By Mike Franklin, Chief Investment Strategist
In looking at the prospects for 2015, apart from the understandable obsession with the fall in the price of oil, one longer term consideration stands above all the economic, social and geopolitical factors. Will Central Banks manage to implement the right policies at the right time? Will the Federal Reserve and the Bank of England, for instance, time correctly raising their interest rates to avoid jeopardising the economic recoveries for which so much sacrifice has been made? Assuming the recoveries are sustained, will they react too late and have to fight a rearguard action on inflationary pressures? Will Abenomics finally deliver for Japan and will the European Central Bank be ‘allowed’ to add broader monetary support to economies where there seems to be a national lack of political will or courage to implement more robust fiscal measures? Can China succeed in rebalancing its economy while maintaining a good level of growth?
As 2014 ends, the big themes include the sharp fall in the price of crude oil – now down over 45% since late-June – triggered by the rapid growth in US shale gas production. The resulting import substitution has disrupted the traditional pattern of global trade in crude oil to the detriment of African and Middle Eastern exporters to the US, now one of the largest oil producers in the world alongside Saudi Arabia and Russia. Given this scenario, Saudi Arabia is disinclined to cut production unilaterally even though it has the wealth to absorb a temporary loss in revenue. The problem is that the budget difficulties of other OPEC members such as Iran and Venzuela make them unwilling to cut too.
Reflecting a slowing trend in demand from major economies part way into the year, prices of commodities have generally suffered in 2014. This disinflationary trend – most dramatically for oil – is a blessing or curse depending on whether you are a consumer or a producer. Given that, historically, producers have generally reinvested but may now be restrained, consumers may not be as big winners as might be expected. However, a net benefit to most major economies can be assumed in contrast to the reduction in income being suffered by significant producers such as Russia and Iran and, to varying degrees, countries in South America, Africa and the Middle East.
Whilst the US is relatively self-contained in global trade terms, more open economies such as those of China, Japan and the UK stand to gain if demand for their products holds up. The reflationary impact, particularly in the Eurozone where inflation is running dangerously close to zero, will depend heavily on how the saving on lower commodity prices is deployed. If it simply goes to savings because of a continuing lack of confidence about the future, any hoped-for economic boost may be watered down.
As we have seen in 2014, unexpected threats to normal economic activity can emerge. These have included the Ebola virus outbreak, terrorist activity in the Middle East and political shocks such as Russia’s annexation of Crimea which prompted retaliatory, mutually-damaging, trade sanctions from the West. As mentioned earlier, assumptions about the levels and duration of depressed commodity prices are critical to assessing prospects for 2015 as are how soon and how quickly interest rates will rise in those countries such as the US and UK after the end of Quantitative Easing.
The weakness in the price of iron ore has been a direct result of the increased production by large mining groups such as BHP-Billiton and Rio Tinto to squeeze out marginal high-cost producers. This theme parallels, to some extent, the situation in the crude oil market. A recovery in the oil price will depend heavily on when Saudi Arabia decides it has regained some control of the global oil market by crimping US production of shale gas where typical costs at $80 per barrel (pbl) stand above current world prices. Interestingly for the international oil market, the US is moving to lift, at least partially, the 40-year export ban on its oil partly due to the need for suitable refining capacity as it approaches self-sufficiency.
After the years of global economic recovery from the depths of the aftermath of the 2008 Financial Crisis, some consolidation of economic growth rates might be considered reasonable. A big disappointment of 2014 has been the inability of the Eurozone to sustain its recovery which was helped materially initially by Chinese demand for Germany’s products but which subsequently eased as the shape of China’s economy changed. The Eurozone has further suffered through the slow pace at which national governments have introduced fiscal reforms. An added concern for next year must also be the political changes afoot in Greece where a swing to the left could renew fears of its exit from the Eurozone and the Euro (which might actually make some sense for the country’s short term economic recovery) but which could threaten to re-open the old wounds of two years ago when the survival of the Eurozone in its present form was seriously in question.
Forecasts from major institutions for global growth in 2015 generally assume modest growth from the 3% level estimated for 2014. 2014’s high-growth economies have been China (estimated at around 7.3% GDP growth), India (5.2%) and the US (2.7%). After a slower start, the expected growth of GDP recovery for the UK in 2014 of 3% compares with around 0.8% for the Eurozone group of economies. There are concerns that the Eurozone could slip into a Japanese scenario of deflation and little growth. Given the internal political tensions around the monetary policies being promoted by the European Central Bank in the face of German opposition, the Eurozone may be doomed to a poor performance in 2015 even if the Euro weakens further as the possibility of fuller Quantitative Easing approaches. Even if Mario Draghi succeeds in orchestrating broader QE eventually, it is widely expected to have little positive impact on eurozone economic recovery without faster fiscal restructuring by the member countries.
The outlook for the UK in 2015
A complicating factor in the assessment of the UK economy in 2015 is the small matter of a General Election scheduled for early-May. The prospect of more coalition government is a high probability and, given the range of political parties expected to be involved, the complexion of this arrangement is not especially attractive, given the level of compromise likely to be involved. Certainly, the need for a deeper level of austerity measures is being touted if government fiscal targets are to be met by whoever comprises the next government.
The Bank of England is generally expected to begin to raise interest rates at around half-way through the year, depending on the trend of economic data. Inevitably, the level of employment will be an important consideration. However, so as not to choke the recovery, interest rates are likely to be increased only slowly. It is recognised that many companies in the UK economy (mainly small ones) have only survived the recession because of the low cost of funds. Some of these will probably cease trading as rates rise and this may modestly impact the improvement seen in the employment levels in 2014.
The general rise in the cost of funds will impact borrowers in the economy such as those with mortgage loans against their homes. This, in turn, will reduce the levels of disposable income while those involved in trying to sell goods and services will face rising operational costs. This squeeze will need to be managed carefully given how long interest rates have been so low. On the plus side, those with savings should begin to enjoy a more realistic rate of return although, unless inflation stays low, real interest returns will remain negative. 2015 will be a year of transition and adjustment and it is not clear that the economy will be able to maintain its 2014 rate of growth. Despite improvement in the employment statistics, with many workers on zero-hour contracts and low wages, the strength in the economy needs to be more broadly-based. Furthermore, with the prospect of (a) tougher austerity measures after the election to meet budgetary targets and (b) more economic contraction in the UK’s largest trading partner, the Eurozone, 2015 can be expected to be challenging.
Conclusion
Attempting to formulate an investment strategy for the next twelve months is not made easier when equity markets globally are in the grip of fears about when the current freefall in oil prices will end and what the resulting collateral damage will be. There are growing concerns about the risk of default in parts of the junk bond market associated with shale gas projects given that breakeven prices stand significantly above current oil price levels. As loan covenants are triggered, the pressure on banks with exposure will grow.
This apart, twelve month (point-to-point) predictions seem to be increasingly for the birds in the New Order mindset of markets and investors. Consequently, this strategic outlook attempts to highlight the most probable key variables but on the understanding that the dominant sentiment drivers are likely to change both frequently and rapidly. As intraday swings in major equity indices in recent days demonstrate, fuelled by uncertainty, volatility in the markets is back with a vengeance.
There can be little doubt that the rate of growth in the global economy is slowing. Lower energy costs will counter this to some extent but these will take a few months to work through the system. This prompts the question of how soon the Central Banks looking to raise interest rates can begin to do so. Most predictions for this currently range between March and the end of 2015. Amongst other things, the rate rises are intended to counter any emerging inflationary pressures but the rapid fall in commodity prices is making low inflation and the hovering threat of deflation the new normal and reflected in the strength of the US Treasury 30-year bond in 2014. Coupling this with slowing economic growth, the timetable for initial interest rate rises looks likely to be delayed beyond the mid-2015 implied by the Fed’s latest comments.
Strategy approach for the FTSE 350 Index stocks.
Markets have followed a tortuous path in 2014 and many ‘expert’ investment groups have been wrong-footed by the markets’ reaction to global events. At Beaufort, in addition to our use of fundamental analysis to assess a wide range of companies including Initial Public Offerings and those quoted on the Alternative Investment Market, we apply technical analytical principles to gauge appropriate market levels and to identify suitable stocks to buy or to sell.
Through the technical approach and recognition of the ‘widening triangle’ emerging in the index between May and July, we correctly identified the FTSE 100 level of 6878.49 on the 14th May as the top of the 2009-14 bull market long before the subsequent market rally which culminated in the early-September intraday level of 6904. Even though we detected a change of overall market direction, we were able to draw our clients’ attention to the start of the mid-October rally and provided several buy recommendations through which to participate. Several of these yielded capital returns of 10% to 15% over the following five weeks of the market rally before we recommended coming substantially out of the market ahead of the recent ‘oil shock’ collapse. In recent days, we have been buyers from around the 6150 level and expect the index to rise back up within the newly-identified trend channel, perhaps to around 6650, subject to how quickly the momentum trends develop.
The ability to offer our clients insights such as these into where markets and stocks are likely to move is increasingly important now that we appear to be moving into a predominantly bear phase and more reliant, for long-only clients, on bear market rallies to generate profits. This approach is quintessentially proactive and is designed to take advantage of the choppy market conditions that look likely to continue to apply in 2015 to ‘make the assets sweat’ and to generate attractive returns for our clients.
Our assessment of prospects for the FTSE 100 and FTSE 250 indices and stocks are made in the context of how we read the outlook for any market-relevant developments globally, including the trends in the US and, specifically, the S&P 500 Index. The long term momentum trend for the S&P 500 Index on the chart below suggests that it is working towards a sell-off in 2015 comparable to the declines in 2000 and 2007. The fundamental factors behind such a move may have yet to reveal themselves. Inevitably, a move on this scale will impact other stock market indices, including the FTSE 100 and 250 indices.
There are many ways for our clients to benefit from such a large move. Long-only investors can participate in market rallies through Exchange Traded Funds, Contracts For Difference and the specific stock recommendations we will offer. ETFs and CFDs will also allow our clients to run positions to benefit on the downside.
As the end of 2014 approaches, it looks as if the current rallies in major markets will persist into early 2015, heavily influenced by the trend in oil prices. However, further sell-offs can be expected during the year as speculation around interest rates grows. In summary, on the basis that events in 2015 are still likely to be fast-changing and require a proactive investment approach, Beaufort’s strategy will be to continue to monitor global developments closely and to follow the technical signposts even more closely. We hope our comments create the sense among our clients that 2015 can be faced with confidence, that we will be able to cope with whatever it throws at us, and that any grey investment clouds really will have silver linings.
Mike Franklin Chartered FCSI
Chief Investment Strategist
Beaufort Securities Ltd
RISK WARNING
The information does not constitute advice or a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. You are recommended to seek advice concerning suitability from your investment advisor. Investors should be aware that past performance is not necessarily a guide to the future and that the price of shares, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. There is an extra risk of losing money when shares are bought in some smaller companies including “penny shares”. There can be a big difference between the buying price and the selling price of these shares and if they have to be sold immediately, you may get back much less than you paid for them or in some circumstances, it may be difficult to sell at any price. It may also be difficult for you to obtain reliable information about the value of this investment or the extent of the risks to which it is exposed. Where a company has chosen to borrow money (gearing) as part of its business strategy its share price may become more volatile and subject to sudden and large falls. This type of investment may not be suitable for all investors, and you should carefully consider your own personal financial circumstances before dealing in the stock market, particularly if on a fixed income or approaching retirement age.
