Q1 2016 Commentary

The first trading day of the year saw Iran and Saudi Arabia break off diplomatic relations, the Shanghai stock market fall 7% and the UK, US and Korea publish poor economic data. That seemed to set the tone for the next six weeks. By the time the first week had ebbed oil had already fallen 10%, Chinese economic news kept getting worse (as per the Purchasing Mangers Index), factory activity in India dropped into contraction for the first time in two years, US car sales were way below expectation and if bad economics wasn’t enough, North Korea gleefully informed the world that it had successfully launched a hydrogen bomb. Decent European PMI data and stronger US job numbers could not lift the pervasiveness of gloom and RBS advised investors to ‘sell everything’ at the end of what had been the worst first week in financial markets for decades (since 1928 in the case of the US).

China and oil seemed to be the intertwined forces of economic destruction that were choking the life out of both global manufacturing and ‘risk on’ financial markets (i.e. equities, commodities and credit instruments).

Reminiscent of late 2008, early 2009, publishers seemed to be in a competition to convey the gloomiest of news. The second week of January saw oil hurtle below $28, not helped by the expiration of sanctions on Iran or an International Energy Agency saying oil is ‘drowning in sea of oversupply’. US Industrial Production fell for a third consecutive month and by January 19th all of UK, European, Japanese and Asian equities had fallen by more than 20% from their 2015 high and thus had entered bear market territory.

January is also when companies convey their budgets and outlook to investors and for many commodity companies this became the time to ‘fess up’. BHP Billiton was first up and duly wrote off $7 billion from the value of shale assets in the US. They also slashed their dividend by more than 70%. Anglo American announced plans to raise £3 billion via asset sales and fully exit its coal and iron ore businesses. Their dividend cut had already been announced. Conoco Phillips became the first mega cap US oil company to endure a dividend cut this cycle as it slashed its pay out by two thirds. The three behemoths mentioned here have been joined by a plethora of their smaller brethren who are both cash strapped and loss making in the current environment.

As we moved towards February the market snared new victims in the form of banks. There has been unease for years about the real health of the Chinese banking system due to the build up of debt in the economy. However, banks globally came under serious stress, particularly in Europe and Japan, as concerns over loans to commodity related companies (overblown in our view) were compounded by the potentially adverse impact of negative interest rates on bank profitability. A sub optimal attempt at a solution to bad debt levels in Italy was the accelerant to the initial spark caused by the Bank of Japan’s shock decision to employ negative interest rates – just days after Mr Kuroda had seemingly ruled out such a move. Negative interest rates are perceived as bad for banks because they have to pay the Central Bank to keep deposits there whilst the low level of mid to long term interest rates means banks cannot earn a decent return on money they lend out. Thus profits are squeezed.

This concern about the consequences of negative interest rates are part of a sub plot to the outlook for global economies and markets that has been building for some months now. The plot is that a growing band of company managements and investors are questioning the efficacy of Central Bank policy in a way they have not before. As we mentioned previously, in recent months investors have questioned actions from all of the Fed, the People’s Bank of China (PBOC), the Bank of Japan, and the ECB.

The moves to negative interest rates have not weakened the Yen and the Euro the way prior policy easing has and after his latest additions to monetary easing Mr Draghi hinted that rates could fall no more and reiterated his (oft ignored) comments that more fiscal policy help and structural reforms are required. We are carefully monitoring market responses to Central Bank policy initiatives as this feedback loop represents the biggest risk to both the global economy and financial markets, in our opinion.

On February 11th UK Gilt Yield hit all time lows as the MSCI World Equity Index joined the majority of regional equity indices in a bear market. The day before UK Industrial Production had its biggest drop (-1.1%) since 2012 and Sweden went further into negative interest rates. Deutsche Bank was in the cross hairs this day as worries emerged new capital rules (introduced to make banks safer) could mean they would not be able to pay interest on the new type of bonds they had issued to strengthen the self same balance sheet!

Amidst all this angst the UAE provided a ray of hope as it floated the idea of a 5% production cut across OPEC members. Although very few gave it a chance of success it was to stabilise the oil price and meant this day marked the low for risk assets in general.

By the end of that week the PBOC had set the Yuan higher against the dollar and began to ‘talk it up’ whilst the next week Saudi Arabia, Russia, Venezuela and Qatar agreed not to increase production any more (as opposed to a cut), dependent on other members following suit. This initially disappointed markets but then investors remembered this was the first agreement of any sort between OPEC members since November 2014 so oil quickly recouped initial losses.

Since late February global economic data has been patchy but enough decent numbers have interspersed the well publicised bad ones to give the impression that the global economy is still growing, albeit slowly. With the PBOC, Bank of Japan and ECB having further eased policy companies and investors are adjusting to a period of slow growth as opposed to hunkering down for a recession.

A surge in UK Retail Sales, US employment numbers exceeding 200,000 in February and March, more optimistic outlooks in the Fed’s February Beige Book, a CBI statement saying UK manufacturing ‘has stabilised somewhat’, shallower declines in Chinese foreign exchange reserves, and German factory orders holding up better than expected are examples of positive developments.

As noted in a recent Harpsden Commentary, we are of the view that if commodities stabilise then manufacturing will stabilise shortly thereafter. Then capital expenditure will stabilise and inventory depletion will cease. Therefore a mini manufacturing cycle will provide some much needed stimulus to the global economy for a few quarters. We of course still need to watch out for bad policy and bad politics but for now we should be past the worst of the negative shocks from falling commodity prices.

Markets

Bungee markets would be an apt description as no sooner had a rapid descent for risk assets been ended an almost as rapid ascent began to take us close to where we started the year. However, most risk markets are still significantly below where they were on the highs of April 2015 due to a combination of reduced profit expectations and equally reduced confidence on the potency of Central Bank policy. The table below depicts the changes in key markets from the highs of last year, the beginning of this year and the present (as of the close on March 21st):

As can be seen after the exhausting round trip many markets are close to where they were at the beginning of the year. However, there is still a lot of work to be done to recover the old highs (with the exception of the S&P).

The fact that the UK issued a 50 year Index Linked Gilt with a record negative real yield of 0.89%, that Japanese conventional bonds have a negative yield out to 10 years and that German Bunds have negative yields out to more than five years tells us investors are clearly still panicked about deflation.

We must also remember the growing influence of short term traders on day to day market movements. Allianz estimates 50% of current equity trading is algorithmic traders whilst another 30% is ETF and Futures traders. Such traders do not think about long term fundamentals but rather short term momentum. Barclays reckon traders have ten times the negative bet on oil they had during the 2008-2009 financial crises. This means not only is it very hard to analyse short term movements but they often deviate significantly from fundamentals.

An ever appreciating dollar was seen as further pressurising Emerging Markets and Commodities. So when the G20 leaders met in Shanghai on March 3rd there was conjecture an accord would be reached to prevent further rises in the greenback. Whilst no accord was publicised it is noticeable that the dollar has stopped going up – even against the Japanese and European currencies where further QE and rate cuts have been announced (as they have in China and Indonesia too). Apart from potential G20 subterfuge, the subsiding of dollar strength could just as easily be put down to the Federal Reserve implying that there would only be two rate rises this year. At the beginning of the year the Fed implied four rises were likely whereas the market had only expected two.

Although the Fed has come down to match market expectations it is strange they have done so at a time non commodity inflation in the US is already rising by more than 2% (the Fed’s inflation target) and when commodity prices seem to have bottomed.

Having just come back from the US this is the first time since 2009 that investors have not been expecting the US to grow 3% in the coming calendar year. Consensus is closer to 2%. Furthermore, in Europe, January year ahead consensus profit forecasts at +4.5% were the second lowest since the 1980’s and Barclays published that positioning in defensive sectors within Europe is the highest since records began in 1973.

What this means is that investor expectations have been reigned in from the over exuberant level of 2010 to 2015 and that with the stabilisation in commodity prices we could see pleasant earnings in the second half of the year. For example Morgan Stanley estimates that although manufacturing is a small part of the US economy fully 55% of S&P profits are related to the industrial sector.

With bond yields close to multi century lows and commodity prices bottoming, bonds are a dangerous investment for those not willing to hold to maturity. Especially as non commodity prices have already picked up in the US.

Also note that year-to-date, in aggregate, it has been commodity, Asian and Emerging Markets that have performed best despite them being the epicentre of bad news.

Positioning & Outlook

Given the very high levels of volatility we felt compelled to make several changes in our portfolio strategies to take advantage of pricing anomalies that appeared across markets and asset classes. The table below itemises the changes we have made to our mainstream portfolios over the quarter:

We first put property into our portfolio strategies when it yielded more than UK Equity Income funds and capital recovery had significantly lagged that of UK equities. Now that yields have compressed and property values have risen considerably, we believe there is better risk reward in equities and therefore we have switched back there.

We had bought both US Dollars and Euros (for clients who could) in anticipation of Sterling weakness. The former was also a volatility dampener (as the dollar tends to rise in tough times). After Sterling depreciated substantially against both currencies we sold out as most of our clients liabilities are in the UK and we only bet against that currency in extremis. The fact we had to start paying to hold Euro cash aided our decision!

With austerity and Brexit adding risk to the UK economy and the list of cashed up foreign property buyers shrinking we increasingly moved monies into international markets where both the recovery and valuations are better supported than here.

By 11th February we moved very close to our maximum (internally imposed) exposure to equities. This makes us feel very uncomfortable as we are here to manage risk at least as much as chase reward. However, given the magnitude of falls we had seen by that date we thought equities appropriately incorporated the manifold risks that are all too apparent. Indeed we think the fact that bad news dominates the press and investors are conservatively positioned makes it unlikely (but alas not impossible) that markets will react too negatively to ongoing slow growth and sluggish profitability. Furthermore we have increasingly bought in areas of the market that have been challenged for a considerable period, such as commodities and Asian companies. These investments are trading at valuations significantly below their long term averages (on price to book as well as PE ratio). Our Asian stocks, remember, are better capitalised than average and are underweight commodities. Our commodity exposure is concentrated on survivors and are all undergoing significant restructuring so long term prospect look encouraging even with oil way below $100 per barrel.

Indeed we think the biggest risk to global financial assets is policy error and all asset classes are vulnerable to such. If anything, bond markets have been more manipulated than equity markets and in an environment where investors lose faith in authorities we do not think bonds will fulfil their traditional safe haven role. This is why we have balanced our equity exposure by reducing property (an equally risky, if less volatile asset class) by eschewing much alternative exposure (where risks can be unanticipated but very real) and by running above average levels of cash.

Summary

In the very short term risk assets have recovered more than we expected (after falling earlier in the year) so we would expect at least one more bout of short term weakness before we grind to positive returns thereafter. Given how sharp market turns can be and the fact we think economics will be okay in the second quarter, we do not think trying to correctly time a sell order and then a buy order in quick succession is the optimum way of running your money. As such we are likely to live with short term volatility in the expectation of earning positive medium to long term returns via the power of compounding.

Best Regards

Ian Brady,
Chief Investment Officer
24th March 2016

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 a fund invests in overseas markets, currency 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. This article is not intended as individual advice. If you require advice or further information please contact us.

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