Turcan Connell Asset Management

The Rocky Road to Recovery Financial Market Overview – January 2014 Summary 

We are now well into the global economic recovery and stock markets in developed countries have responded with significant gains during 2013. However, there are signs of complacency among some investors.

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There is room for stocks to extend more, but further advances will be interrupted by periods of increased volatility as central banks tighten, or ‘taper’, monetary policy as we enter a period of ‘normalisation’.

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History shows how difficult it is for central banks to smooth the normalisation process. With an unprecedented amount of monetary stimulus unleashed to overcome the financial crisis, we really are in uncharted territory as we emerge from the downturn and, as a result market, volatility may be significant – interest rates have never been as low as they are now.

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Bonds look especially precarious at the moment. The recovery and ensuing monetary tightening will be detrimental to bonds and any fall in prices may be exacerbated by declining liquidity in the market.

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The US is recovering quicker than many thought possible, but the improvement is already well discounted into many larger company shares.

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European markets have considerable room to extend, having come off a particularly low base. While others fret about low inflation in the region, we think it is an opportunity for policymakers to keep stimulating the economy for longer.

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Expectations for the UK are running away with themselves, as exemplified in a very strong pound. There is no doubt that things are improving, but trade imbalances are still at worrying levels

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Correlations in markets, which have limited the ability of many stock-picking investors, have dropped dramatically in recent months. Hedge funds that can bet on falling as well as rising share prices may be best placed to exploit this change – particularly in Europe where there is latent growth.

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Introduction Markets and the economy are very much playing out as we have anticipated over the past couple of years – the US is leading a global recovery which has sparked a surge in stock markets in the developed world. The upturn has prompted the Federal Reserve (Fed) in the US to start the process of normalising the economy, tapering its bond purchases and hinting at the prospect of increased interest rates. Our challenge is to stay several steps ahead of perceived market wisdom. Just a year ago many sceptical commentators believed the recovery was illusory. Now that the evidence is irrefutable, it is time to look beyond the present situation. We are not of the opinion that markets are at their peak – yet. There is still plenty of scope for companies, who in general happen to be cash rich, to spend more, something that has been notably absent for the past five years. An increase in corporate spending would most certainly lift company fortunes and stock markets further. On the other side, downward pressure on stocks will come when policy makers increase interest rates (a somewhat counterintuitive concept that we explain later). Investor behaviour at present indicates the belief that that is some way off. But in the same way that pride comes before a fall, market shocks tend to follow periods of investor exuberance. We are seeing signs that investors are getting just a little too carefree. Hard evidence of this can be seen in the significant slide in option prices – in other words, there is low demand from investors for insurance against a market decline. More generally we are seeing a little carelessness creep into financial markets – for example, brokers are starting to boost charges for initial public offerings. In short, the scene is set for markets to roam higher and then for them to retreat periodically in short, sharp movements as tightening is introduced, a pattern that could continue for the next couple of years. In the long term, we are still bullish on stocks. However we might see some volatility over the shorter term, but that should provide opportunities for us to buy more at attractive prices.

Central Banks Setting interest rates is not an exact science and central bankers are only human – we should not expect them to guide us into a more normal environment without some ups and downs along the way. One need only look a decade ago when Western economies were starting to recover from the crash that followed the technology bubble to see the difficulties markets faced in applying evolving monetary policy to company valuation: from the middle of 2004, the Fed pushed up interest rates five times. The uncertainty meant the Standard & Poor’s 500 index dropped by 6% in little more than a month over that summer, and then climbed 14% by the end of the year. In 1994 a similar stop-start tightening by the Fed led the market to drop 7% over February and March, before climbing 7% again by the end of August.

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Most recently, we have seen volatility due to central bank intervention in the summer’s steep decline in emerging markets securities (the MSCI Emerging Markets index dropped 17% between 8 May and 24 June) following Fed Chairman Ben Bernanke’s indication that tapering would come sooner rather than later, a position which was later toned down. For the moment, markets remain calm. Bernanke’s replacement Janet Yellen is considered a dove – more keen to cure unemployment than worried about inflation – and recent statements from the Fed have indicated that interest rates would stay low even after the unemployment rate dropped below the significant 6.5% figure they had previously said would be the trigger for tightening. Graphs of interest-rate expectations show very little change for the next year, as demonstrated below.

Source: Bloomberg

However, interest rates will have to go up eventually, and because that will adversely affect both bond and, through contagion, stock markets, it is worth explaining why. An increase in interest rates lifts the hurdle that other securities need to reach to make them worth purchasing. If you are getting an extra 0.5% interest at the bank, bond yields will need to rise to take that into account. And because yields move inversely to bond prices, the price of bonds declines. (This relationship can be explained by the fixed payments from bonds. As the price drops the value of those payments as a percentage of the price – in effect the yield – increases. And vice versa.) Increased bond yields also push up the so-called equity risk premium, the hurdle that stocks need to pay in order to make them worth owning. With that hurdle rising, again that pushes prices down. But the central bank is not just a harbinger of bad news. While market participants may seem particularly sceptical about policymakers’ abilities, their opinion is highly regarded throughout the wider business community. Heads of businesses can be swayed by the positive rhetoric coming from the Fed which until now has been quite muted in its bullishness, and companies may take this as the signal they need to increase corporate spending and merger activity, both of which have been very subdued since the financial crisis (as a result companies are sitting on significant piles of money – reports last year showed that FTSE 100 cash levels had risen to almost £74 billion from £12 billion in 2008).

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So the tension in markets is really down to the prospect of increased interest rates coming up against improved economic fundamentals and the possibility that corporate spending could increase significantly. It is fair to say we can expect a bumpy ride.

Bonds (Return Free Risk) We have been cautious about government bonds for some time. In recent years, yields on securities such as UK gilts, US Treasuries and German Bunds have been pushed artificially low, and prices consequently driven higher, because they were perceived to be ultra safe in the unusually volatile market that followed the financial crisis. But safety is a relative, not an absolute, concept. Because prices have been pushed so high, the eventual tightening will almost certainly mean material losses on these investments. We are still wary of holding these securities, but it is surprising how many people still do not appreciate the losses that could occur. The UK 10-year yield climbed from about 1.8% to 3% in 2013. If yields were to advance to 5% or more – not an unrealistic prospect if the economy were to recover faster and further – that would result in a hefty double digit loss on gilt holdings. But that is not the only problem facing the securities. Larger banks have been reducing their investment banking operations under commercial and regulatory pressures. At the same time investment banks have been reducing their brokerage businesses. Unlike equities, which trade on exchanges, bonds are bought and sold through these brokerages and the declining number of places where you can trade these securities is putting a squeeze on liquidity (estimated to be a reduction of up to 75% in the number of bonds being traded). Any reduction in liquidity tends to amplify movements either way and, with bond prices already falling, this situation will send them lower even faster.

US The key driver behind the developed market recovery is the US, whose economy has staged a remarkable turnaround over the past two years. Consumption is increasing, with core consumer spending climbing 0.2% in December, more than analysts had predicted. Unemployment has dropped rapidly – most recently it slid to 6.7% at the end of 2013 – just 18 months before it was at 8.3%. Most significantly, given the focus in the past halfdecade on the indebtedness of western nations, the deficit dropped to $174 billion in the final three months of 2013, down from $293 billion in 2012. The US government even posted a surplus in December. The Standard and Poor’s 500 index jumped 30% last year, its biggest annual advance since 1997, indicating investors are already discounting quite a lot of future growth, and consequently larger US company shares are looking quite expensive. As we have said before, there may be further value to be found away from the largest US companies, and we are looking at sectors below the radar that may be underappreciated. Alternatively, we have been moving money to other regions of the world where the stock market advances have not been so marked.

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Europe To reiterate a point, investing is a relative game. While we were not particularly bullish on the European economy, we were positive compared to the large sections of the market who were pricing in Armageddon. Given the special circumstances arising from the debt crisis, the recovery in Europe has not been as fast as that of the US (the Stoxx 600 index of European shares advanced about 17% last year, a little more than half the growth of the main US index). With stock valuations starting from such low base, and many aspects of future growth not yet priced in, there remains ample room for gains in European stocks. And a European recovery is very important to Britain – in fact the primary reason for the upswing in the UK economy has been down to a stabilisation in Europe where over 50% of our exports go – something that politicians or journalists are unlikely to acknowledge. As regards the broader economic picture for Europe, we are again seeing evidence that our long-held views have prevailed. The so-called peripheral European nations are starting to enter the market again to sell their debt – Ireland recently sold €3.75 billion of bonds with demand for the securities exceeding supply by almost four times. Its 10-year yield recently slipped to the lowest since early 2006, while its credit rating was raised to investment-grade by Moody’s earlier this month. Far from the euro being a curse, it has helped accelerate the changes these countries needed to make. Without the ability to devalue the exchange rate the only option was to become more competitive through wage decreases and efficiency gains. Recent data showing very low inflation in Europe has been creeping into the discourse as a reason to be sceptical of the continent’s recovery. We are not overly concerned about this – it is likely that most of the downward pressure on prices is coming from a deflationary environment for commodities around the world rather than in Europe in particular. And the continuing low inflation environment provides the European Central Bank more room to keep its accommodative monetary policy in place for longer, which in the end will be beneficial to the European economy.

UK The UK, in line with other Western economies, is experiencing a significant recovery, but again we would caution that expectations may be running ahead of themselves. The country still faces a number of key challenges: economic data is still pretty mixed and the economy is imbalanced, with a recent report showing that services sector growth slowed in December. The country also faces competitiveness issues, posting a goods trade gap of £9.4 billion pounds in November. Recent growth figures and predictions may be flattering given the low base from which they are starting. While the International Monetary Fund may be predicting growth of 2.4% this year, it is coming after a climb of just 0.1% in 2012, compared with the 2.8% posted by the US.

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An indication of where investors are too bullish on the UK can be seen in the sterling/dollar exchange rate. The pound has increased by 10% against the US currency in the past six months, a gain that cannot be justified given the relative economic stages of the two nations. We expect the pound to decline against the dollar at some stage, but at the present rate of roughly £1 to $1.66, that is a level where UK investors can buy US assets at relatively cheap prices. However, one area where there is significant positive momentum is at the Bank of England. We are very enthusiastic about Mark Carney’s performance so far, and have little doubt that his stewardship of stimulus policies, including funding-for-lending for small businesses and help-to-buy for home purchasers, are delivering the improvements that the UK economy needs. We have been critical of the central bank under Mervyn King, but have been impressed by Carney’s approach and more open stance with the investment community.

Emerging Markets A slowdown in growth in emerging markets has been long anticipated on the basis that their exceptional advances could not last forever. In particular, we highlighted China’s deceleration as a deliberate move by the government there to shift the focus of its economy closer to a developed nation, consumption-led model. The change in market perception for developing nation prospects can be seen in the 2.6% decline for the MSCI Emerging Markets index last year, compared with gains in developed regions. While a slowdown might be expected, it is not necessarily welcome in places such as the eurozone and the UK. With currencies sliding in India, Indonesia and Brazil, that makes it more difficult for their citizens to buy our goods and services. That in turn may hold back some growth in our part of the world.

Alternative Investments One of the most marked aspects of stock markets in recent years has been the binary, risk-on risk-off behaviour exhibited by equities. Share prices have moved in lockstep in relation to major economic news and data rather than being affected by specific company issues – a headwind to those stock-picking investors who try to choose individual companies with the most potential. As we have observed before, the normalisation of stock markets will herald a greater dispersion amongst individual share returns. This change is now becoming more marked, with recent data showing in a significant decline in share correlations – the FT reported that stock correlations between the 50 largest US companies reached the lowest level earlier this month since 2007.

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Against this background, it is intuitive to try and find the best performing companies and industries rather than just betting on the market as a whole, and therefore it is sensible to try and find those managers who can benefit most from individual share performance. We believe that long/short equity hedge funds are best placed to take advantage of this trend as they make money from declining as well as rising share prices. Also, so-called-trend following hedge funds, which identify particular subsections of the market that might rise and fall, could do well in this environment.

Portfolio Activity 

The increased volatility in stocks that may arise as a result of tightening obviously makes us cautious about short-term equity prospects. One approach might be to take on board some of the very cheap insurance available at present to protect against stock market declines.

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The more likely strategy, however, is that we are going to build up our cash position. While our thesis remains that the recovery is ongoing, the prospect of further tightening makes increased volatility in markets more likely, and any shock to equities will be an opportunity to purchase assets with good long-term prospects at knockdown prices.

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We are watching carefully fixed-income markets, and we reduced further our developed government bond exposure at the end of 2013.

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Record prices for US stock markets may send us looking elsewhere for returns. As stated, we may try and find value in smaller US companies, and may direct some money towards Europe. Already we are increasing our quota in European shares.

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We may continue to use the dollar’s reduced rate versus sterling as an opportunity to buy securities denominated in the US currency at a reduced rate.

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The recovery in the UK has disproportionately lifted the fortunes of UK smaller companies, who tend to be tied to the domestic market more closely than their larger counterparts. We are looking to withdraw some money from this asset class.

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Increased dispersions in stock returns will benefit those investors who can differentiate between individual stocks. We have been adding more money to a European long/short equity fund to benefit from the increased disparity as the economy in the region recovers.

Haig Bathgate Chief Investment Officer January 2014

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Turcan Connell, Princes Exchange, 1 Earl Grey Street, Edinburgh EH3 9EE Tel: 0131 228 8111 Email: [email protected] www.turcanconnell.com Turcan Connell Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Registered Office: Princes Exchange, 1 Earl Grey Street, Edinburgh, EH3 9EE.