For anyone watching markets, 2015 wasn't a particularly great year. After kicking off the year with markets more-or-less fully priced, markets spent the next 12 months seemingly trying to find direction. And, as we know, in the absence of direction they just make it up as they go. Of course we did have a few events scattered throughout the year that were interesting (most notably a commodities glut and economic slowdown across emerging markets), but all in all it was a fairly dull year. In fact the leading contributor to our portfolios was a further weakening in the Aussie dollar, which helped squeeze a little bit extra out of our global equities strategies.
Of course not included in Calendar 2015 results, but worthy of mention, is the past week and a half, which has seen markets across the board haemorrhage under the weight of uncertainty and fear.
Of course not included in Calendar 2015 results, but worthy of mention, is the past week and a half, which has seen markets across the board haemorrhage under the weight of uncertainty and fear.
North America
Having started the year fully priced, throughout 2015 we began to sell down our North American equities exposure. Having been heavily overweight North America for a number of years now, our decision to reduce exposure was driven primarily by our belief that corporate earnings growth would slow as remaining QE residue evaporated and the Federal Reserve began raising rates. In hindsight we probably began to unwind a little early as the Fed didn't raise rates till December. From an economic standpoint the United States still looks ok, but from a valuation standpoint equity market valuations are quite stretched. We don't necessarily think a correction is on the horizon, but neither do we expect anything spectacularly brilliant from US equites in CY2016.
Europe
One of the few positive surprises for the year was Europe, with returns of 9.6% and 8.5% for the German DAX and French CAC respectively. Key driver here was a modest acceleration in GDP and (arguably more importantly) a resurgence in consumer and business confidence (albeit from a very low base). After a tough few years it's great to see economic conditions stabilise, though they aren't out of the woods yet. With their post-GFC battle scars still fresh is seems evident that policy-makers are committed to rebuilding the regional trade. Loose monetary policy and aggressive stimulus (where needed) are likely to sustain a regional economic recovery while containing the Euro's competitiveness and helping fuel inflation.
Emerging Markets (ex China)
Despite appearing fairly attractive at a market-level, emerging markets continue to face significant headwinds. The key problem here is debt. With many countries funding their economic expansion through foreign debt (as they don't have the tax base to fund it themselves) many emerging economies now face risks associated with higher foreign debt costs. Of course the higher their debt-to-GDP the greater the drag on performance. On the balance of probabilities it seems perfectly reasonable to expect we will see at least one market going into crisis, however for the true long-term investor (those with an investment horizon of 15 years or more; which is most investors under the age of 75) there are pockets of opportunity that we believe offer compelling value.
China
While China is also quite highly leveraged, they are somewhat less exposed to many of the common "emerging market" risks thanks to their size (in an economic sense), domestic stimulus program and currency controls (used to keep their export-competitive edge, even if at the expense of short-term profits). Of course like any economy China has its own unique challenges. Top of the list for China at the moment is their transition from an export-driven economy to consumption-driven economy while keeping levels of foreign debt under control (it is worth noting that much of what is reported as "negative" economic data out of China is indicative of this paradigm shift). As it stands, China's debt-to-GDP is quite high (241%, compared to 230% in Australia and 234% in the US), but a key difference are the components of debt: Chinese household debt is still only one-third that of Australia and roughly half that of the US and Government debt is at manageable levels. In fact the vast majority of debt is held by the business sector, with total private sector debt growing by roughly 50% since 2010 (vs close to zero for Australia and -15% for US), supporting the view that their economy (and policy settings) have plenty of fuel left in the tank.
Australia
With valuations still on the expensive side and credit growth and inflation set to remain subdued in the year ahead, Australian equities continue to play only a relatively minor role in our portfolios. We have explained in depth elsewhere reasons for our bias against Australian equities so we shall not repeat it again here.
Fixed Income
It was a frustrating year for fixed income markets. Having expected the US Federal Reserve to raise rates early in the year we missed out on a number of opportunities. At the risk of making the same mistake in 2016, we hold much the same view as this time last year: We expect the RBA to hold rates (keeping household credit growth in check while leaving room for business growth) and the US Fed to slowly raise theirs (curb inflation and improve $USD purchasing power). With both US and Australian Treasuries trading barely above 2%, boring old Term Deposits and cash (both of which offer rates above 3%) seem a reasonable alternative to Bonds.
Commodities
It was another terrible year for commodity markets. Australia felt the full affect, with some of our key markets taking a significant hit over the course of the year, including iron ore (-33%), natural gas (-39%), aluminium (-23%) and urea (-18%). Oil also ended the year down another 30%. Common to all these markets were supply gluts, with most hard commodities suffering from a slow-down in emerging markets (particularly Asia), while an extension in the oil price crash was largely due to accelerated production by OPEC in an attempt to force the low-sunk, low-margin North American frackers out of business (a strategy that, for the time being, has more or less succeeded, though at a cost of literally hundreds of billions to Middle East producers). It's hard to see 2016 being any worse than 2015, though inventory stockpiles should remain very high for some time yet. With spot prices trading below the marginal cost of many producers this is bad news for commodity producers and refiners and may see further consolidation in the years ahead.
Currency
Our currency strategy focuses on the AUD/USD swap, thus we concentrate our attention on our forecast for changes in economic growth rates and quality, inflation and interest rates. Having explored a range of probably outcomes we have established a trading band for the $AUD of $US0.599 - $US0.825, with a mid-point of $US0.712. This is based on our expectation that economic growth both in Australia and the US will slow slightly, with US growth to be higher quality and more evenly distributed across state and sector.
Having started the year fully priced, throughout 2015 we began to sell down our North American equities exposure. Having been heavily overweight North America for a number of years now, our decision to reduce exposure was driven primarily by our belief that corporate earnings growth would slow as remaining QE residue evaporated and the Federal Reserve began raising rates. In hindsight we probably began to unwind a little early as the Fed didn't raise rates till December. From an economic standpoint the United States still looks ok, but from a valuation standpoint equity market valuations are quite stretched. We don't necessarily think a correction is on the horizon, but neither do we expect anything spectacularly brilliant from US equites in CY2016.
Europe
One of the few positive surprises for the year was Europe, with returns of 9.6% and 8.5% for the German DAX and French CAC respectively. Key driver here was a modest acceleration in GDP and (arguably more importantly) a resurgence in consumer and business confidence (albeit from a very low base). After a tough few years it's great to see economic conditions stabilise, though they aren't out of the woods yet. With their post-GFC battle scars still fresh is seems evident that policy-makers are committed to rebuilding the regional trade. Loose monetary policy and aggressive stimulus (where needed) are likely to sustain a regional economic recovery while containing the Euro's competitiveness and helping fuel inflation.
Emerging Markets (ex China)
Despite appearing fairly attractive at a market-level, emerging markets continue to face significant headwinds. The key problem here is debt. With many countries funding their economic expansion through foreign debt (as they don't have the tax base to fund it themselves) many emerging economies now face risks associated with higher foreign debt costs. Of course the higher their debt-to-GDP the greater the drag on performance. On the balance of probabilities it seems perfectly reasonable to expect we will see at least one market going into crisis, however for the true long-term investor (those with an investment horizon of 15 years or more; which is most investors under the age of 75) there are pockets of opportunity that we believe offer compelling value.
China
While China is also quite highly leveraged, they are somewhat less exposed to many of the common "emerging market" risks thanks to their size (in an economic sense), domestic stimulus program and currency controls (used to keep their export-competitive edge, even if at the expense of short-term profits). Of course like any economy China has its own unique challenges. Top of the list for China at the moment is their transition from an export-driven economy to consumption-driven economy while keeping levels of foreign debt under control (it is worth noting that much of what is reported as "negative" economic data out of China is indicative of this paradigm shift). As it stands, China's debt-to-GDP is quite high (241%, compared to 230% in Australia and 234% in the US), but a key difference are the components of debt: Chinese household debt is still only one-third that of Australia and roughly half that of the US and Government debt is at manageable levels. In fact the vast majority of debt is held by the business sector, with total private sector debt growing by roughly 50% since 2010 (vs close to zero for Australia and -15% for US), supporting the view that their economy (and policy settings) have plenty of fuel left in the tank.
Australia
With valuations still on the expensive side and credit growth and inflation set to remain subdued in the year ahead, Australian equities continue to play only a relatively minor role in our portfolios. We have explained in depth elsewhere reasons for our bias against Australian equities so we shall not repeat it again here.
Fixed Income
It was a frustrating year for fixed income markets. Having expected the US Federal Reserve to raise rates early in the year we missed out on a number of opportunities. At the risk of making the same mistake in 2016, we hold much the same view as this time last year: We expect the RBA to hold rates (keeping household credit growth in check while leaving room for business growth) and the US Fed to slowly raise theirs (curb inflation and improve $USD purchasing power). With both US and Australian Treasuries trading barely above 2%, boring old Term Deposits and cash (both of which offer rates above 3%) seem a reasonable alternative to Bonds.
Commodities
It was another terrible year for commodity markets. Australia felt the full affect, with some of our key markets taking a significant hit over the course of the year, including iron ore (-33%), natural gas (-39%), aluminium (-23%) and urea (-18%). Oil also ended the year down another 30%. Common to all these markets were supply gluts, with most hard commodities suffering from a slow-down in emerging markets (particularly Asia), while an extension in the oil price crash was largely due to accelerated production by OPEC in an attempt to force the low-sunk, low-margin North American frackers out of business (a strategy that, for the time being, has more or less succeeded, though at a cost of literally hundreds of billions to Middle East producers). It's hard to see 2016 being any worse than 2015, though inventory stockpiles should remain very high for some time yet. With spot prices trading below the marginal cost of many producers this is bad news for commodity producers and refiners and may see further consolidation in the years ahead.
Currency
Our currency strategy focuses on the AUD/USD swap, thus we concentrate our attention on our forecast for changes in economic growth rates and quality, inflation and interest rates. Having explored a range of probably outcomes we have established a trading band for the $AUD of $US0.599 - $US0.825, with a mid-point of $US0.712. This is based on our expectation that economic growth both in Australia and the US will slow slightly, with US growth to be higher quality and more evenly distributed across state and sector.
Summary
Wrapping it all up, our outlook for 2016 could be described as "cautiously optimistic". Sure, we don't expect to see anything too spectacular, and sure there is a chance that China or Australia could mis-time their policy settings and trip into recession, but for the long-term investor - as most of us are - current conditions are still conducive to positive real returns.
That is to say, so long as businesses are mostly sensible most of the time, the return from equities should at least equal the cost of debt multiplied by the constituents' leverage.
**
Choosing which countries to invest in is somewhat more subjective, though to lessen sentimental influences we apply a fairly stringent quantitative approach. For equities this starts with valuing the country's equity market fundamentals, earnings margins and economic growth and inflation. From this we can roughly set short and long-term expectations of normalised earnings. We then deconstruct earnings into components of inflation, real interest rate and earnings premium. The earnings premium is then reframed as a multiple of the risk-free-rate. While not an exact science, this does provide some feel as to how (all else being equal) a market is likely to react to changes in earnings, inflation and interest rates.
It's times like this, more than ever, that sensible investors catch the edge on their more emotional peers. .
Wrapping it all up, our outlook for 2016 could be described as "cautiously optimistic". Sure, we don't expect to see anything too spectacular, and sure there is a chance that China or Australia could mis-time their policy settings and trip into recession, but for the long-term investor - as most of us are - current conditions are still conducive to positive real returns.
That is to say, so long as businesses are mostly sensible most of the time, the return from equities should at least equal the cost of debt multiplied by the constituents' leverage.
**
Choosing which countries to invest in is somewhat more subjective, though to lessen sentimental influences we apply a fairly stringent quantitative approach. For equities this starts with valuing the country's equity market fundamentals, earnings margins and economic growth and inflation. From this we can roughly set short and long-term expectations of normalised earnings. We then deconstruct earnings into components of inflation, real interest rate and earnings premium. The earnings premium is then reframed as a multiple of the risk-free-rate. While not an exact science, this does provide some feel as to how (all else being equal) a market is likely to react to changes in earnings, inflation and interest rates.
It's times like this, more than ever, that sensible investors catch the edge on their more emotional peers. .