The (Investment) Hunger Games - Ideas for investors in 2015

When tasked with providing a summary of Russell Investments’ 2015 Annual Global Outlook, our Asia-Pacific strategist Graham Harman drew on inspiration from the popular book and movie series - The Hunger Games. The 2015 investment landscape could resemble the plot of The Hunger Games, where investors face a changing and unexpected environment that requires multiple talents and smarts to emerge victorious.

Russell’s overall expectations for 2015 are for global equity market returns of 5 – 10%, but we think some volatility could be ahead. After all, these are hungry times for many investors. As we enter 2015, global cash rates are close to zero and bond rates both internationally and in Australia are close to multi-decade lows. The Australian share market delivered flat returns over 2014 (a price return of just 1%), and at the beginning of 2015, stands at levels which are still no higher than 2006. With patchy global economic growth and with Australia in particular facing a painful adjustment phase as the resources boom winds down, there’s no shortage of challenges to tackle

SO, WHAT WILL IT TAKE TO ‘WIN’ IN 2015?

1. Recognise that investors may face relatively hungry times. Our expectations are for the ASX 200 to be 5,600 by the end of 2015 (a gain of 3.5%), the 10-year bond rate to be 3.5%, cash to be 2.25% and the Australian dollar to be worth the equivalent of US $0.75. Cash rates in most regions of the developed world will remain close to zero, with increases projected in the US of 1%. Global equities and bonds are projected to return 10% (hedged) and -2% (hedged).

2. Be prepared to adapt quickly to changing market conditions. “May the odds be ever in your favour” is a popular catchcry from The Hunger Games , highlighting the element of chance or luck. This saying may provide little comfort to investors, but a lot can be done to tilt opportunities in your favour. For example, our 2015 expectation is that both international equities and global high-yield debt securities will deliver returns of 5% – 10% (after hedging back to Australian dollars). However, the range of likely returns around those forecasts (the ‘standard deviation of return’) is large: plus or minus 20% for shares, versus a well-behaved plus or minus 5% for high-yield debt. The Investment Hunger Games January 2015

3. If you choose freedom, you must accept the risk. The listed ‘free’ markets may well be a great long-term choice, but they also bear the risk of eliminating precious components of your investment portfolios in the short term. In some years, it makes sense to focus on the return dimension of investment, while in others, risk is to the fore. As we enter 2015, we observe stretched global equity valuations; a US Federal Reserve system preparing for higher official interest rates; pressure in commodity markets and in some emerging economies; and a continued winding down of the resources boom that has underwritten the Australian economy for so many years. The year ahead will be a time to focus on the risk, rather than on the return dimension, of financial markets. We’d let uncertainties in the energy markets settle down before committing too heavily to global high yield debt, although the risk-return trade-off is clear. The odds of finishing 2015 with returns reasonably close to your prior expectations are significantly better in the high yield debt markets than in equity markets. Your risk profile is important in determining whether you are able to access well-valued assets that may take time to pay off, or whether you need to be more prudent with your investment choices.

4. Hope for the best, but prepare for the worst. Our forecast for 2015 is that Australian and global equities will each deliver total returns of about 5 – 10% over the year, as improving global growth and subdued inflation allow the ageing global bull market to persist for a while longer. At the same time, there’s a significant risk that equities will close down for the year – not up. Investors should take this into account as they formulate their investment strategies and goals. For the last three decades, the Australian share market has fallen over the course of about one calendar year in every three or four. On Wall Street, one year of decline has historically occurred every four or five years. If our positive 5-10% forecasts do not come to pass, we believe stretched valuations in the US and increasingly complacent investor sentiment could be the likely factors creating more challenging “hungry times”.

5. Arm yourself with tools to help manage your portfolio. While not as fatal as many of the decisions competitors make in The Hunger Games, choosing to invest in global equities at the end of a six-year rise can be risky. Option protection, subject to an assessment of pricing and of market conditions, will be an important component of investment strategy in 2015, as will the judicious use of futures contracts and timely switches to cash. Our multi-asset portfolio team is drawing on these tools to help navigate changing market conditions.

6. Be smart, not just brave. In light of the potential challenges described above, be mindful of the risks you are taking in your portfolio as you chase yield. Traditional assumptions of accessing ‘riskier’ assets to gain larger returns may not provide the pay-off you expect. Investors will have to think smarter, not braver. In our view, this means considering dynamic trading strategies; active equity management, particularly in emerging markets; and the intelligent exploitation of unlisted opportunities such as global physical property.

7. You may need to search further afield to gain returns. In 2015, the local Australian economy will have to deal with the ongoing downdraughts of weaker commodity prices and collapsing resource capital spending – problems potentially compounded by a downturn in the housing cycle. Following five favoured years where the Australian unemployment rate was lower than that of the US, Russell expects that in 2015, by contrast, the Australian labour market will be noticeably weaker than its American counterpart. Investors looking to gain exposure to economies that are in a more dynamic phase of the economic cycle will therefore need to consider markets in the Asia-Pacific region, within the Northern Hemisphere developed world, and in the emerging world more generally.

8. Be resourceful in the face of challenges. In a year when traditional investments in shares, bonds and cash may fail to deliver, greater diversification and the incorporation of non-traditional assets and strategies should be considered. That’s why Russell Investments believes in ‘open architecture’. Successful portfolios will continue to incorporate products from the best external managers around the globe, but may also need to enlist the help of made-for-purpose approaches and vehicles. Tools include direct investment such as options-overwritten equity income funds; risk-mitigating plugs, including addressing manager underweights to China via added index exposures; centralised portfolio management, such as that taken for the emerging markets exposure within the Russell International Shares Fund; and ‘smart beta’ portfolios, such as the use of exchange traded funds in the Russell Australian Bond Fund. Another missing weapon in many investment armouries is a low-risk instrument to hedge equity risk – especially since government bonds, which have traditionally played that role, are currently extremely expensive. Incorporating exposures to volatility (through strategies focused on capturing returns from market volatility, which is represented by the VIX 1 ) was a key new development in Russell’s multi-asset portfolios in 2014. We expect that volatility strategies will continue to play an important role in portfolio construction in the year ahead.

9. Adopt the camouflage of stability. As noted above, our central expectation for 2015 is that listed investment opportunities – for example, share market exposures – will deliver relatively modest, single-digit returns while also displaying significant return volatility. Short-term swings in equity markets will be laid bare in the media as the year unfolds – a visibility that can be traumatic for investors with short- term horizons. Other investments such as private and unlisted investments – including physical property – have different supply and demand dynamics. This typically means that their prices adjust more slowly and an expert can buy and sell unlisted investments at good valuations.

10. Be alert for opportunities. In an environment where nothing is as it seems, the lead character in the The Hunger Games, Katniss, remains on guard to access valuable supplies. Likewise, given the unpredictable investment landscape, one of the lessons of 2014 was to stay diversified across a full range of asset classes. We expect more of the same unpredictability in 2015. Over the past year, for example, the Australian equity market was little better than flat, with a full-year increase of just 1%. However, there were also three occasions in 2014 that saw monthly market returns in excess of 4%. In this environment, active management becomes especially important – investors must have wide-ranging sources of opportunities, an eye for making timely decisions and a nimble process.

11. Recognise that the rules can change in a flash. Just as the contestants in The Hunger Games are presented with new rules without notice, investors need to be on alert for similar shifts in ground rules in 2015. One area that comes to mind is the way equity markets are trading in major markets such as Japan and the Eurozone. These are regions where central banks’ monetary policies are unquestionably stimulatory, but evidence of genuine recovery in the underlying economic fundamentals is scant, at best. Many commentators are now interpreting good economic news as good news for equity markets—they see it as evidence that monetary stimulus is working. With equal confidence, many commentators believe bad economic news is good news for equity markets because they think bad news is likely to elicit further stimuli. Those were the rules for 2014 at least. But there is a growing possibility that if central banks maintain stimuli and economic growth stubbornly fails to respond, these rules could change overnight. This is not our central case, but if bad news about global economies (such as those of Europe and Japan) was viewed as evidence that monetary stimulus was failing, with a potential negative impact on the markets, then other equity investments could suddenly be at greater risk.

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