Whilst I accept one can never get too much of a good thing I also acknowledge that this is, due to timing of holidays, my third Commentary in five weeks. This will not happen often so please bear with me as I develop thoughts from my prior two recent Commentaries.
Fortunately, very little has changed on the Macro front with the world ex-UK continuing to bomb along whilst many of our domestic facing companies struggle, even as our exporters enjoy the good times. Indeed the world has been so strong of late that the Citigroup Economic Surprise Index has reached a height (75) from which it has fallen precipitously (to below zero) on the other four occasions since 2010 it has reached similar levels.
In Europe the Markit Factory Index hit a twenty year high and the US ISM Index rose to a very high 59.7. Japanese unemployment fell to a twenty four year low whilst November retail sales grew at the fastest rate since the 2014 VAT increase.
In China Q4 GDP growth was very respectable and slightly above expectations at 6.9%. However, corporate profit growth in December decelerated from a phenomenal 25% to a still robust 15% and GDP was slightly flattered by the fact that exports remained buoyant but imports surprisingly stopped growing at the end of the year. Press reports suggested that shadow banking was further reigned in via curbs on entrusted lending businesses. Capital investment was strong in Q4 but retail sales growth decelerated quite a bit, which surprised several commentators. Official Chinese numbers are unlikely to deviate much from target but we will need to see whether the market concludes some sectors are slowing more than desired, particularly property as Goldman Sachs estimate that 61% of Chinese household balance sheets are accounted for by property holdings.
In the UK Next bucked the trend with positively surprising results and added that it saw an “imminent end to currency crises driven cost increases that have forced retailers to increase prices and deterred consumers from buying”. Let us hope that they are correct.
Whilst the UK Purchasing Managers Index did rise a little to a respectable 54.2 in December this was likely driven by exporters as auto sales and retail sales have been disappointing while small business optimism, unlike the US, has fallen four quarters in a row and now stands at -2.5 versus +20 in Q1. We must hope that directors are merely reflecting current conditions and that it will improve under the “Next scenario”.
Inflation is picking up a little in the US and Japan, whilst it is seen to be peaking here. In Europe core inflation picked up a tad but remains a full percent below the 2% target.
There is a clear dichotomy among investors between those who think that wage increases will cause an increase in core inflation and those who think that the trade off between unemployment and wage increases is dead due to globalisation and technology. As I said last time it is too early to conclude the latter and we should remember that as recently as 2011, the last time we had robust global growth, inflation fears and reality abounded (including food riots in some emerging markets).
Equities have fared well since our December Commentary with Asia leading the way with the US not far behind (in local currency terms). Europe stumbled into year end but has begun 2018 in fine fettle whilst the UK rebounded in December before underperforming other markets in early January.
Sterling has continued to strengthen, particularly against the dollar, and this has dampened returns somewhat. Currencies will be a big part of our risk/reward consideration in 2018 and we have already hedged our Euro exposure. Oil has held up well, despite talk of accelerated US supply growth later this year, as inventories have experienced much more dramatic drawdowns than is normal in winter and demand estimates have increased of late. Canadian oil giant Suncor have even warned of oil shortages in 2019 and beyond due to the collapse in mega projects being undertaken or completed outside the US.
US 10 year government bond yields have continued to rise and are now at the highest levels since 2014. UK and European Bond yield have also increased and even in Japan have edged up a tad despite the Bank of Japan having a policy of yield control in place.
The US Bond yield is now at a level that is very important to those who invest via technical analysis. Over the last several years this would represent a buying opportunity but if this does not prove to be the case this time then the view that the thirty six plus year bull market in bonds is over will be bolstered further.
Positioning & Outlook
All of government bonds, corporate bonds and equities have experienced lower volatility than usual of late and despite our portfolios also becoming more becalmed we have taken further steps to reduce ours even more.
As mentioned in previous Commentaries this will be done on a gradual and controlled basis as we continue to be aware there is a non trivial probability of a final surge to the upside in equities that could be fuelled by wholesale switches out of bonds and by those who have stayed on the side-lines these past nine years due to macro concerns (and there have been plenty of such). We have written ad nauseam about how expensive bonds of all types are but as of now most equities are above average valuations (as accompanied by above average profit growth and below average inflation) whilst the US market was approaching valuation it has only enjoyed in 10% of its history. The recent corporate tax cuts have added about 5% to 2018 profits (estimates vary widely but that is one that makes most sense to me when current tax breaks are considered) so short term valuation concerns have been tempered a little.
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.
That the current level of activity is well above recent trend and that Central Banks are deliberately taking away liquidity make it likely we are in, or very close to, the “as good as it gets” period. However a study by Lombard Research found that stock market returns tend to accelerate in the six months prior to rolling over. JP Morgan also highlighted that since the 1920’s the twelve month return to the peak for the S&P 500 has ranged from 15% to 36%. So whilst we do want to reduce volatility and smooth long term returns we do not want to move too far away from an asset class that compounds dividends over multi year periods.
We have reduced some Japan exposure (as illustrated below) as the Yen is now, like the Pound, undervalued on both Purchasing Power Parity and Real Effective Exchange Rate.
If the Yen rises then Japanese shares typically underperform. They also tend to underperform when optimism in global growth wanes. As mentioned above we view this as likely to occur at some point over the next 12 months.
We will not sell all our exposure as we remain impressed with the ongoing improvement in returns of Japanese companies. Areas we are looking to add to include UK domestic facing companies which have been struggling but now appear to be past the worst. Another is non correlated multi strategy funds which seek to deliver 4 – 5% returns per annum over the cycle with less than half the volatility of equities.
If we can gain confidence that the recent upward trajectory in wage growth is sustainable then some European focussed companies are also attractively valued.
A domestically orientated European fund was added to our Income strategy in late December and we will add more when the above criterion is met.
We have been underweight these areas versus competition and indices for a while now but will add as our understanding and comfort with their respective attendant risks grow.
Last year was the year when none of the risks from Korea, protectionism, populism, politics or interest rate rises came to pass. However, this is not always the case and I consider it prudent to recycle some money from high flying and popular assets into other areas.
Chief Investment Officer
23rd January 2018
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