Commentary, May 2018

Macro Overview

In our January Commentary I wrote that the Citigroup Economic Surprise Index had reached a height (75) from which it had historically fallen precipitously – often to below zero. By the first week in April this phenomenon had been repeated (much quicker than I thought) with Europe being the main culprit this year as opposed to the US in 2017. However, weakness was widespread and although weather was partly to blame in both the UK and in Europe (due to the Beast from the East), higher commodity prices and trade tensions have also played a part. We also need to add that last year’s growth was way above trend globally and was never likely to be sustained.

Confirmation of the slowdown included; European Business Optimism hitting the lowest level in 15 months; ZEW Investor Confidence Index falling to levels last seen in 2012; Chinese Credit Growth being the slowest since 2006; falling Purchasing Managers Indices in Korea and Taiwan; Japanese Retail Spending being the weakest since the 2014 tax increase and the Bank of England’s measure of bank lending slowing to its lowest growth rate since Q2 2015.

As ever, not everything was bad and Japanese cash wage increases of a whopping 1.3% were the best since 1997 (except for the companies paying them). Oil prices hit a three and a half year high on geopolitics and falling inventories and both US and UK Personal Consumption picked up of late after earlier weakness.

We have also seen a wobble, but thus far not a crisis, in Emerging markets as Dollar Liquidity has tightened. Argentina had to increase interest rates by 10% in one week (to 40%) to stave off a run on the Peso whilst Turkey increased a smaller, but still considerable, 3% as investor confidence waned on lessening independence of the central bank.

Macro Outlook

Anyone who says they are very confident in their macro outlook at the moment is, sadly, even more deluded than normal and is not to be trusted regardless of what view they are espousing. I say this not merely because we are in a world where US Dollar Liquidity is tightening or because the US has embarked on a significant fiscal stimulus at close to full employment. I say this because Mr Trump has added bite to his 2017 bark and since our last Commentary has launched sanctions and/or investigations affecting trade in Russia, Japan, China, the EU and Iran. On top of this NAFTA renegotiations have hit an impasse. He has also agreed to and then cancelled and then reconsidered his summit with Kim Jong-Un and formally opened the US embassy in Jerusalem. So, despite some of his actions stemming from credible US concerns, it is safe to say he has upset countries representing the majority of world trade whilst only keeping Saudi Arabia and Israel fully on board (and even then we need to ignore his rant at Saudi-led OPEC over the oil price rise). No one is quite sure yet whether this bluster and bellicosity is part of a grand tactic (Trump seems too short term to do such a strategy) aimed at wilting the opposition’s resolve, or if the administration is actually going to follow thorough on tariffs and sanctions as they think the US will come off least bad against all perceived opponents in all circumstances. Political leaders across the globe are working out how to cope with this new way of dealing with the US. America is the world’s biggest economy and military power therefore in the short term the assumption that other nations would fare worse in a spat is probably correct (even though both sides will likely end up losing something). This makes trade policy difficult to assess, as a result, the ability to gauge which industries are going to be most affected is diminished until we can observe which policies will go through and how diluted and/or delayed they will be. It must have an impact on capital investment that in turn will have ripple effects on the rest of the economy, so the issue is not something we can ignore.

Then there is Italy, who elected a coalition government the EU could only have imagined in their worst nightmares. One partner from the far left, one from the far right, with very little in common apart from a propensity to increase the already very large government debt load and antipathy towards the E.U. When the French asked for fiscal responsibility from the new coalition, Northern League leader Salvini responded; “no, Italians first”.

Then the coalition was replaced with a technocratic government including a pro-Euro former IMF man as the finance minister. The consequence of this is a probable autumn election that will see Italy’s continued membership of the Eurozone enmeshed in the ‘Elites versus Populists’ agenda that the election is likely to be fought on.


I was very worried in January when fund cash balances were running at very low levels and the American Association of Individual Investors (AAII) had a stratospherically high bullishness (optimism) ratio of 60. By the first week in April I was soothed by the fact that AAII bullishness had collapsed to a near paranoia level of 26% as it is a very good contrarian indicator at extremes. We are now at the long term average of 38.6% (as of late May) so I am somewhat indifferent using this as a signal at the moment.

Sterling has weakened significantly since our last meeting, especially against a strong dollar which has risen steadily against the Euro too.

Investors have become less concerned about interest rate rises given another about turn into inactivity by the Bank of England and minutes from the US FOMC meeting implying the Fed would be slow to raise rates even if inflation overshot target for a while.

However, Corporate Credit, particularly in the US and Emerging Markets, has had a tough ride of late and the former has now lost 3.26% year to date. This is highlighted in the following chart from the Federal Reserve Bank of St. Louis.

Italian bonds (government and corporate) have also provided cause for concern post the formation of the coalition government and it’s subsequent dissolution after the President blocked the appointment of a Euro sceptic Finance Minister. The extra yield over German Bunds has widened from 120 basis points on April 26th to 219 basis points by May 28th. However, this is still way below the 500 basis point premium seen during the 2012 Sovereign Debt Crisis. Part of the reason investor reaction has been muted is that they are banking on (no pun intended) a replay of the Greek scenario in which the radical words of a new government were stymied by the Germans, the ECB and investors. It is also down to the fact that the ECB is still buying Italian bonds and indeed now own 25% of all outstanding Italian Government Debt. There is undoubtedly some posturing going on but as Italian bonds still yield less than comparable US Treasuries there is considerable upside to yields if negotiations don’t go to plan and fiscal largesse transpires.

Profit and Earnings per Share growth has been robust in absolute terms and relative to expectations in the US, more modest but still positive in Europe and decent in absolute but disappointing relative to expectations and with regard to outlook in Japan. Investors seem as concerned about sustainability of growth as they are about absolute level so there up until the Italian crises there was little differentiation between markets.

The table below depicts the changes in selected assets since close 22nd March 2018 until close 29th May 2018.

Activity, Positioning & Outlook

We have sold our Energy ETFs at a tidy profit as the oil price has approached our price target and energy related shares have belatedly played catch up to the oil price.

We added to Woodford after further disappointment and also bought some more Japan after pronounced underperformance. Both funds are in the money in respect of the top ups we did in February and in March. Allianz Structured Return is another pleasing example of a subsequent purchase adding to the returns of our clients.

As explained above the outlook is clouded by how the world reacts to increased American assertiveness/aggression. If all goes well the world should grow at a slower but still respectable 3% and the impact from the liquidity withdrawal will be contained. However, there is no escaping the fact that a new geopolitical regime being implemented at the same time Central Banks are taking away liquidity means we are in a period of above average risk for economies and financial markets alike. This doesn’t even take into account the shenanigans over the Italian elections or Brexit.

I therefore find it difficult to believe that at the margin firms won’t delay plans until they sense more clarity with regards to the environment they will be operating in.

Things can change quickly. For example, as of Monday 21st May Italian banks were one of the best performing asset classes in 2018. All of that gain had been given up by Monday 28th May and indeed the entire Italian market has lost it’s year to date outperformance. Financial stocks, and particularly banks, had the most positive profit revisions in the most recent quarter in Europe but for now politics has usurped that momentum. This occurrence clearly highlights how considered we need to be when trying to balance economic opportunity with political risk.

We only have a little over 1% total exposure to Italian stocks (not just banks) due to the above mentioned conflict and our bias towards erring on the side of caution.

Unlike the overwhelming bullishness of January, more serious investors are now at least beginning to discuss how and when a US recession (and hence severe global slowdown) could commence. Consensus has it that this is unlikely until at least a couple of quarters after the yield curve inverts (short term interest rates rise above long term rates). If historical norms persist we are clear for the next year or so as we have not crossed that Rubicon yet (although the gap is narrowing somewhat). There is also a general view that equities will continue to rise until about six months before any recession begins so risk assets still offer appreciation potential.

However, we need to bear in mind the extraordinary times we live in and therefore be alert and ready to respond quickly when opportunities arise.

The table below illustrates asset allocation trades in the period since 22nd March 2018.



We will continue to act as we have in the past and buy when the risk reward is in our favour and sell when it is clearly not. Likewise we continue to have dividend increasing equities at the core of our strategy as this is a time-tested way of increasing wealth over the medium to long term.

We are still wary of bonds and bond proxies, particularly ex US as the latter has been the trailblazing market, highlighting what can happen to yields when normalisation begins (the yield has gone from 1.36% to 3% since July 2016, producing a significant capital loss). So we will continue to hold cash in lieu of bonds in order to reduce the probability of such a capital loss. This is whilst acknowledging that at first glance US 10 Year Bonds are not overly expensive when the yield exceeds 3%. However, the cost of hedging currency is over 1.5%, so the net yield is not that much different to the UK. We don’t have enough confidence that the dollar is going to strengthen further against Sterling to buy without hedging and so are not buying currently, even at c.3% yields.

Property is fraying at the edges and we will need to see higher net yields to tempt us.

So it is going to be a summer of vigilance which we hope will throw up opportunities, much like oil shares presented last year, to the benefit of Harpsden clients.

Best Regards,

Ian Brady
Chief Investment Officer

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.

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