Commentary, January 2017

Macro Overview

We definitely have Trump, we may (May) have hard Brexit but what we also have for sure at the moment is the consequence of the rally in commodity prices and that is an uptick in industrial production in most parts of the world. The widely followed US (oil and gas) rig count is already approaching 700 versus a low of just over 400 last Spring and RJIS expect it to average 800 in 2017 versus an average of 509 in 2016. As we first discovered at the Raymond James (RJIS) conference in 2015 the commodity complex is the lynchpin of industrial capex and now that this has stabilised after a precipitous decline, a few quarters of industrial upswing is virtually guaranteed.

Nor is it just in the US; European and UK industrial production is also picking up as evidenced by the Continents’ PMI rising to a 67 month high, UK CIPS Manufacturing rising to 56.1 from 53.6 whilst European unemployment has fallen to its lowest level since July 2009. A double edged sword in recent data is that UK consumer credit has risen at 10.8% of late – the fastest rate in eight years. This can be viewed as either an endorsement of confidence or the fact incomes are not sufficient to sustain expenditure. I imagine it is a bit of both as I previously wrote Bulldog Britain euphoria was a short term possibility post Brexit.

Japan’s Economy Watcher Survey has been positive of late and the PMI index has been 51.4 and 51.3 in the last two months.

China is more nuanced as measures have been taken to reign in property bubbles and capital flight (overnight rates touched 60% earlier in January) but credit expansion is still very high in absolute and against expectations. However, the route of travel may be indicated by President Xi saying he could tolerate GDP growth below 6% as versus 6.7% last year and rates above 7% before that. However, with Mr Xi hoping to consolidate power at the Party Forum in November he will not want to derail the economy too much. That said, credit growth is still far too high and it is just a question of time as to when the piper will have to be paid.

In the US a Republican clean sweep has energised small businessmen. The latest US small business survey showed optimism was three times the post Lehman average (at 50%), although the publishers did note that 99% of respondents were self avowed Republicans and therefore the upswing was perhaps overstated somewhat. Nevertheless the sugar rush of less tax and less regulation is likely to further buoy corporate confidence until it has to be paid for.

On the potentially negative side are Trump trade policies. Barclays estimate if Mr Trump enacts a 20% border tariff it will take 1-1.5% off of GDP growth whilst adding 0.5% to 1% to CPI. There are many permutations of trade policies and these are very complex calculations re effects. However in anything other than the very short term it is almost certain tariffs will end up being an economic own goal.

On the subject of very difficult calculations, Man GLG think EU tariffs on UK exports under World Trade Organisation rules (currently a less preferred ‘hard‘ option) would only amount to £4.7 billion p.a. Whilst I would not personally like to write the cheque, in the grand scheme of the overall UK economy it is small change and if accurate does not seem worth all the wailing and gnashing of teeth we have experienced. However, the calculation does not include the additional administrative burdens such a regime would involve and assumes our financial services industry remains intact.

India has been hit hard by the demonetisation. An FT article quoted a survey which concluded small service companies had seen sales fall by half and had cut their workforces by one third since. Offsets have been the resilience of Industrial Production which still grew 5.7% in November whilst scooter and motor bike sales ‘only’ fell by 8%. Both numbers were considerably better than feared. The Bank of India has also cut interest rates by nearly 1%.

So in most of the world we have decent short term momentum in GDP coincident with an easing of deflationary pressures.

The biggest short term risks therefore emanate from politics and Central Bank policy. Despite the fact the transmission mechanism into the real economy can take quarters, or even years to occur, the challenges are profound and many so the scope for error has increased significantly over the last year.


Markets have been very active since our last Commentary. Sterling staged a dramatic rally against all major currencies before giving back a good part following Mrs May’s ‘hard Brexit’ speech.

The US dollar initially soared after the election but has given back a little.

Equity markets have rallied strongly as UK, Japanese and European markets have taken up the mantle from the US, whose ascent has slowed since mid December.

As expected with the pick ups in industrial and inflation EPS estimates have troughed across the developed world and this is exciting investors after two years of torpor.

Government Bond markets has seen the performance of the UK diverge from the US and Germany by remaining unchanged as the other two have seen yield increase a little since our November 24th Investment Committee meeting. Each of these markets had experienced a ballooning out of yields in the prior period.

During this last period we had the second US rate hike and QE time extended and tapered by the ECB. Investors are noting that the US Central Bank is appearing a little more hawkish than their European counterparts. However, even the Fed have said they are adopting a ‘wait and see’ approach with regards future rate increases.

The table below depicts the change in price of selected asset classes since our last Investment Committee meeting on November 24th 2016:

Activity, Positioning & Outlook

Our positioning has not changed much since our last meeting. We bought a small position in India after the demonetisation melt down as it is clearly the correct course of action for the long term. In the Ethical Strategy we added to existing holdings which have more mid cap growth bias and therefore have missed out on the majority of the reflation trade.

We sold our Alliance Trust holding as the company has ceased to do fund management itself and has instead outsourced to eight other funds.

The table below illustrates the asset allocation trades in the period since our last Commentary:

Taken at face value, Trumpism and Brexit will increase inflation as they will decrease the supply of labour (therefore driving up the price). Economic theory also suggests secular growth will slow as there is less specialisation (countries want to do more of everything themselves). However, short term (i.e. a few years) individual countries can do better as others do worse. Trump has repeatedly said under his stewardship he is going to make the US win at the expense of the rest of the world. No one knows as of yet how much of this is posturing or how the world will react/retaliate to any actions. As he does not seem to be a fan of Europe there is even a (smallish) chance the UK is given a decent trade deal by the US in an attempt to further test the resolve of the European Union.

That the largest economy in the world now has a Chief Executive who describes himself as the ‘King of Debt’ and has seen several of his enterprises file for bankruptcy should lead to an increase in the risk premium of assets he has sway over. Thus far the rise in US Treasury Yields seems to be more to do with a rise in inflationary expectations than concerns about such. However with China and Japan the biggest foreign holders of US debt (in total foreigners hold c 27%) and with both recently being referred to as currency manipulators by the President, then at the very least volatility of the asset class seems set to increase.

As mentioned before we expect equities to outperform over time in this environment.

The chart below shows that US equities in particular are very expensive:

The overall index valuation is being held back by the banking sector, which is still languishing with a below average rating. Indeed this is true across developed countries. It is actually very different to 1998-2000 when the overall index appeared very expensive but actually it was only a clutch of mega cap stocks plus TMT that were extremely rich valuations. The rest of the market was reasonably priced. This time the median stock is very high. Several bullish commentators have opined that bull markets do not end until markets become very expensive (a la bonds of late or oil in 2007 and 2014) and that we need to see widespread euphoria, which is present but not yet ubiquitous in equities. Historically this does indeed seem to be the case but even in the absence of widespread extremes it means returns from here over the medium to long term are likely to be muted and that it will be prudent to lock in profits after steep ascents and to remain patient about when to reinvest. It is Warren Buffett who commented, using baseball terminology, “that investors should not swing at every pitch but wait until there is a ‘fat’ opportunity”. I am certainly going to be mindful of that maxim in the coming years.

Another factor we need to be mindful of is the reigning in of Central Bank largesse. Each of the Bank of Japan, ECB, Peoples Bank of China and US Fed are going to reign in monetary policy (or announce such a move is coming) in 2017 and they will need to bear in mind the fickleness of markets as they communicate such changes.

We will also be on the lookout for opportunities as they arise in property and commodity markets but do not see favourable risk/reward in either at the moment. Henderson’s UK property manager Ainslie McLennan observed that the London office sector has already rolled over and that when the first bank ‘brass plates’ (relocates) an office outside the UK then at least a short term panic will ensue. OPEC has stabilised the oil market at a sensible level and the industrial upswing will help. However inventories are still vey high and US production will start increasing soon. Both phenomena will slow down price increases from here.

So in conclusion we are on the lookout for return enhancing investments but remain vigilant on risk. I see no bargains this year that compare with what was offered by emerging Markets and Commodities at this time last year. There are pockets of value in domestic UK small caps but one has to be extra careful with regards the earnings outlook as the UK consumer could suffer declining real wages this year as inflation outstrips wage growth. India offers similar opportunities but further investment will be made as the depth of the short term adjustment to demonetisation becomes clearer.

I am also investigating the ‘Liquid Alternatives’ market and have found some interesting funds. My issue is that they all have experienced double digit peak to trough declines before bouncing back much quicker than equities. I am trying to decide whether such declines make them useless vehicles or whether they are suitable lower risk less return vehicles which play a part in overall portfolio construction. At the moment I am keeping the cash.

Best Regards

Ian Brady
Chief Investment Officer
31st January 2017

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 a fund invests in overseas markets, currency 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. This article is not intended as individual advice. If you require advice or further information please contact us.

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