With tailwinds turning to headwinds as investors move into 2019, John Stopford, Alastair Mundy, Blake Hutchings and Greg Kuhnert, portfolio managers at Investec Asset Management, share five themes informing the view for their year ahead, including the macro economic outlook, China, the UK and Brexit. Alongside this, Therese Niklasson, Global Head of ESG shares key responsible investment themes.
1. Selection to come into its own
John Stopford, Head of Multi-Asset Income & Manager, Investec Diversified Income Fund
2019 is likely to be a challenging year for financial markets. We are already in the tenth year of a bull market for most pro-cyclical asset classes, valuations are no longer compelling and potential catalysts for a market drawdown are building. These include a variety of leading indicators which, if history is a guide, suggest a recession by late 2020 is becoming increasingly likely. In addition, monetary policy, which has supported asset prices for much of the last decade, is beginning to become steadily less accommodative. In particular, quantitative easing is gradually being pared back globally and the US Federal Reserve (Fed) has begun to shrink its balance sheet and raise interest rates, with the strains this is causing being transmitted primarily to the rest of the world, especially net debtor nations in the developing world, rather than tightening financial conditions materially in the US. This absence of tightening alongside loose fiscal policy gives the Fed every reason to continue to tighten policy.
The case for adopting a steadily more defensive posture in portfolios is, therefore, pretty clear, but the timing of a bear market remains highly uncertain. If the global economic expansion still has a year or more to run, then equity markets can go on to make new highs before they peak. Equity call options, which provide a way to participate if the rally continues, while protecting the downside, are still cheap in a historical context.
We think a sensible strategy is to sell equity futures to hedge some of our physical equity exposure and then buy out of the money calls to benefit if the bull market carries on. US President Trump’s policies and the resulting growth divergence with the rest of the world remain dollar supportive, which may keep the pressure on countries with weaker balance of payments positions, although some of these appear increasingly oversold.
The Japanese yen stands out as being significantly cheap and offering naturally defensive behaviour if equities crack, thanks to Japan’s status as an international creditor. There are selective value opportunities in many areas and a bottom-up security driven approach looks increasingly relevant at this stage of the market cycle. A focus on attractively valued holdings with attractive yields supported by sustainable cashflows should help to underpin returns in a difficult market environment.
2. China: Inclusion and transformation in the year of the Earth Pig
Greg Kuhnert, Portfolio Manager, Investec Global 4Factor Team & Investec All China Equity Fund
Volatility in the Chinese equities market in 2018 has been driven by tightening domestic liquidity as well as escalating trade tensions with the US. However, the long-term investment case for China remains clear and opportunities are emerging in this environment. We’d caution against ignoring China’s ongoing transformation, which is being driven by government reform and ongoing innovation in the economy. This transformation addresses many of the concerns investors have and supports the development of the equity market over the long term. China’s transformation, based on reform and technical innovation, continues unabated.
International investors remain underweight and increasing levels of index inclusion together should support markets over the long term. The drawdown offers an attractive entry point for investors. Likewise, the correction is generating stock-picking opportunities on a valuation basis.
Although we won’t attempt to call the bottom without seeing evidence of positive surprises on corporate earnings, an increasing number of opportunities are emerging on the back of the market pull back. As more value emerges, we are finding attractive opportunities in an increasing number of sectors. The evidence suggests that companies with good quality, attractive valuation, improving operating momentum and increasing investor attention tend to outperform over the long term and this remains the framework for our stock selection. Our 4Factor screen currently sees most opportunities in the materials, energy, financial, utility, and communication services sectors.
Clearly the Chinese equity market entails short- to medium-term risks, most significantly policy execution and the growing tension between China and its trade partners, particularly the US. However over the long term, we believe a consistent investment strategy focusing on high conviction ideas, selected using a bottom-up approach, is the best way to provide long-term risk-adjusted returns to our investors, and we remain broadly fully invested in our portfolio as there are abundant opportunities that can be found in a dynamic market environment like China.
3. Looking through Brexit – extreme investor sentiment points to pricing anomalies
Alastair Mundy, head of Value and Manager, Investec Temple Bar Investment Trust and Investec UK Special Situations Fund
We fear the market may lose confidence in central bankers and their bag of tricks over the next cycle. In this environment, those assets which have been most supported by easy money over the last decade become the most vulnerable and those which have been most out of favour become more attractive. In this transition stage there is a good chance that asset volatility could increase significantly. Consequently, we remain defensively positioned in both bonds and equities in our strategy. We continue to use precious metals – both bullion and shares – to protect the portfolio against the tail risks of a return to quantitative easing (and derivatives of) or higher-than-expected inflation.
We have no insight as to the outcome of the Brexit negotiations, but typically when investor sentiment is this extreme, pricing anomalies occur. We try to look through short-term issues and assess if we are being invited to pay a low price for the profits the companies can generate through the cycle, and the Brexit paralysis has provided us with a chance to build holdings in some of these companies, including banks such as Royal Bank of Scotland and Barclays.
2019 is likely to be the ‘moment of truth’ where we will see clearly which asset classes have become the most distorted over the last decade. Looking further afield we see many more opportunities in emerging markets, Europe (including the UK) and Japan than we do in the US. UK and emerging market equities appear particularly attractive to us, owing to their recent weakness.
4. Opportunity knocks amid uncertainty for quality capital-light, cash-generative businesses
Blake Hutchins, Manager, Investec UK Equity Income and Global Quality Equity Income Funds
As we look forward to 2019, we expect the environment to be even more challenging and uncertain. Again, however, opportunities still exist at the stock level across the market cap range for companies able to generate cash and reinvest that cash at rates of return well in excess of their cost of capital, supporting future growth in cashflows and dividends.
Going into 2019 against this uncertain backdrop, we believe it will be important for equity income investors to focus on companies that largely control their dividend-paying ability. Investors cannot rely solely on the fortunes of external factors, such as commodity prices, interest rates, or the economy, to sustain dividend growth. As Quality investors, we focus on capital-light, cash-generative businesses that are typically underpinned by structural growth. These companies can sustainably return a proportion of their growing cashflows to investors as dividends and re-invest the remainder for future dividend growth. Most of these businesses have continued to grow their dividends. Prudent stock selection will be required to separate the good from the unsustainable in terms of income.
In the UK, the consumer environment continues to be weak. While at the time of writing it remains nearly impossible to predict the Brexit outcome, most scenarios still point to continued political infighting, sterling volatility, and weak business investment resulting from the ongoing uncertainty. Market sentiment has started to reflect this caution. We believe larger multinational companies with globally diversified revenue streams will be best placed to deal with the domestic political and economic challenges and risks to sterling. Smaller companies, despite their relative nimbleness and flexibility, will not be immune to more difficult market conditions, and liquidity will be important.
However, opportunities still exist in smaller companies with proven business models whose valuations already price in the risks of a UK recession, as well as smaller companies that have demonstrated quality characteristics through previous cycles or have niche products, services or business models that provide an element of protection from general market volatility.
As we look forward to 2019, we see a continued shift back in favour of more resilient quality stocks with sustainable business and financial models, reliable cashflow and dividend growth drivers, strong balance sheets, and lower sensitivity to the economic and market cycle.
5. An evolving and expanding ESG focus with significant milestones in the year ahead
Therese Niklasson, Global Head of Environmental Social Governance
Never has the focus on environmental, social and governance (ESG) been greater within the investment community. Responsible investing has gone mainstream, moving beyond value screens to consider a deeper understanding of the relationship between society, nature and the economy.
There has been a surge in the quality and depth of ESG-related investment products, as well as reporting by companies and industry. Regulators and policymakers are strengthening their messaging and focusing on more long-term sustainable capital markets. ESG in emerging markets also continues to evolve, with China leading the way in some regards, and continuous efforts around environmental legislation. Efforts to avoid ‘runaway’ climate change are stepping up and the investment community has come under increasing pressure to demonstrate action.
We are moving towards key milestones, including the UN Sustainable Development Goals (SDGs), post-2020 Biodiversity Framework and COP26 in 2020. Progress is mixed, but hope prevails.