Commentary, May 2019

Macro Overview

I said in my January commentary that activity and sentiment seemed to be the diametric opposite of January 2018 and would likely evolve in the opposite way too (i.e. go from bad to better as opposed to good to worse like last year). We still seem to be just about on track for such an outcome. Whilst by no means uniform there are several pointers to indicate economies are improving from the nadir of last year. Most importantly, both the official and private sector estimates of Chinese Purchasing Managers Index moved back above 50 (indicating expansion) in March whilst similar indices in Thailand, Indonesia and Vietnam also improved. Europe, including Germany, had better than feared Q1 GDP as strong construction and domestic demand more than offset continued weakness in manufacturing. Surprisingly, French Factory Confidence rose to a six month high. In the US mortgage applications rose to the highest level since 2009 following recent declines in interest rates and Consumer Confidence hit a fifteen year high. In the U.K. Q1 GDP was similarly above expectations, as was job growth, although the former was boosted somewhat by precautionary stockpiling.

Offsets to the above are that forward looking business sentiment indicators have the French optimism as an isolated case. Confidence has ebbed as global trade volumes have now contracted year-to-year after spending all of 2017 and 2018 growing in a range of 2-6%. It is also true that inventories remain high in many industries as stockpiles were built as insurance against not just Brexit but also trade war escalations. As these are worked back down several industries could see subdued growth for a few quarters.

However, unfortunately, in my last commentary released in March I included the following opinions.

“There now seems to be far less chance of a disruptive hard Brexit and the US-Sino trade talks seem to be heading for a more amicable conclusion than anticipated in October.” Alas just two months later, and despite a Commons vote coming out against a no deal Brexit, neither assertion stands true today. The light at the end of the tunnel is now most likely to be merely the shock of Boris Johnson‘s blond hair (although favourites seldom win Tory leadership contests) and the US has ramped up the trade related feud by blacklisting the Chinese National Technology Champion Huawei. This happened shortly after trade talks stalled at the last minute. We should remember that this follows a similar clampdown by the US on ZTE last year, another important Chinese technology company. Whilst there are undoubtedly political cases for both a hard Brexit and tough actions on Chinese trade practices, the former will have a significant negative impact on parts of both the U.K. and European economies whilst the latter could have seismic implications for the global technology sector, as well as a detrimental impact on both the Chinese and US economies as I will elaborate below.


We have had the volatility predicted in the last Asset Allocation Commentary but despite this the U.K., European, Japanese and US equity indices look strangely becalmed since our last commentary in March. Asian markets (excluding Japan) have suffered mid single digit declines. The action has been in currencies and bonds where the trade weighted dollar has risen close to a twenty year high whilst Sterling has relinquished all of its year to date gains in light of domestic political developments.

The chart below illustrates how much below Purchasing Power Parity the Pound is currently valued:

Chart 1. Purchasing power parity estimates for Sterling/US Dollar exchange rate

Source; JOHCM UK Equity Income fund presentation

Bond yields have fallen precipitously as investors sought perceived safe havens and CPI in February and March came in a little below expectations in the US, U.K., Japan and Europe. April saw an uptick in inflation rates but investors are not focusing on that for now and are unlikely to until trade angst is mollified.

The action for equity investors was within markets where high beta, economically sensitive sectors, especially Technology Hardware and Industrials, led handsomely until mid April. This was despite Earnings per Share (EPS) numbers being moderate at best and in many instances being accompanied by downgrades on future results. This was possible as many investors, including me, anticipated the Chinese stimulus will lead to at least a moderate reversal of fortunes. Then as international trade issues arose, markets sold off and investors fled from such sectors, especially semiconductors, and sought refuge in traditional safe havens. Almost all economically sensitive sectors globally have been hurt but U.K. domestically facing companies have really been in the doghouse. Whilst results have been neither especially good nor especially bad such companies have been hit by an unholy alliance of Brexit fears driving foreign investors away whilst many U.K. domiciled investors are increasingly nervous about Brexit but also really terrified by the non trivial prospect of a Corbyn government, given the disarray in the Conservative Party.

The chart below shows that, even in periods of rising equity markets, breadth (percentage of stocks participating in the upside) has been falling and below average for a while now. This is something that bears will be watching as it is usually associated with the latter stages of an advance.

Chart 2. Market breadth; markets narrowed again during March, particularly in developed markets

Source; Schroders. Proportion of stocks beating the respective index return. Breadth is calculated each month using 12-month roling returns. Data is from July 1999 to March 2019.

The table below shows performance of several key asset classes from close on the 19th March until close on 28th May.

Figure 1. Percentage change in markets and currencies from 19th March to 28th May 2019

Activity & Positioning

As mentioned above and in prior commentaries, our portfolios have been positioned to benefit from a positive re-rating of UK domestic stocks post Brexit and from a pick up in GDP as the Chinese deleveraging morphed once again into moderate reflation and the one off hits to growth in Europe passed. Both of these things were happening in tandem with all of the leading Central Banks easing or bringing tightening to an end, thus enhancing global liquidity.

Politics has put at least a temporary dampener on the first part of the thesis but as of the time of writing all of equities, corporate bonds and government bonds are showing decent year to date gains.

Our discipline led us to lock in some of such gains close to the peak in markets so we now have more firepower to take advantage of further weakness. However, as far as we know, most of our portfolio managers are still underweight in traditionally defensive areas on a combination of generally high absolute valuations and a deterioration in organic growth rates (stiffer competition from online start-ups and indigenous Asian companies).

Thus we are having to make decisions on whether the US-Sino trade war is above all else or whether there will be a break in the impasse to allow trade to flow. Capital Economics and Oxford Economics put the cost of placing 25% tariffs on most Chinese goods at 0.6% and 0.5% respectively of US GDP. Barclays are more moderate at 0.2-0.3%. Capital Economics also say up to 0.7% could be added to US CPI unless some is offset by margin contraction at US companies. The cost to China will be far higher, with Oxford Economics estimating a hit of 1.3% to GDP.

To put things in perspective, 20% of all US imports last year came from China and 25% of these were Technology related! Similarly China accounts for 50% (or more) of global demand for semiconductors, circa 35% of smartphones and 36% for robots. Apple makes circa 30% of its profit from China. As these numbers imply, the knock on effects to publicly quoted companies in both countries are likely to be far greater than the effect on overall GDP. It does seem unlikely a President obsessed with the stock market, standing for re-election next year, would willingly inflict such harm on his own economy. However, stranger things have happened in politics these last few years so it is a very tough but very important binary call to make.

In the U.K. only very long term orientated foreigners are likely to become involved before Brexit is resolved but corporate buyers may be more willing to snap up the bargains on offer. However, I am hopeful the mauling both the major parties have just endured (in the European elections) will focus the minds on October 31st being the last day of the current arrangement. Business especially but also consumers and investors need to be given clarity as to what type of environment they are operating in.

What remains true is that there are many good businesses at bargain prices. Very good money will ultimately be made in them and in most instances attractive yields will be earned during the wait. However, it would be naive to expect positive capital development amidst a policy vacuum. So we did cut U.K. exposure reluctantly as a volatility smoothing mechanism in April, despite seeing significant long term opportunities. We will revisit and act quickly as soon as there is clarity because the U.K. is an economy with pent up investment demand and the fiscal wherewithal to boost spending. I would even buy gradually on a Labour led coalition (as the worst elements would be constrained) but not an outright Corbyn majority (I still see this unlikely though).

Elsewhere China continues to ease in a way that is focussed on consumers and private companies. This will help the economy significantly but will continue to be overshadowed short term by trade issues.

It is likely in both the US and China that if the trade situation stays moribund then further policy action will take place as the economies are impacted. I should add that several commentators are of the view that trade negotiations have deteriorated so much partly due to the fact that in both countries the stock markets and economies performed well through April and hence agreeing a deal was not so important. Only time will tell if the latest setback will re-focus minds.

Below you can see the trades we enacted since the last meeting. All trades were done to reduce risk.

Figure 2. Portfolio changes since 19th March 2019 – RJIS


It is difficult to form an outlook from here without a resolution on trade and Brexit. As mentioned above early signs of recovery were apparent in Asia and European domestic demand was holding up even in the absence of an export recovery. The US is naturally slowing from the one off boost from tax cuts but is still eking out moderate growth. However, all of this could be interrupted, or even reversed, by the trade impasse as companies try and re-engineer complex supply chains and cope with tariffs. And for us Brits we have the added uncertainty related to our relationship with Europe (and each other). If both are resolved financial assets will continue to see good gains but the opposite also holds true, alas. It should also be noted that the US has postponed potential automobile tariffs on Japanese and European producers for six months and has cancelled waivers on Iranian oil purchases. So there is certainly a lot going on at the moment!

We won’t abandon equities as yields are at very attractive levels versus inflation and other asset classes and many companies remain well placed to grow dividends further. However, as we are concerned with managing volatility and protecting your capital we will be more concerned with managing downside risk than maximising gains during this period of real uncertainty.

Best Regards,
Ian Brady
Chief Investment Officer

29th May 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 Wealth Management Limited 2019 (unless otherwise indicated). All rights reserved

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