Outlook 2015: the mending continues

We believe the gradual mending of the global economy will continue in 2015, and the best investment opportunities will be in risk assets such as equities.

The past year showed again that forecasting the economy is not the same as getting markets right. Many chose to pile into equities at the expense of bonds, and 2014 was a year when consensus trades in general were punished.

Bond ownership and valuations have rarely been as overstretched as they currently are, in our view. Yet business cycle indicators in major developed markets are positive and rising. Trends in demand and spending look firm, which we expect will get a boost from the recent sharp drop in energy prices. Against this backdrop, we see little scope for another year of strong returns from bonds, and will fund investments in risk assets mainly by being underweight fixed income.

Last year also highlighted the need to access a wide range of sources for collecting risk premia (the additional expected returns for taking on risk). This includes the ability to express unconventional views and to have enough time for them to pay off. This is a key theme of our Investment Outlook 2015: On and off the beaten track. Some ideas that look foolish to the crowd can be highly profitable.

Unconventional success

It is important to have an investment process that can capture this 'unconventionality premium.' At times, being unconventional may look foolish but the more diversified 'risk premiums' we can collect, the better off our clients will be in the long run.

Our outlook looks at a number of such unconventional ideas, including a little-know vehicle that we believe will benefit from the US shale gas revolution. For years investors have been scouring the globe for income, but there are still some hidden gems out there. Master Limited Partnerships (MLPs) are little-known, but we see them as an attractive source of high and rising income streams, gained through exposure to the growing US shale energy sector.

Toxic assets

We also see an opportunity to join the European Central Bank in embracing assets that came to be viewed as toxic following the global financial crisis, where asset-backed securities were labelled toxic. But higher-quality issues have come through the crisis unscathed, with superior yields and near-zero defaults. The ECB have embraced this unloved asset class and we see this as a good idea too.

Geopolitics

Geopolitical risk came to the fore over the course of 2014 with the Russia crisis. But when it comes to geopolitics, it can pay to go against the crowd. We've studied periods of geopolitical crisis since 1939 and found that the median market fell 13 per cent from the start of the crisis to the low, then recovered by 54 per cent three years from the start of the crisis.

Some of the opportunities we see in the year ahead are admittedly closer to the mainstream, though we hope by now they will be less crowded and believe they can deliver above-average returns in the face of continued ultra-low interest rates.

We remain positive on equities, given favorable valuations compared to expensive 'low-risk' investments and our positive view on global growth. Europe and Asia are our favoured regions, where valuations are more attractive than in most other areas. There is greater potential in these regions for earnings recovery compared to more expensive markets, especially the US.

In Asia, we also see corporate bond yields as attractive and believe they should weather price volatility in anticipation of rate rises in the year ahead. Since the end of the credit crisis, the higher yields from emerging market bonds in general have typically offset the extra price volatility, providing better risk-adjusted total returns. We see this continuing.

Risk is of course inherent to any form of prediction. But as we note in this year's outlook, the risks or disasters that move markets the most are those that investors did not (and perhaps could not) expect. Our approach is to be vigilant but not alarmist, using unforeseen disruptions as an opportunity to buy quality assets at good prices.

 

Alan Higgins is chief investment officer at Coutts

Coutts writes a regular blog for Private Client Adviser