a transition to generic drugs, economies of scale or other means.

We invested in several of these companies 18 to 24 months ago and they have been significant performers since. Within the sector our focus has shifted away from the multinational pharmaceutical companies towards the service providers, which are incentivised to lower costs.

Energy

Oil prices dropped by about 50 per cent at the end of 2014 as a result of additional supply entering the market contemporaneous with a decline in global oil demand. While we expect the benefits of lower oil prices to filter through to increasing oil demand, this process will take time.

However, one thing that is quite unique in the oil market is the fast supply response. Most commodity markets have a supply response that significantly lags the demand response (both up and down) because of the time it takes to switch on and off production. But this is not the case with oil.

We saw an example of this recently with shale oil. Shale oil has a very short production cycle as drill rigs can be easily decommissioned and transported, in contrast to deep sea drilling platforms. Since the oil price’s decline from its peak in September 2014, the rig count has fallen 12 per cent from its peak as high-cost producers reduce their capital expenditure budgets. This supply-side response should see the oil price stabilise and push higher over the course of 2015.

Within the energy sector, we are looking for businesses that generate free cash flow and distribute this via dividends and share buy-backs, as well as growing intrinsic value over time.

Typically these companies are few and far between as most firms seek to grow production at almost any cost. However, North American companies such as Occidental Petroleum and Canadian Natural Resources are keenly focused on cash flow and return on capital and have low-decline oil assets. This is where we have chosen to invest.

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