The risks for charity investors in 2016
After a couple of lacklustre years for the returns of most investment markets, it is not surprising that charity trustees may be wary of the future. The performance of most asset classes in 2015 has been increasingly volatile, with extremes in the summer, but for the year to date most returns have been flat with the exception of commercial property. Investors would be forgiven for thinking, is it worth the effort to endure the increasingly bumpy ride for low total returns?
However, the risks are manageable, provided trustees are willing to take a long term perspective and diversify investments with a suitable mix of different asset classes. While the risks have increased, having a careful eye on the key factors that influence market returns will be critical in an increasingly connected investment world.
Looking forward over 2016, global central bank divergence is expected to be a dominant theme. Charities should expect the US economy to retain its role as the engine of global growth in 2016. However, growth is likely to remain modest compared with previous economic cycles, allowing the Federal Reserve to proceed on a very gradual tightening path. The Bank of England is likely to be keen to follow the Fed’s lead and initiate its tightening policy, in contrast to Europe and Japan, where ongoing central bank stimulus is expected to support those economies’ mild recoveries.
Sustainability of US growth
Confidence in the sustainability of US growth has been tested in 2015, particularly as third quarter data releases disappointed expectations. In my view, though, investors became overly bearish. A strong labour market has been a pivotal underpin to US consumer spending in the second half of 2015, which has also been helped by real income gains through lower energy prices.
The manufacturing sector saw protracted weakness on the strength of the US dollar and slower global growth, but services activity – a larger contributor to US GDP – remained robust. More recently, there have been signs that the contraction in manufacturing activity is beginning to bottom as external headwinds abate. Headline inflation remains low, but core inflation has remained steady on the strength of services.
Trustees should expect the impact of lower energy prices on headline inflation to be transitory and, more importantly, we are finally seeing evidence that tighter labour market conditions are placing upward pressure on wages. In an environment of steady economic growth, the Federal Reserve is expected to proceed on a very gradual tightening path, stopping at a point that is likely to be significantly lower than seen in previous tightening cycles.
The UK economic and interest rate cycle has closely followed the US, but some would now describe UK policy to be in a quandary. Domestic demand has been firm but, similar to many other economies, it is the manufacturing sector that has taken the pain. Market pricing has pushed out a first Bank of England interest rate hike to late 2016/early 2017.
As the Federal Reserve embarks on its tightening path, however, there is a risk that the Bank of England will be keen to follow its lead. Price pressures in certain parts of the economy, such as property and services, are rising, and headline inflation should begin to rise as lower energy price effects diminish through the course of 2016.
Global central bank divergence
Meanwhile, the European Central Bank and the Bank of Japan are both expected to remain very accommodative, reinforcing the theme of global central bank divergence. While the balance of probabilities is weighted in favour of more monetary stimulus in 2016, there is no guarantee that either bank will act. In Europe, one has been particularly encouraged by the positive turn in credit trends, providing some evidence that the European Central Bank’s stimulus programme is working. Moreover, domestic demand has held up well in 2015, despite headline risks surrounding Greece, specifically, as well as broader financial market volatility.
Japan’s macroeconomic picture has been lacklustre, but we one is not convinced that the Bank of Japan is keen to extend the qualitative and quantitative easing programme; indeed, how far can banks keep administering the medicine without the desired outcomes? It is expected that the government may announce a supplementary budget to support growth. Next spring’s wage negotiations will be important for Japan’s near term inflation outlook, but recent activity data is pointing towards broad-based improvements across the economy.
Furthermore, Chinese growth trends should begin to stabilise as monetary easing takes effect, relieving the pressure on Asian economies more generally. Additionally, the People’s Bank of China has the room to ease policy further to support China’s transition to a more domestic demand orientated economy.
What are the investment implications in an environment of moderate global growth and a benign Federal Reserve tightening cycle? It is prudent for charities to maintain a short duration profile in fixed income, holding shorter dated bonds and constraining their overall exposure to this asset class. One expects US and UK government bond yields to rise moderately across the curve in response to gradual central bank tightening. There will be fewer opportunities across the broader corporate credit universe than in 2015 due to weaker fundamentals, and investors will need to be selective to find pockets of value.
Cautious equity market sentiment
Equity market sentiment remains cautious, following the heightened levels of market volatility seen in the late summer. With the focus centring on Federal Reserve policy decisions and the theme of global central bank divergence, financial markets should stay volatile in the short term. Nonetheless, the interest rate tightening cycles in both the US and UK are likely to proceed very gradually against a backdrop of modest growth. In this environment, global equity markets can continue to grind higher.
While a broader asset allocation decision of maintaining an overweight equity exposure should remain intact, what is likely to change next year is the orientation of equity exposure across style, sector and market capitalisation. We have been in a prolonged period of growth stocks outperforming value stocks since 2009 and this dispersion situation is now at extreme levels, particularly in the US. In an environment of uncertain growth and low inflation, investors have been willing to pay the premium for the predictability of earnings and evidence of profitability.
This policy has worked well for charity investors, who have followed a higher income bias in portfolios compared to a boarder total return approach, but one should be wary that valuations are looking stretched. As a consequence, any US growth bias should be reduced in favour of increasing exposure to more cyclical markets, namely Europe and Japan, as well as to certain parts of the UK market capitalisation spectrum, namely large, medium and smaller companies, where there is better upside potential over the medium term.
More broadly, a key question for next year will be determining when it will be appropriate to rotate from developed markets into emerging markets. Where charities have had limited exposure to the emerging markets, over the longer term it makes sense to be looking for opportunities to allocate more to these markets. Ultimately, the decision to rotate will depend on when the growth picture starts to stabilise in emerging markets, which represents a story for the second half of 2016 and into 2017.
Best potential returns
In a low growth/low interest rate environment, charities should continue to believe that equities offer the best potential risk-adjusted returns versus other asset classes over the longer term. Retaining a cautious view on the government bond markets and remaining selective in corporate credit makes sense. Expect another eventful year, characterised by performance dispersion between markets, particularly as global central bank policy diverges. This differentiation should create a fertile environment for those charity investors who are able to take advantage of tactical opportunities.
