Commentary, January 2019

Macro Overview

Economic numbers have generally been weak over the last two months with the not inconsiderable exception of employment and wage data. Examples of the weakness include Japanese exports, Chinese exports and imports, Chinese Credit Creation dropping below 10% growth for the first time in 15 years and retail sales growth also hitting a 15 year nadir. Manufacturing globally has borne the brunt of the damage with Chinese, Asia ex-China, European and US Manufacturing numbers all declining and being below estimates in December. Ironically the U.K. bucked the trend but some attribute this to stockpiling in case of a hard Brexit. On top of all this Japanese leading indicators have fallen two months in a row. Chinese Factory Profits fell for the first time in three years in November. Investment in the U.K. fell for three quarters in a row (first time since 2003 this has happened outside a recession). U.K. Manufacturing fell for five months in a row. German Business Climate Index fell and saw an even bigger fall in its forward looking component, which declined to 94.2 from 97.3. US businessmen were not immune to the gloom as discovered by a survey conducted by Duke University. In such 50% of CFOs surveyed thought the US would be in recession in 2019 whilst a whopping 82% expect a recession by 2020. Similarly the Japanese Machine Tool Builders Association expects a 12% decline in orders this year as Chinese companies hold off capital expenditures (presumably at least partially due to trade concerns).

Whilst consumer confidence numbers are also on the wane as yet consumption in both Europe and the US has held up remarkably well with Festive Period sales in Europe rising +0.6% versus +0.1% expected whilst the US real Personal Spending was strong in both October and November. This is probably due to still strong labour markets and wage growth. For example, in December the US produced 313,000 new jobs and average hourly earnings rose 3.2% year on year. In Europe unemployment fell below 8% for the first time in more than a decade while private sector wages in the U.K. are also increasing at an above 3% clip.

It should also be noted that not all measures of US Manufacturing were weak as both the Philadelphia Fed Manufacturing Survey and US Durable Goods orders were up and ahead of expectations.

However, the undeniable good news is that central banks and governments are on the case and markets have been discounting this slowdown for some time now (since late September in the US and even before that elsewhere). The chart below highlights that the MSCI World price action is discounting a far bigger decline in earnings, and therefore economic activity, than has actually occurred (this is not to say that a further decline won’t happen, just that investors have been preparing for it and it is at least partially already reflected in asset prices). Furthermore, Maya Bhandari, of Columbia Threadneedle noted that “sixty per cent of big corrections in the US stock market since the second world war have given false signals of a recession”. So while activity is clearly slowing down, the extent to which this is happening may have been exaggerated by investors.

Chart 1. The MSCI World appears to be pricing in an earnings recession already

Source; Barclays, Datastream, IBES

After spending several quarters informing investors economies were doing well and to expect policy tightening to continue both the US Federal Reserve (Fed) and the European Central Bank (ECB) have performed a volte face of late. Chairman Powell at the Fed, just one month after giving a hawkish testimony, changed his tune, saying “(interest) rates are hovering just below their natural rate” and at their December meeting the Fed reduced the number of rate hikes they expected to make in 2019. Previously the ECB had maintained that the slowdown was due primarily to temporary factors but in the latest press release Mario Draghi informed us that the board “were unanimous about acknowledging the weaker momentum and changing the balance of risk for growth”. The ECB backed this up by reducing growth expectations. The Bank of England did likewise, alongside another Armageddon warning regarding a hard Brexit.

The Chinese authorities are way ahead of others in that they achieved the slowdown in credit growth they wanted (perhaps too well) and are now re-injecting liquidity into the system, cutting interest rates, incentivising banks to lend to small companies, cutting taxes for both firms and individuals and at the same time reducing import tariffs. All these measures are focussed on controlling the rate of slowdown and re-orientating the economy away from the old heavy manufacturing sector. The measures will take time (as always) to work through, just as efforts to cool the economy took a few quarters to kick in, but the bottom line is that growth is likely to trough soon, excluding an escalation in US trade frictions. As this recovery unfolds it will help bolster European manufacturing, which will receive a further boost from the normalisation of car production following the emissions standards changes.


We discussed this theme in our December Quarterly Commentary but investors, whilst not as early as they could have been, are way ahead of the authorities in discounting the slowdown. The chart below is similar to Chart 1 in the Macro Overview in that it shows most companies with a cyclical/financial market orientation have been marked down much more than their non cyclical counterparts. Whilst individual companies can struggle until the final downgrade, it does show that at the aggregate level a lot has been reflected in recent price action.

Chart 2. Cyclicals have de-rated vs Defensives

Source; Barclays, IBES, Datastream

At the high level we have experienced a rollercoaster ride since the November 27th Commentary to finish only slightly down over the period. It was certainly a period of two halves with, for example, the S&P 500 experiencing a precipitous fall (over 10%) immediately followed by a dramatic recovery. Such ‘V shaped’ recoveries have only happened twice before in the previous eighty years. Oil had a similar collapse and ‘V shaped’ recovery as US inventory build and recession fears battled output cuts by oil producers. OPEC cutting output by 750,000 barrels per day has definitely helped but the oil price remains significantly below the autumn peak, despite oil demand estimates for 2018 continuing to rise.

The catalysts for the rebound are undoubtedly more dovish statements emanating from Central Banks as well as more conciliatory overtures being hinted at by both the US and China. Even here in the U.K. investors are reducing the probability of a hard Brexit despite Parliamentary consensus sadly lacking.

Sterling was a surprise winner against both the US dollar and the Euro as it began to appreciate rapidly when markets started to reduce the odds of a crash out Brexit. It is still down 1% against the Yen as the latter played its role as the ultimate safe haven asset in crises. However, the pound has still recovered by 6% against the Yen since the January low.

Corporate Bonds also lost money over the period while Government Bonds delivered on their safe haven status, bolstered by rate expectations declining. German and US 10 Year Government Bonds returned about 3% whilst the UK 10 Year Gilt returned over 4%.

Figure 1. Percentage change in markets and currencies from 27th Nov 2018 until 31st Jan 2019

Activity & Positioning

Given political uncertainties coexisting with economic fears the U.K. has been the poster child of valuation and performance dichotomies.

Shown below is the recent performance of four companies whose shares have been significantly de rated, despite decent long term profit growth. Artemis maintains, and I agree, that they are indicative of a widespread trend across the U.K. market.

Chart 3. Top down fears driving markets

Source; Artemis, Bloomberg as at 7 January 2019

As you can see each of the shares has a single digit PE, so there is hardly irrational exuberance embedded in these prices.

Chart 4. Valuations: stock dispersion remains wide

Source; Artemis, Datastream, Exane BNP Paribas estimates as at 31 December 2018

Indeed the chart above highlights that only in the financial meltdown of 2008-2009, when the entire U.K. banking system was under extreme stress, has the FTSE 350 thrown up so many attractive valuations. This is obviously due to Brexit fears on top of global fears but the cyclical v defensive phenomenon is not U.K. specific. Also note that despite coming off a twenty year high, the number of shares sporting a PE above 20 is still very elevated by historical standards.

Below is an excerpt from my January 2018 Commentary;
“As discussed above current economic momentum is strong but investor enthusiasm whether measured by sentiment polls or (low) cash levels have increased accordingly. It is unlikely that investors and economists will be as enthusiastic in twelve months time as they are now.”

As I have said before, to me it seems like we are in a diametrically opposite position now. Economic momentum has been waning and investor confidence has eroded accordingly. This has thrown up interesting valuation opportunities as highlighted in the earlier part of the commentary. Below we can see how stretched the relationship has become between the Earnings Yield on U.K. equities and the yield offered by 10 Year Gilts.

Chart 5. UK equities – relative valuation

Source; Artemis, Lazarus Partnership as at 31 December 2018

We will therefore use the inevitable and normal bouts of downward volatility to add to investments with good balance sheets and whose intermediate outlook has been overly discounted by nervous investors. Similarly we will use periods of upside volatility to further trim positions we think unlikely to meet lofty expectations and recycle the money into more attractive opportunities.

The reason we have not been more aggressive in buying U.K. shares thus far despite the valuation case put forward above is partly due to the binary nature of the Brexit outcome and also due to the fact that as other markets began to fall dramatically we could pick up reasonably valued equity exposure with less political risk. I will repeat here my often espoused mantra that in binary outcomes we will always strive to err on the side of caution as opposed to chase maximum upside.

Figure 2. Portfolio changes since 27th November 2018 – RJIS

As you can see we have continued our policy of adding to equities across diverse regions in small increments. We also used the period of extreme Yen strength to hedge half of our JO Hambro Japan exposure. We had taken off this hedge earlier in the year before the recent bout of Yen strength.


I will finish by saying that last year was not extremely volatile. It just felt like that because almost all financial markets had been unnaturally becalmed the year before and there had been near uniformity of positive returns.

Chart 6. VIX volatility history

Source; Artemis, Bloomberg as at 18 January 2019

Global liquidity has diminished and will diminish further in 2019 (although not at the rate expected in early December) so it is likely we will have to navigate more bouts of volatility in coming quarters. Markets have bounced hard since the holidays so it would not be unreasonable short term to expect at least a period of consolidation through the earnings season.

However, investor expectations have been beaten down and Central Banks have dampened their monetary tightening rhetoric. At the same time government spending is becoming a little less constrained. Taking all this into account I am of the opinion that by 31st December investors will have regained at least some of the composure that was lost last year.

Best Regards,
Ian Brady
Chief Investment Officer

30th January 2019

Current Asset Allocation

Important Information/Risk Factors:
Past performance is not a guide to future performance and investment markets and conditions can change rapidly. Investments in equity markets will be more volatile than an investment in cash or fixed deposits. The value of your investment may go down as well as up. There is no guarantee you will get back the amount invested. If you fund invests in overseas markets, currents movements may affect both the income received and the capital value of your investment. If it invests in the shares of small companies, in emerging markets, or in a single country or sector, it may be less liquid and more volatile than a broadly diversified fund investing in developed equity markets.
The views expressed herein should not be relied upon when making investment decisions. The article is not intended as individual advice and if you require advice or further information you should contact us.

Copyright ©Harpsden 2019 (unless otherwise indicated). All rights reserved

Download the full commentary here