July 2018 Harpsden CIO Commentary

Macro Overview

We have seen the US economy accelerate from a sub par first quarter to the fastest rate of growth since 2014. China is still showing signs of slowing whilst the depreciation of their currency against the dollar is causing the People’s Bank of China to publicly state that weakening their currency is not a matter of policy in the face of a potential trade war. Evidence of China’s slowdown has become more pronounced of late. Q2’s GDP was the slowest since 2016 at 6.7% and within this number fixed asset investment was much weaker than expected at 6%. In an economy which has relied on debt growth for propulsion it is also worrying that overall credit recorded its lowest rate of growth in June since records began. JP Morgan and Credit Suisse have now joined Capital Economics’ long standing position that China will ease policy in the second half of the year. Indeed some measures have already been taken, including a significant cut in personal taxation, three modest cuts in the Reserve Rate Requirement and some other liquidity measures by the PBOC. This is unlikely to have as profound an impact as the 2015 measures but should provide some short term relief.

Europe has stopped decelerating post a marked slowdown early in the year, as evidenced by the 1.3% increase in May Industrial Production. However, German ZEW Investor Confidence fell sharply to -24.1 versus -16.1 last month. This was primarily on trade war concerns so we will need to hope this does not cause a slowdown in activity in the coming months.

The U.K. has seen buoyant consumer spending – somewhat helped by weather, weddings and World Cups – whilst the industrial part of the economy has shown signs of stress. Construction orders falling four months in a row and a year-to-year fall in new house building are evidence of this. However, wages are still growing 2.5% year-on-year and this should prevent a collapse in overall activity.

Despite the above, the macro outlook has been dominated by politics, not economics, as America First policy has created ructions across Asia and Europe. The U.K. does not need anyone else to muddy our own political waters as fifty shades of Brexit have been discussed and discarded, leaving the impression we are rudderless and without a united vision.


There have been significant differences across geographies since our last commentary. The US has been the star performer; being considered a relative safe haven as it has less to lose percentage wise in a trade war and its economy is being significantly boosted in 2018 by tax cuts and, to a lesser extent, government spending increases.

Asia, on the other hand, is seen as the whipping boy and markets are now generally down for the year despite getting off to a very strong start. Equities, Credit and Currencies have all sold off as investors have fled the region that ended last year a firm favourite.

Sterling has also been weak given Brexit bickering whilst our equity markets are becalmed despite decent interest from foreign corporates about buying British companies. Gilts have moved in the opposite direction to US Bond Yields as institutions view them as the least risky U.K. asset in the very short term.

Europe, particularly Germany, is seen as vulnerable to an escalation of trade wars whilst domestic politics in Italy, Eastern European countries and even Germany itself are providing obstacles to Macron’s grand vision for Europe’s future. However, an agreement was thrashed out regarding an immigration policy and cost sharing for recipient countries.

So we have seen a slight widening in bond yields of peripheral European countries whilst the German Bund has retained its safe haven status once again.

In July, two long standing bulls on equities, namely Ned Davies Research and Bank Credit Analyst, downgraded their view on equities globally from overweight.

The table below shows returns of selected asset classes since our last Asset Allocation meeting on May 31st through close on 27th July 2018.

Harpsden Commentary July 18

Similarly, even though several of last years leading US tech companies are continuing to excel, their performance year-to-date has not been close to being matched by their previously feted Asian peers. Taiwan Semiconductor downgraded their outlook on saturation of the mobile market and this, aligned with concerns about supply in some memory markets, has impacted semiconductor names across the globe. This year is more normal as last year the market wasn’t as discriminating as it could have been in a sector which is very quick to see changes in business models and markets.Within markets performance is diverging too. Until very recently banks, even in the leading US market, were lagging and this is not usually a good sign. Much of the underperformance is due to the flattening of the yield curve which has reversed in the last week ex U.K.

Overall equities are below where they were at their January peak as policy has overshadowed earnings advances, which were particularly robust in the US (the S&P is only c2% off its peak versus more than 10% in China and high single digits in Germany).

Activity, Positioning & Outlook

Since our last commentary we have very slightly reduced cyclicality and reinvested some of the monies into domestic facing U.K. investments which don’t have much cyclical recovery baked into them. However, given the somewhat binary nature of current politics I don’t think it is prudent to go too overweight as the chances of a hard Brexit are certainly not negligible and its implications are far too complicated to dismiss as irrelevant or inconsequential.

Several UK managers have pointed out that the U.K. market is bifurcated. Whilst overall market valuations are slightly attractive this disguises the fact we currently have a record number of stocks with a Price-to-Earnings (PE) ratio above 20 and a record number of stocks with a PE below 10. The determining factor of such multiples is usually, if not always, whether the profit stream is derived from within this country or from overseas (overseas preferred). We have stated since our formation that in binary situations we will always err on the side of caution in order to protect capital. Below I have included the following correspondence from Unicorn U.K. Equity team. They are mid-cap growth managers who discuss how they have performed roughly in alignment with the sector despite being unable to invest in certain areas of the market, and how they are positioned to hopefully outperform from here.

“As of 11/07/18 the UK Equity Income sector had returned 23% over 3 years vs. 23.3% for the Unicorn Income fund. This is disappointing relative to a 31.2% return from the FTSE All Share over the same period. However the managers feel they are well placed for the portfolio to benefit from here.

Over the last three years, three of the top five contributing sectors to the return of the all share are excluded by Unicorn as part of the team’s process.

  • Oil & Gas: +8.5% Compounded Total Return (CTR)
  • Mining: +3.7% CTR
  • Pharma & Biotech: +2.2% CTR

The compounded total return of these excluded sectors is +14.4% (i.e. nearly half of the index return over the period). The UK Domestic index (All companies deriving 70% or more of earnings from the U.K.) has returned only +2.77% Total Return since the Brexit referendum over 2 years ago. The managers feel confident that with underlying trading in their investee companies remaining strong and with much of the portfolio now trading at a discount to long term average PEs there is a lot of inherent value in these companies. Over 3 years, 26 stocks (57% of the fund) are trading below 3 year average 12M P/E and over 5 years 25 stocks (54% of the fund) are trading below their 5 year average 12M P/E.” (Source; Unicorn Asset Management)

The chart below from JP Morgan Cazenove puts recent relative U.K. Equity performance into perspective:

Harpsden commentary 2018

The chart below illustrates the asset allocation trades in the period since May 31st 2018:


Harpsden commentary July 2018


So our direction of travel is to add to domestics on weakness but in a judicious way without the U.K. market in its entirety becoming too large a part of our portfolios (we do need a decent representation as most of our clients liabilities are in Sterling).

We remain underweight in Europe as it is more expensive than the U.K. and Brexit is not good for the Continent either. We have been wary of China weaning itself off the prior big stimulus and see no reason to chase just yet. India and Vietnam are better stories but again we need to adopt a gradualist approach given external influences (current account in India, international fund flows in Vietnam as JP Morgan estimate that 72% of Vietnamese exports are financed by foreign firms).
Japan continues to disappoint as it is seen as a loser in a tariff imposing world whilst domestic cyclicals are not seen as secular winners yet despite improving profitability and rising returns. JP Morgan point out that through May share buybacks by Japanese companies rose 26% year-on-year. However, the FT reported that in the first half of the year volume on the Tokyo stock exchange hit a 14 year low, so there is scant evidence of investor interest. We can but hope it is return deferred, not return cancelled.

Another consideration at the moment is the rate at which global liquidity is becoming less favourable as the US and several emerging markets raise interest rates, US companies repatriate dollars and the EU buys incrementally less bonds. The indecisive Bank of England will probably raise rates a little from here but I don’t expect much activity until more is known about Brexit.
Where we go from here in financial markets over the medium term will be driven by how policy impacts the real economy. Except in crisis situations like 1987 and 2008-9, there has not been a time in my thirty plus years in the markets where differing policy decisions (or non decisions) could cause such a spectrum of outcomes.

There is a significant possibility that the current US administration is not merely concerned with unfair trade but is on a mission to prolong US global hegemony. This involves slowing or halting the rise of China and fracturing Europe, currently the world’s biggest economy. As the US is currently the most powerful single state it would therefore be logical for it to move from multilateral negotiations and solutions to bilateral ones in which it would almost always have the upper hand. If this is indeed the case (which is not certain) then there will be ructions to trade, industries and companies around the world. The very recent signing by the EU and Japan of their biggest ever bilateral trade deal offers a glimmer of hope but is very much secondary to what the US and China end up doing.

If the US is no longer the trusted ally is it still in the national interest of Asian and European countries to rely on US companies for so much military equipment and other vital supplies? What will the financial implications be of countries and/or blocks attempting to do things themselves as opposed to relying on the US? These are long term issues and are unlikely to be resolved near term but we do need to consider whether we are witnessing a change in the world order of historic proportions. Or, it could all just be the one negotiating tactic a single US President has and the world will get used to it and revert to carrying on as normal. If the former turns out to be true then it will be inflationary to an extent investors have certainly not prepared for. If the latter is true then a strong bounce in equity markets is very likely.

Through year end the US should have two more strong earnings results seasons before tough comparisons and the stronger dollar kick in to dampen the party mood. UK companies are doing okay in aggregate but are not doing enough to dispel the political pall. Revisions in Japan should already have fallen by more than enough to be handily beaten whilst European profit expectations have stabilised and the Euro is off its peak versus the dollar, which should help further. Credit Suisse reckon Emerging Market profit expectations have stabilised too, although as pointed out above profits have not been the issue holding back markets of late.

In conclusion, we will continue to be both vigilant and opportunistic as sentiment and fund flows can change very quickly and the global political situation is becoming ever more fluid. Whilst valuation will always be a key factor for us, being risk aware is equally vital and we will concentrate on assets that can deliver a rising income stream over time.

Ian Brady
Chief Investment Officer
27th July 2018

Current Asset Allocation

Harpsden Asset allocation July 2018

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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