That said, 2016 challenges are broader-reaching than just China where, as we have written before, a hard landing actually seems an unlikely scenario. Rather, we expect Chinese growth to continue at a 5-7% rate, as the transformation process towards a more domestic and service-oriented economy unfolds. Industrial, building and export sectors are likely to stay “weak” for the time being, although the prospects for the former two could revive somewhat depending on the forthcoming details of the government’s new 5-year development plan. The extent of infrastructure spending, and the speed of implementation of both north-western China development and the “One Belt, One Road” project (see October Investment Letter for details), will determine whether the industrial and building sector continue to stagnate or revive somewhat in coming months.
Mounting tensions in the Middle East between Sunnis (Saudi Arabia) and Shiites (Iran) should also be flagged as reasons for investor concern in these early days of 2016. A dangerous level has now been reached, which could lead to more violence in the region. Prospects for a solution to the war in Syria – and Yemen – have definitely receded. Yet despite such geopolitical events, the oil price has pursued, even accelerated, its drop. It has now lost some 30% since the early December OPEC meeting, when it became evident that Saudi Arabia intends to hold to its strategy of gaining market share while “punishing” its political adversaries Russia and Iran, and making the life of US shale producers very difficult.
As we discuss in greater detail on page 2, our decision last October to raise exposure to commodity and energy stocks proved costly in terms of 2015 full year balanced portfolio performance – and continues to hurt us as we enter 2016. While recognizing that an oil price recovery is extremely difficult to time, we elect to maintain energy exposure, in accordance with our value-oriented investment approach. With oil demand continuing to rise steadily, the supply-demand gap should close sometime in the second half of the year – sooner perhaps if OPEC supply is affected by an escalation of the Middle-East situation. In a context of unattractive yields across the government and investment grade bond spectrum and generally richly valued equities, we feel that the battered energy sector offers an attractive risk-reward profile (see page 3). The remainder of the “risk” portion of our balanced portfolios consists of alternative investments, a volatility fund (whose yield increases with volatility) and European equities (less expensive than their developed market peers).
THE WHY AND HOW OF DISAPPOINTING 2015 PERFORMANCE
Let us focus first on the January to September period. Our value approach, relatively defensive with respect to (expensive) equities, led us to underperform the average balanced fund during market rally phases (in the first quarter and then briefly during the summer, after the Greek saga and before the Chinese “devaluation”). But during each down market phase (May-June and August-September), we managed to close the performance gap, meaning that our portfolio return at the end of September was in line with that of our peers – and close to break-even.
In early October, we felt that the time was right to increase risk. The predominant influence of central banks on financial markets appeared to be finally waning, with a negative equity reaction to the Federal Reserve’s decision not to begin raising interest rates in September – when the very reason for delayed action was to appease investors – as well as a not fully subscribed 10-year German Bund auction. In our view, equity markets thus stood a chance of reverting to their more normal fundamental-driven functioning, in turn offering opportunities to invest on the basis of valuation.
During our October Investment Committee meeting, we thus elected to increase equity exposure in balanced portfolios by 7%. Rather than focussing on traditional “blue chips”, still richly valued and offering limited earnings growth prospects due to already elevated profit margins, we selected equities that had undergone a severe correction – notably in the energy, commodity and shipping sectors.
Admittedly, there were reasons for their depressed valuations: the commodity down-cycle, on the back of a slowing/transforming Chinese economy, was making for very difficult operating conditions and little, if any, profitability. But we were more willing to take the risk of a long wait in a cheap but disliked sector, than to buy already expensive and consensual assets.
As it turned out, further short-term downside materialized – and in a big way. From our purchase date to 2015 year-end, these investments suffered a marked drop. Together with our direct exposure to oil (4%), they took 3.5% out of overall balanced portfolio performance. Meanwhile, traditional blue chips recouped some of their third quarter losses, which added to our year-end underperformance versus the peer group.
NOT THE TIME TO GIVE UP ON ENERGY STOCKS
Beyond valuation considerations, our decision to focus on energy/commodity/shipping stocks when increasing our equity allocation last October rested on a relatively constructive view on the oil price. We pointed out that, at just 2% (i.e. 1.5-2 million barrels of oil equivalent per day), overcapacity was actually not that substantial. We felt that with demand rising by a steady 1.5% every year, production from existing wells losing some 3 million barrels per day on an annual basis and major companies having scrapped more than USD 200 billion of exploration investments, fears around the return of Iranian oil were exaggerated. All told, we anticipated that the oil market would return to equilibrium within a year, indeed perhaps faster should Saudi Arabia decide to cut production.
The December OPEC meeting made it clear that Saudi Arabia has no intention to cut production, being willing to take further short-term pain to increase its long-term market share. It is not blinking in its resolve, despite having to dig into reserves in order to finance public spending – and even consider sale of part of its joint ventures in refineries abroad to raise cash.
In this context, predicting the short-term downside on oil and the timing of the trough is extremely difficult. The oil price is already well below the lowest level we had anticipated. But we do feel that a more “appropriate” pricing remains in the charts for the latter half of 2016, when the supply-demand should find a “natural” equilibrium, on the back of production cuts in the shale industry.
Once the oil price does start to recover, the upward potential on energy stocks will be substantial. Now is thus not the time, in our opinion, to give up on these investments.