Heartwood: EM equity comeback ahead
Michael Stanes, investment director at Heartwood Investment Management comments on the global equity outlook in 2016.
Equity market sentiment remains cautious, following the heightened levels of volatility seen in the late summer. With the focus centring on Federal Reserve policy decisions and the theme of global central bank divergence, we expect financial markets to 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, we believe that global equity markets can continue to grind higher.
While our broader strategic asset allocation decision of maintaining an overweight equity exposure remains intact, what we are likely to change next year is the tactical orientation of our equity exposure across style, sector and market capitalisation, although we are sensitive to the increased volatility of financial assets in this low growth environment.
Since 2009, we have been in a prolonged period of growth stocks outperforming value stocks and this dispersion is now at extreme levels. 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. We believe the extreme focus on growth at any price, most strikingly in the US, looks to be running its course.
As a consequence, we expect to be reducing our US growth bias in favour of increasing exposure to more cyclical markets, namely Europe and Japan. We recognise that overweighting Europe and Japan has been a consensus trade in 2015- one in which we have participated – but we continue to believe that these markets will retain the support of both the corporate earnings recovery cycle, which remains at an early stage versus the US, as well as ongoing central bank stimulus.
Our positioning in the UK equity market is expected to shift towards the two extremes of the market-cap spectrum: large-cap and micro-cap. UK small- and mid-caps have had a strong year relative to the FTSE 100. Interestingly, the US has seen a counter trend where small-caps have underperformed. Current valuations are looking more attractive and the domestic focus of US small-caps should provide more shelter from the headwinds of a strong US dollar.
More broadly, the key question for investors in 2016 will be to determine when to begin the rotation from developed market equities into emerging market (EM) equities. Within our own portfolios we have had limited exposure to the EM, but over the longer term, we will be looking for opportunities to allocate more to these markets. Ultimately, the decision of when to rotate will depend on seeing further signs of growth stabilising in EM; we believe this represents a story for the second half of 2016 and into 2017.
While EM equity valuations have cheapened, the economic fundamentals remain weak. The obvious concern is China: will the economy successfully rebalance? We remain optimistic that the authorities have the tools to support growth and transition China’s economy towards a more consumer-orientated model. We are seeing some signs of stabilisation in fourth quarter data trends.
Overall, we are expecting another eventful year for investors characterised by performance dispersion between markets, particularly as global central bank policy diverges. This differentiation should create a fertile environment for those investors who are able to take advantage of tactical opportunities. We continue to believe that equities offer the best potential risk-adjusted returns versus other asset classes over the longer term, particularly in a low growth environment.