By Michael Stanes, Investment Director at Heartwood Investment Management
Going into 2015 we held a constructive view on developed equity markets, expecting that a moderate economic recovery and accommodative central bank policy would support investor sentiment. That view has broadly played out. Developed market equities have significantly outperformed emerging market (EM) equities, with the US, Europe and Japan all delivering positive returns in sterling terms (Europe and Japan saw significant outperformance in local currency). Large-cap UK equity performance, however, has been disappointing due to its high exposure to the energy and materials sectors. In contrast, UK small- and mid-cap equities performed strongly. Concerns about the slowdown in emerging market growth have contributed to negative EM equity returns in the year-to-date, both in local currency and in sterling.
Despite our constructive view, however, we were cognisant of increasing risk given the higher valuation levels of some markets. We reduced some of our equity exposure earlier in the year with a view to increasing it again on potential volatility. The volatility that we then saw in markets during late summer came somewhat later than we anticipated, but nonetheless we held to our view and bought back into developed equity markets on weakness.
Heading into the twilight of 2015, investor sentiment remains cautious, albeit at less extreme levels than seen in September and early October. With the focus centering 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 the broader asset allocation decision of maintaining an overweight equity exposure remains intact, what is likely to change next year is the orientation of our equity exposure across style, sector and market capitalisation, and more broadly the question of when it will be appropriate to rotate from developed markets into emerging markets.
We have been in a prolonged period of growth stocks outperforming value stocks since 2009 and this dispersion is now sitting 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. The MSCI US Growth Index has outperformed the MSCI US Value Index by 7% in the year to date as at the time of writing and by nearly 40% since 2010. We believe that 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, as well as to certain parts of the UK market-cap spectrum, where we see better upside potential over the medium term. We recognise that overweighting Europe and Japan has been a consensus trade in 2015, 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. We believe this area of the market is attractively valued and should be more sheltered from the headwinds of a strong US dollar, given their domestic focus. According to the research house Strategas, it is telling that year-to date gains of the S&P 500 Index have been driven by the ultra-large cap names, such as Amazon, Microsoft and Google.
More broadly, the key question for investors in 2016 will be to determine when to begin the rotation from developed equity markets into emerging market 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 to rotate will depend on when the growth picture starts to stabilise in EM, which we believe represents a story for the second half of 2016 and into 2017.
EM equity valuations have cheapened, but the economic fundamentals remain weak. The obvious concern is China: will it successfully rebalance its economy? We remain optimistic that the authorities have the tools available 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.
In summary, our central case is that investors should expect to see modest positive returns from equities next year. It is likely to be another eventful year with performance dispersion between markets. Nonetheless, this should create a fertile environment for investors who are able to take advantage of tactical opportunities.