Light at the end of the tunnel, hopefully not an oncoming economic train, at last emerged after at least four quarters of mostly negative economic news flow. Whilst bad news releases still outnumbered good news, forward looking indicators pointed to a trough or nascent turnaround in manufacturing activity. The 9.8% year over year increase in European car sales followed the first advance in over a year in September, whilst semiconductor companies, despite printing modest near term numbers, indicated better times ahead. Both NXP and Melexis Semiconductor intimated auto related semiconductor sales were participating in the rebound. This is very good news for both the European and Asian economies.
It is important manufacturing does indeed stabilise as the contraction in this smaller part of the global economy was beginning to seep through into services and slow growth there. Whilst services growth was still positive in most regions it was off the best and the confidence of those making investment decisions on behalf of corporations needs to be restored.
As referred to above, bad news still wasn’t hard to find over the last two months, especially here. I echo the frustration of the CBI who lamented that British businesses have now prepared three times for Brexit deadlines that have come and gone without resolution. It is no wonder U.K. year to year GDP Growth in Q3 was the slowest in a decade at 1.1% whilst Retail Sales volume contracted in October and U.K. Services PMI fell to the lowest level since just after the referendum in 2016.
We were not alone, however, in feeling gloomy. In Japan, the Economic Watchers Index fell to 36.7 from 46.7 prior when a small rise was expected. Machinery orders fell for a third month too. In the US the ISM Non-Manufacturing Index fell to its lowest level in three years while Core Retail Sales underwhelmed with zero growth. In Europe, Germany continued to be the whipping boy with Business Expectations of future prospects falling to a ten year low in August (just before signs of a pickup emerged!) while the European Economic Sentiment Index hit a 57 month low in September. The Composite European Purchasing Managers Index unexpectedly fell to 50.3 in October (although manufacturing edged up from a very low level). Chinese growth continued to slow with all of Retail Sales, Industrial Production and Fixed Asset Investment decelerating slightly more than expected.
US job growth, US housing, European September Industrial Production, German Manufacturing Orders, Japanese October Industrial Production, Japanese New Export Orders and both European and US Money Supply Growth (M1) were among the key indicators offsetting the pervasive gloom and thus providing some cause for optimism. The good news was augmented by a Bloomberg report that in October Asian electronic orders rose for the first time in over a year.
Chart 1. Euro Area car registrations
In addition, policy makers have not been idle. Despite Brexit related paralysis at the Bank of England, across the globe more policy easing has taken place. South Korea enacted its biggest stimulus since the Financial Crisis, the Fed cut rates for the third time, the People’s Bank of China cut the reverse repo interest rate for the first time this cycle whilst the Philippines and Indonesia also eased.
In Europe, prior policy easing has been followed up by incremental pressure, even from within Germany, to enact fiscal easing. For example, German Union (the DGB) and Business leaders (BDI) made a joint call (subsequently rejected by Mrs Merkel) for a €450 billion public investment in infrastructure over ten years. In another first, the German Finance Minister proposed Germany could drop opposition to a common European Bank Deposit Protection Scheme (unlikely near term in my view) whilst another Economic Think Tank in Germany declared the manufacturing industry in recession and called on the government to scrap its balanced budget commitment. The new ECB Chief Christine Lagarde also called on Germany and Holland to start spending (the latter have already made such commitments). Perhaps as importantly (if true) the Telegraph reported that the ECB admitted “that its own record low interest rates are destroying bank profits and pose a key threat to the ailing regions financial stability.” ECB Vice President De Guindos said elsewhere, “that the effects of ECB policy are becoming more tangible and provided closer scrutiny of any adverse consequences.” Taken together all this just builds additional pressure for fiscal easing to do the incremental work in Europe. In Sweden the Central Bank actually moved to get rid of negative rates.
Here in the U.K. all parties are promising more spending and it seems the era of austerity is well and truly over.
Breakthrough or breakup? Whether it is Brexit talks or trade negotiations markets for the time being seem to be more sensitive to politics than economics or short term profitability. Direction of markets and what works within them changes with how well (or not) political negotiations are going.
Since the last meeting in late September a glass half full interpretation has prevailed on both Brexit and US-Sino trade talks. This stands in stark contrast to the May to September period. As a result bond yields have backed up a little, gold has sold off somewhat while equities have delivered strong returns in most regions. The pound has had its best run in years whilst the Dollar, Swiss Franc and the Yen have lost some lustre as safe havens became less coveted.
Within equity markets U.K. domestics and globally more economically sensitive stocks generally began to perform, bouncing off valuation levels that were close to record low levels (some absolute lows, some relative to perceived safe havens).
The FTSE 100 due to Sterling strength and Hong Kong (Hang Seng Index) due to political unrest failed to join the party but Japan and Germany performed well along with the US in local currency terms.
The table below shows performance of several key asset classes since the September commentary;
The Bank of America Merrill Lynch survey had its biggest ever jump in sentiment in October (off a very low level) and sector rotation from Bonds and Bond Proxies to assets which benefit more from positive economic activity has been reasonably pronounced. However, we must remember this occurred at a time when many stocks and indeed entire markets (Japan and South Korea as well as U.K. domestic shares) had been marked down to multi year lows in relative and/or absolute terms. The converse was true of Bonds and Bond Proxies. Across asset classes many instruments had already reached valuation levels which in the past had been associated with recessions. So, whilst back and fill is a natural part of the investment process, there is ample scope for further meaningful appreciation from here, political accidents notwithstanding.
As a reminder of this here is the chart we have shown before on how far the JO Hambro UK Equity Income Fund share price appreciation has diverged from the Dividend Growth enjoyed by the fund. Standard Life UK Equity Unconstrained tells a similar story.
Chart 3. Divergence between dividend growth and share prices
Source; JOHCM/Bloomberg as at 30/09/19. *Dividend growth from 31/12/10 to 30/09/19 is based on a 5% annualised growth estimate.
I have also included again the chart from Invesco (see Chart 4) depicting the increasingly divergent valuations awarded to US and U.K. derived revenue.
Chart 4. PE ratios of U.K. and US based revenues
Activity & Positioning
Since the last meeting we added a little to equities but have been measured in our approach as nothing is signed and sealed yet. The U.K., particularly outside the steady international earners, still offers many stocks trading significantly below their long term average valuations despite a good record of dividend growth. Elsewhere there are bargains relative to history that can be had in most assets tainted by trade fears or indeed actually hurt short term by fall out from the trade skirmishes that have already taken place.
To put the current environment into context let us compare it with the beginning of 2018. Then investor optimism was at decade highs, Brexit wasn’t really a saga (the Pound was over $1.40), no tariffs had been imposed and the Fed and People’s Bank of China were both simultaneously raising interest rates and withdrawing liquidity from the financial system. Elsewhere the ECB had finished loosening policy. Actual and expected Earnings Per Share (EPS) growth were at elevated levels and the US tax cuts were just kicking in. What could go wrong?
Apart from tariffs kicking in, a Brexit impasse, corporate confidence taking a hammering on the back of ensuing slower global trade and there being a drop in demand for financial assets due to less liquidity being available.
Turning to the present environment, it is no secret each of the Central Banks mentioned above (and many others ) are now taking the opposite actions to what they did then i.e. they are lowering rates and injecting liquidity, to varying degrees, at the same time. Across the globe both actual and projected EPS have collapsed and the US is now the highest tariff country in the developed world. There even seems to be some end in sight for Brexit, albeit the efficacy of the proposed solution is still being widely debated. Nevertheless businesses crave certainty even more than an optimal solution.
So the implication is that the economy and markets will turn out differently from the prior eighteen months or so. This is especially true given the signs of bottoming we have seen in some key manufacturing sectors, as mentioned above.
Extending this thought process there is a decent probability beneficiaries of a more benign industrial economy will benefit, be it asset class, geography, sector or stock. The likelihood is bolstered given the valuation extremes depicted above.
This is not to say we will be in nirvana. As one speaker at a recent conference said “Don’t worry, once Brexit is done there will be something else crop up to worry about. There is always something to worry about in investment.” So true. However in the next eighteen months it is likely to be things other than the worries of the last eighteen months.
We are set up reasonably well for such an environment but are aware one tweet or misplaced quip could derail without any notice. This in itself is a worry!
Figure 2: Portfolio changes since the last Asset Allocation commentary – RJIS
So we believe opportunities still exist to enhance both our portfolio yields and dividend growth by continuing to add judiciously. Lastly, the other change in investor behaviour of late is that they seem to have fallen out of love with fast growing loss making companies. Privately owned WeWork is the poster child of this ilk (some are arguing after the fact it was never a Technology company) but also ride hailing firms Lyft and Uber which have also seen valuations crumble. It may just have been part of the risk off mentality prevalent in the summer but it may be a sign that profitability is once again seen as an important part of investment consideration.
Chief Investment Officer
28th November 2019
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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 your 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.