Neptune IM reviews 2014, looks ahead to 2015
Mark Martin, head of UK Equities and Manager of the Neptune UK Mid Cap Fund
- UK equity markets have been resilient: Despite ongoing concerns over domestic politics and international geopolitics, UK equity markets have performed reasonably. Economic activity continued to be stimulated by accommodative policy from both central banks and political bodies. This has aided the progressive repair of economies affected by the financial crisis and supported the improving outlook for global growth. In addition, despite no longer appearing cheap in absolute terms, equities remained attractive relative to other asset classes. From a currency perspective, the pound sterling performed poorly on a trade-weighted basis. The strength of the US dollar accounted for much of this weakness: versus the euro, sterling was in fact a strong performer.
- Inflation not an issue: Despite aggressive monetary policy around the world, inflation is currently well contained. Indeed, in many parts of the world deflationary forces continue to assert themselves. The current oil price – below $80 per barrel at the time of writing – is evidence of highly constrained inflation. Although a negative for commodity-producing countries, the UK consumer is a major beneficiary of low energy prices. Low energy prices not only reduce fuel and heating bills but also the threat of interest rate rises – and hence the threat of rising mortgage payments. Unsurprisingly, the metals and mining sector was weak, as was the oil and gas sector. Areas of the market that performed strongly included general retailers, such as Next, as well as the healthcare sector, which benefited from M&A speculation. Given the resource-heavy nature of the FTSE 100, it was perhaps surprising, that it outperformed the more domestically-focused FTSE 250 and Small Cap indices.
- Mid- to early-cycle rotation: Whereas the latter stages of 2013 and the first half of 2014 saw investors bringing forward their expectations of interest rate rises in the UK, the second half of 2014 saw a sharp reversal of this dynamic. This resulted in a shift back towards the more domestically-orientated and cyclical parts of the market.
- Political uncertainty builds: The outcome of the forthcoming general election is highly uncertain. We do worry that political mavericks such as Ukip could lead to some instability that could potentially render this a political market.
- UK equities are a relatively attractive option versus gilts and bonds: Despite the political uncertainty, we believe selective UK equities can make progress. Although absolute valuations have increased markedly over recent years, we believe parts of the UK equity market remain attractive relative to many other asset classes. Ongoing de-leveraging continues to be a headwind for Western economies, and companies with structural growth opportunities are likely to be increasingly sought out.
- Wide range of potential outcomes from global monetary policy experiment: The ability of the US economy to withstand a tighter monetary policy environment will be important for 2015 equity returns – as will the ability of Europe to avoid a deflationary shock. In both cases, we are optimistic. Tighter monetary policy in the US may cause volatility but ultimately represents economic recovery and therefore should benefit the UK equity market. Where the strength of sterling was a headwind for UK exporters for much of 2014, recent weakness should be a tailwind for much of 2015. We expect the UK stockmarket to make progress in 2015, although we continue to advocate a balanced, diversified approach.
- Corporate activity: As usual, we focus on attractively valued companies that we believe are set to benefit from structural growth trends or a significant level of internal self-help or management change. In the absence of organic growth opportunities, well-funded companies may look to return excess cash to shareholders, or engage in M&A to grow sales and profits. Pfizer’s approach for AstraZeneca, as well as several lower profile deals, bears witness to the renewed corporate appetite for M&A.
Felix Wintle, head of US Equities and Manager of the Neptune US Opportunities Fund
- Economic data: A strong 3.5% GDP reading for the third quarter backed up our thesis that the weak first quarter (-2.1%) and strong second quarter (+4.6%) were weather-affected and that the underlying US economy was strong.
- Market strength: 2014 is set to be another strong year for US equities both in absolute terms and relative to the rest of the world’s equity markets. The market is up strongly, led by more defensive sectors such as healthcare and utilities. This year the majority of market performance has come through earnings, which are forecast to rise 12% year-on-year from 2013. The re-rating of the market over 2012 and 2013 was in anticipation of an increase in corporate earnings and it is encouraging that this has come to fruition.
- Dollar strength: The US dollar has strengthened against the majority of currencies rising around 7% compared to sterling whilst the trade-weighted dollar has risen 9%. There are a number of factors supporting this trend, including the end of tapering, the anticipation of interest rate rises in the US, a lower fiscal deficit and an improving trade deficit (due to shale gas reducing US oil imports).
- Economy: Data will continue to be strong, particularly compared to Q1 14’s weak results. Job creation will continue to be a positive and efforts to get the housing market kick-started could be a boost for homeowners. Low inflation is a major benefit to US consumers and the economy as a whole, and we expect this to continue. This is best evidenced by slow wage growth, falling oil prices and the strong dollar.
- Strong dollar: We believe the US dollar is at the beginning of structural bull market. The EU is contemplating embarking on QE, the Bank of Japan is dramatically increasing its QE program and China cut interest rates in November, yet the US has just finished its QE program. This shows how far ahead of the rest of the world the US is in terms of its recovery and continued economic progression; and this is very dollar bullish. As the economy outpaces other geographies this will also propel the dollar, as will the continuing collapse in commodities – particularly oil.
- Large-cap: Large-cap growth stocks are likely to perform well in this environment. With money flowing into the US as investors seek exposure to the strong dollar and strong corporates, large caps are a natural home. The low inflation environment may also bring with it P/E expansion, which will boost this part of the market. Many large-cap stocks have good earnings growth but are also pursuing aggressive capital return policies, which should deliver shareholders some extra returns in terms of share buybacks and dividends. We remain bullish on the US and the US stockmarket.
Douglas Turnbull, head of Chinese Equities and Manager of the Neptune China and Neptune Greater China Income funds
- Consolidation of power: President Xi Jinping has surprised many with the strength of his leadership. Xi has consolidated his power via the anti-corruption campaign, which has succeeded in uniting the party as well as gaining public support. This is an important step in enabling the Government to enact tough reforms that are necessary processes for China’s economic development.
- Softer economic data: China will likely print a weaker but tolerable 2014 GDP growth figure of just above 7%. This represents a continued slowdown from previous years and weakness across many sectors. In particular, there has been broad-based weakness in property and in industrial sectors with excess capacity.
- Stimuli: The Government responded to slowing growth with two rounds of stimulus measures. Mid-year these involved targeted infrastructure investments, removal of home purchase restrictions, and injections of liquidity into the financial system. In the fourth quarter, the People’s Bank of China took the more emphatic measure of reducing interest rates. In doing so, they declared their intention to reduce the real cost of credit to corporates and support growth. In response, there have been two strong reactions from the equity markets, albeit rallies of shorter duration than previous years’ half-yearly market oscillations.
- Further monetary stimulus: The Government’s stimulus signals a firm commitment to deliver solid growth. There is an expectation that further interest rate cuts are to come, which will be positive for many sectors.
- More targeted investment: The Government will likely continue to support growth by targeting strategic areas of the economy for investment, such as rail, clean energy and healthcare.
- Stronger equity markets: We believe investors can take greater confidence that monetary and fiscal stimulus will deliver a soft landing in Chinese growth. With this less pessimistic outlook, there is scope for stronger equity markets in 2015.
However, the recent history of growth oscillations indicate that such a rally will probably be of a shorter timescale. Further, investor awareness of the challenges faced, such as medium-term tail risk, means that it may be hard for the market to break out of range (although it certainly could overshoot it).
Tom Smith, manager of the Neptune Latin America Fund
- Brazil: 2014 has been dominated by the uncertainty surrounding the presidential election, with polls showing huge swings in the months leading up to the tightest election since re-democratisation. Dilma Rousseff was re-elected and will begin her second term in January with plenty of work to do. Brazil has an economy on the verge of recession, inflation well above the Central Bank’s target and the threat of downgrade from ratings agencies.
- Mexico: Continued to make good progress advancing the energy reform, although the anticipated acceleration in growth has taken longer to materialise than expected. Robust US growth supported manufacturing, while construction finally began to pick up following the lull in public spending since the beginning of Pena Nieto’s presidency.
- Colombia: Was a standout within Latin America for its robust economic performance in 2014, with growth staying around 5%. The re-election of President Santos will ensure continuity in economic and social policies. Chile continued to suffer a de-rating as a result of a weak economy and uncertainty surrounding Michele Bachelet’s economic reforms.
- Brazil: We believe the outlook for Brazil in 2015 is heavily reliant on Dilma’s policy decisions, and whether or not we see ‘more of the same’. Early indications are that we will see a material improvement – we have already seen the Central Bank hike rates after the election to anchor inflation, and her cabinet appointments are expected to include much more market-friendly candidates than are currently in place. With the necessary fiscal adjustment, we expect the economy will remain weak in 2015 but with market expectations low, there is ample room for surprise if Dilma embraces more orthodox economic policies and economic reforms, paving the way for future growth.
- Mexico: Will likely see continued economic acceleration in 2015, benefiting from continued strength in the US economy and further domestic recovery. If we see more US dollar strength and the Federal Reserve begins the hiking cycle, the Mexican peso looks more robust than many other emerging market currencies. Companies exposed to infrastructure and US exports look well placed to continue to perform strongly.
- Colombia: Should continue to grow strongly, although stabilisation in the oil price will be important. 4G infrastructure projects will continue apace supporting construction companies, suppliers of construction materials and broader economic growth – better infrastructure and sustainable peace could add up to 2% to potential GDP growth.
Chris Taylor, Head of Research & Manager of the Neptune Japan Opportunities Fund
- Economy: The economy continued to improve overall, although there was some short-term negative impact from the VAT hike from 5% to 8% on 1 April. During the second quarter the economy contracted by -1.9%, then by only -0.4% in the third quarter as it recovered from the sales tax hike. However excluding the very volatile inventory and capex figures, the -0.4% fall became a 0.2% rise. More recent statistical releases indicate that the economy is fully back on a growth trajectory.
- Politics: After sticking to his policy guns Abe, after barely 2 years in power, used this bad economic news to call a snap election scheduled for the 14 December 2014. His objective is to take advantage of the opposition’s structural weakness to gain re-election for another 4 years and to try to benefit from the electorate wish to delay the second VAT hike or cancel it. This can only be achieved by the passage of new legislation.
- Corporates: For the year ending 31 March 2014 the broad market index, the TOPIX, saw its constituent firms’ profits rise by 96.4%, mainly due to continued global growth but also Yen weakness. So after initial stockmarket weakness ahead of the tax rise, the market regained its momentum and largely shrugged off the news of a snap election.
- Politics: The issue regarding Abe’s snap election is not whether he will retain his majority but how large it will be. Since his initial electoral win in 2012, he has also gained a clear majority in the upper house, when last time it was only wafer thin. Then a supermajority of over two-thirds of the lower house was critical as it meant Abe could override the upper house to pass contentious legislation. Now a smaller majority is of far less political consequence. This means that once Abe is back in power, he is free to pursue the same three arrows policy but on an even more aggressive basis, with more frequent and sizeable interventions.
- Economy: The economy should regain its momentum, helped by no VAT increase until 2017 as well as continued government largesse, the oil price falls and wage rises.
- Corporates: Corporate profits should continue to rise but not by as much as during the last financial year. The greatest rate of increase will be enjoyed by the large, multinational firms, particularly the manufacturers. This will be driven principally by both their US and non-Bric emerging market exposure as well as being helped by continued Yen weakness.
Robin Geffen, CEO & Manager of the Neptune Russia and Greater Russia Fund
- Macro fundamentals: Russian markets were looking attractive coming into 2014, after showing resilience to the taper tantrum of 2013 due to robust macroeconomic fundamentals (low external debt and a current account surplus). Cyclical headwinds, including lower export demand and tighter fiscal and monetary policy, were easing and there were signs of economic acceleration.
- Geopolitics: However, rising tensions with Ukraine weighed on the market during the first quarter before Russian military exercises near the Ukrainian border caused a major sell-off in early March. The immediate impact was capital outflows and much tighter domestic monetary policy in an attempt to stem the ruble’s depreciation and reduce capital outflows.
- Ruble: Following the annexation of Crimea, Russia had recovered much of its underperformance versus the emerging markets by July. Ongoing unrest in Eastern Ukraine and the shooting down of flight MH-17 led to sector level sanctions from the US and Europe and caused further weakness. This was exacerbated by the precipitous fall in the oil price in the Autumn, which contributed to further pressure on the ruble and the Russian market. In November the Central Bank of Russia (CBR) finally allowed the ruble to float, changing their policy for FX interventions. This is a major achievement for the CBR. While it could have been done earlier in a less stressed and volatile environment, it will be positive for the Russian economy and financial system in the long run and will provide additional stability to the budget if the oil price remains volatile.
Developments surrounding the two main negative catalysts of 2014 will be key to a market recovery in 2015.
- Ukraine: We have largely seen the ceasefire, agreed as part of the Minsk Protocol, upheld with only low level fighting continuing, although in recent weeks tensions have been rising again following the elections in Donetsk and Lugansk. The current situation remains fluid although the cost of further escalation is becoming prohibitively high for all involved. We are moving towards a frozen conflict suggesting that it is unlikely to be resolved rapidly, but also should not flare up into an open conflict.
- Oil: The recent decision by OPEC not to cut production has applied further downward pressure to the oil price. With a fully floating ruble, oil is much less of an issue than it used to be, although continued weakness will begin to impact the purchasing power of the consumer. We believe oil should return towards the marginal cost of production, which is currently around $90, although there could be further short-term weakness before the market turns.
- Valuations: Looking beyond the current uncertainty around Eastern Ukraine and the oil price, the Russian market is now trading at 0.6x price to book value, which is in line with the level reached during the global financial crisis. This is a discount of over 60% to emerging markets, the highest level seen since 2002, and a discount of 75% to the MSCI World, providing opportunities for the longer term.
Shelley McKeaveney, manager of the Neptune Africa Fund
- Global: The state of the global economy is mixed. The US recovery continues to gain momentum and monetary policy has responded accordingly, with QE coming to an end in October. In contrast, the European recovery has faltered, economic weakness continues in Japan and in China growth numbers have disappointed. Within the emerging markets, conditions were similarly mixed.
- African macro: The South African macro environment has been very weak in 2014, characterised by low growth and high inflation. Already challenging conditions were exacerbated by a record six month long platinum industry strike in the first half of the year. Although inflation appears to have peaked, growth remains subdued. Africa’s other major economy, Nigeria, has had mixed fortunes this year too. A rebasing of its GDP in April led to an exceptional 89% revision upwards, taking Nigeria’s GDP to US$510bn for 2013 and making it the largest economy in Africa, significantly ahead of South Africa. Growth in 2014 is forecast to be robust, higher than last year’s figure. However, oil price weakness is a major headwind.
- African equities: Corporate South Africa continues to defy the weak macro environment, putting in a very respectable earnings performance. This is in part due to a very high proportion of international earnings, which provide diversification away from the low growth domestic economy. The market has been strong in 2014, significantly outperforming both the MSCI Emerging Markets and the MSCI World indices so far this year. Likewise, the Kenyan and Egyptian markets have both put in exceptionally strong performances. In contrast, 2014 has been a very difficult and volatile year for the Nigerian market. Risks around the falling oil price and the upcoming 2015 elections, as well as investor fears around Ebola have weighed heavily on both the market and the currency in the second half of the year.
- Global growth recovery: We expect the global growth recovery to remain uneven. We are encouraged by the momentum behind the US recovery but elsewhere in developed markets, the outlook is more uncertain. The fortunes of the emerging markets will depend on various factors, including the path of US rates and the dollar, the oil price trajectory and individual reform programmes.
- African growth: South African growth is expected to continue to be very subdued, given both cyclical and structural challenges. However, the low oil price is a positive development for the economy, given South Africa imports virtually all its fuel needs, and will help improve the trade balance as well as the inflation outlook. In fact, inflation appears to have already peaked, allowing for the continuation of accommodative monetary policy. The outlook for Nigerian growth remains positive, with a healthy 7.3% forecast by the IMF for next year, higher than in 2014. However, a persistently low oil price is a major risk to this outlook, given the oil sector represents 75% of government revenues and 90% of exports.
- African equities: Earnings resilience will continue to be a key theme within the South African market. Investors remain cautious on the value end of the market, which is dominated by the structurally challenged mining sector. Given the outlook for subdued growth in the domestic economy, we expect investors to continue to favour companies with overseas and regional earnings profiles. Sectors with structural growth profiles, such as healthcare, will also continue to attract interest. The Nigerian market is likely to remain volatile in the near-term, with performance closely linked to the fortunes of the oil price. Uncertainty and instability in the run up to the upcoming elections also increase the risk premium. Although we believe risk remains very much to the downside at this stage, we expect some good long-term buying opportunities to emerge as stocks and sectors with decent structural earnings profiles are discounted beyond fair value. The Kenyan market has been a star performer over the last three years but valuations look relatively full and investors will need to be more selective going forward. The political environment in Egypt has stabilised and the reform agenda is promising but given the significant re-rating of the market already, it could be vulnerable if economic performance disappoints.
Rob Burnett, head of European Equities & Manager of the Neptune European Opportunities Fund
- Fading recovery: The European economic recovery that began in early 2013 faded in the summer of 2014. Slower emerging market growth, Russia’s incursion into Ukraine and the EU banking system’s stress test all combined to create a slowdown that hurt investor confidence in Europe. In October we saw the largest outflows of European equity funds on record.
- Defensive vs. cyclical sectors: Whilst the equity index performed reasonably in this context, secure growth and defensive strategies outperformed at the expense of more cyclical and financial companies. The Asset Quality Review and Stress Test in November did not prove to be a powerful catalyst for the banks. Weaker economic data trumped a better-than-expected outcome in the stress test.
- Secular stagnation: Inflation moved lower and this pushed many investors to the conclusion that Europe was turning into Japan. Secular stagnation is now the base case for many investors and this was reflected in valuation differentials between cyclical and defensive companies.
- Deflationary pressure: Europe’s economic problems are well-documented. Indeed recent months have seen something close to capitulation from US investors in Europe. However, we do see positive catalysts in the months ahead.
- Growth outlook: We have a better than consensus outlook for Europe in 2015. It is our belief that easing financial conditions, the end of the stress test, increasing money supply, stabilising housing markets, the lower euro and the lower oil price are combining to allow Europe to post a better-than-expected performance in 2015.
- Constructive policy: We believe that the premium for secure growth is too high and the discount for domestic European exposure is too wide. We are underweight pharmaceuticals and overweight banks. We see the ECB as providing ongoing support for asset prices and for the economy and are positioned in companies that benefit from monetary support.
- Valuations: European equities are deep value on a global and historical basis. On a price to book, price to sales or cyclically adjusted P/E (CAPE) basis, Europe stands apart as the cheapest major market in the world. We believe that European markets are priced for secular stagnation and deflation already, and so any upside in growth ought to be rewarded with higher ratings.
Kunal Desai, manager of the Neptune India fund
- The macro heals: The first few months of the year were defined by a sharp macro adjustment. India has improved the most out of its Emerging Markets peers from an external front in terms of a contracting current account deficit, falling inflation and rising foreign currency reserves. If and when Federal Reserve policy does change next year, India will be in a far stronger position, with its external imbalances having diminished significantly.
- New government, new India: We believe the general election of May this year will go down as one of the seminal moments in Indian history since Independence. More than 800m people went to the polls and delivered the strongest Indian government for 30 years. The pro-business BJP party now have an absolute majority, with a leader at its helm who appears determined to kick start an investment cycle in India.
- The markets respond: At the beginning of 2014, we had argued that India could be the surprise outperformer of the year. However, even we did not expect such strong returns in a year when a number of key events fell neatly into place. A stunning election result, a ruthlessly effective prime minister, falling inflation, a contracting current account deficit and lower oil prices. The Indian market has outperformed all global peers, with more than 50% returns (in GBP)* – we believe the foundations are now being put into place that will likely result in a multi-year investment cycle.
- India will get busier and busier: We expect India to have one of the most pro investment and pro-growth policy calendars seen in Asia for years. This will keep the equity markets interested as India moves to a market with a constant drip of reformist action coming from the government. There is no denying that much is expected from this government – rightly so, but we still have confidence that they will be able to perform. Our interactions with key players suggest that there is a focused goal of making the system work much better.
- Watch the earnings: The earnings cycle will be the key in driving returns in 2015. What pleases us is that there is significant operating leverage in the system. The corporate sector has been through a tremendous amount of balance sheet repair over the past three years, whilst margins and utilisation lies at multi year lows. As operating leverage filters through over the next two years, the earnings power could be terrific. We are focusing on such companies.
- Be mindful of the risks: A characteristic of a healthy market is perhaps one when risks are flagged and can be digested. If oil prices were to spike sharply next year, this could be a near-term headwind for the market. Furthermore key man risk in India is certainly something to be aware of. If we were to see volatility in India as a result of a change in Federal Reserve policy and a strong US dollar, we would see this as a buying opportunity given India’s much changed external profile.