Q1 2017 Commentary

Macro Overview

Let’s hope economic surveys are more accurate than political polls as of late the former have presented a picture of a broad upturn in sentiment about the prospects for economic growth in the developed world. Indeed Federal Reserve Chair Janet Yellen opined that if there was any point in the last 10 years that the US didn’t need a fiscal stimulus it was now! Examples of strong survey data include UK Manufacturing rising to its highest level since 2014, sentiment on European profits being at the highest level since 2010 (source Goldman Sachs), German Financial Conditions Survey (IFO) increasing to 111 from 109.9, Barclays Global Manufacturing Confidence gaining further momentum in February, a recently published Bank of England survey of 700 UK companies found they intend to increase investment despite rising inflation and higher business costs and US Consumer Confidence surging to a 16 year high.

For sure activity based US data has been more mixed and UK retail sales have only been up one of the last three months. Japanese data has also been sluggish on the back of the strong currency.

We will need to wait and see what the lagged effect of recent tightening of Chinese policy will be as the impact of the 2015 stimulus took at least six months to be acknowledged. At the margin it will surely slow down growth. US growth should perk up in Q2 as the March quarter has been held back by inventory drawdowns and expectations based survey data is way ahead of actual activity. In the UK I believe everyone has upgraded prospects at precisely the wrong time. The weak pound will continue as a boon for exporters but the domestic economy will be buffeted by stagnant (at best) real wages and a slowdown in consumer credit growth from the double digit rates witnessed over the prior twelve months. Furthermore government expenditure is also going to slow from prior growth rates, making it likely that growth in the next year will be slow (I didn’t even mention the ‘B’ word)

Markets

Beneficiaries of resurgent global growth started the year in fine feckle but as the quarter progressed we have witnessed a dramatic turnaround in relative performance. Despite the most synchronised economic upturn for several years, defensive sectors have snatched back the leadership role and many cyclical sectors are nursing losses in the double digit range, even though indices overall remain close to all time highs. Oil is pacing the decline on US inventory and production levels both being above expectations. The US is also causing investor angst as it has become apparent Mr Trump has as much chance as all of his predecessors in seamlessly enacting his touted policies in their entirety. That chance is, of course, zero. However, some will be enacted and markets will ebb and flow with the news until a decisive trend is discovered.

Despite the overall move to defensives, both Asia and Europe (judged to be more cyclical than the US), have emerged as the strongest markets of late. In fact Asia is the best market year to date. Japan is a traditional cyclical stalwart but has been held back by Yen appreciation against the Dollar. Indeed, the shine has come off the Dollar following the post election love in.

We should note that at the margin both the Federal Reserve and People’s Bank of China are tightening and both the Bank of Japan and ECB could make pronouncements about reducing QE by the end of the Summer. Since 2011 investors have practised in a world of tepid economic growth supported by unprecedented central bank liquidity. If we are now entering an environment encompassing a synchronised uptick in global GDP just as central banks are tempering their provision of liquidity, then a whole new ball game could be emerging – especially for bond investors. That outlook notwithstanding, bonds have rallied since January along with defensive equities and yields are actually lower than they were at year end despite the increased confidence on the economic outlook from investors and businesses alike. This is all tied in with the fall in oil prices and the paring back of expectations of what Trump will achieve (from very elevated levels).

The table below depicts the change in price of selected asset classes since 31st December 2016 to a.m. on 30th March 2017:

Activity, Positioning & Outlook

We have made few changes this quarter as we have set out our stall on a secular basis and there has been less volatility year to date than in prior years. The consequence of this is that there have been fewer opportunities to take advantage of. The only switch of note was taking a little profit out of our biggest holding, JO Hambro UK Equity Income, and moving into the more defensively positioned Invesco Perpetual UK Strategic Income run by Mark Barnett. The fund has about 80% commonality with Mark’s Keystone Investment Trust, which we have held since 2009. Mark has significantly underperformed in the cyclical rally due to his positioning as described and due to some disappointing results from a few holdings. We like Mark’s approach and think that, given the rally, his fund will provide ballast from here. Furthermore whilst we believed fully in the impending cyclical upturn in the economy and attendant cheap valuations of cyclicals last year, both economic expectations and share prices of cyclicals moved on considerably between Q1 2016 and January 2017. Therefore we deemed it prudent to take a little off the table in order to remain true to our goal of only taking risks we are being well rewarded for taking.

It is well known we hold a large cash position in most of our portfolios. As this currently yields zero and has no chance of capital growth, why do we continue with such a policy? Put simply it is in order to comply with the promise we make clients in terms of balancing risk and reward i.e. delivering attractive absolute returns over the long term whilst controlling volatility, particularly drawdowns, in the short to medium term.

Since inflation was broken in the early 1980s nearly all market falls have been associated with recession/financial crises fears (1987 and 1994 being the exceptions, even though we did have a market meltdown on 19th October 1987). In such sell offs long term government bonds have acted as ballast for investors, delivering capital appreciation as equities and other risk assets fell, often heavily. However, as discussed in several of my prior Commentaries, government bond yields remain close to the 300 year lows they touched last summer and in all developed countries remain way below the levels economic theory and history suggest they should be. Furthermore, as long ago as 2011, way before Brexit or Trump was even considered, I wrote that I was not sure modern democracies could survive a deflationary ‘cold turkey’ way out of the debt bubble and that it was likely that governments would resort to inflating their way out. Although the change in OPEC policy in November 2014 and German intransigence have made the global environment less inflationary than I expected between 2013 and Q1 2016, we now have a US government who states it wants to take growth from 2% to 3% at a time when the country is close to full employment and the Central Bank does not think it needs more stimulus. Fiscal policy in Europe is less tight than it has been and China is cutting back some excess capacity in its basic industries. Therefore there is a good chance that in the coming years we will see as many financial shocks that are caused by excess inflation rather than deflation and in such situations bonds are not likely to confer the safe haven status they have over the last thirty five years. So this combination of stratospheric valuations and heightened risk is why we don’t hold any.

I think the chart below explains secularly why inflation has been low and not sustained. My research also leads me to believe it is the main reason (not the only one) we have had Trump, Brexit and the rise of populism in Europe i.e. most workers have not shared the benefits of increased productivity through higher real wages. Trump talks as if he understands the US ‘man in the street’ frustrations and that higher disposable income is the way to alleviate them. Mrs May has hinted at empathy but has already stepped back from proposals for worker representation on Corporate Boards. However, both ‘Trumpism’ and Brexit will reduce the supply of labour and this should lead to a consequent increase in wages. If they do not then the disillusioned will look to blame a group other than foreigners for their perceived woes. Governments will therefore need to relinquish power (via the ballot box) or try and give them what they want – more permanent higher paying jobs (whether they will be successful or not in a world of increased automation is a question we can address later, never mind what it could do to the demand for labour in general from the private sector). This political cycle, which is manifesting itself across the developed world, further increases the odds of a secular shift away from disinflation and provides another reason bonds should be avoided.

There are, of course, several other asset classes outside of bonds and equities. We have often held property in the past. But this is another cyclically sensitive asset class that can be illiquid in stressed times (as we witnessed only last year) and usually fails to provide diversification in recessions (although it can perform okay in inflationary times). Given how low net yields are at the moment and with the internet disrupting the physical retail space, we don’t think property offers a compelling risk reward at present.

We made a promise to all our clients that we will only invest in daily priced vehicles so that precludes most private equity funds (except illiquid Investment Trusts such a Standard Life Private Equity Trust or the ETFs). We have had the ETF (Exchange Traded Funds) in some portfolio strategies in the past but leverage and price of Private Equity deals have risen to well above average levels and recent meetings with private equity managers confirm they are currently leaning more towards realising past investments rather than making more purchases.

Absolute Return strategies abound but our analysis leads us to conclude that not only are they opaque (often by design) but that most of them work all the time except when you really need than to i.e. in times of extreme market stress a la 2008. Neither do we think that it is a coincidence that returns from such strategies have become much more mundane since their ability to leverage up was curtailed post 2008.

The previously described travails of Standard Life GARS fund in 2016, which lost money even as both bonds and equities delivered significant positive returns, only deepens our findings that many peddling and buying such funds do not fully comprehend the underlying strategies. We only want to take on risks we think we understand (whilst accepting this is an ongoing, tumultuous task).

We have recently added to a strategy that seeks to deliver low to mid single digit returns per annum over a cycle by writing call options. This is a relatively low risk strategy but it is neither risk free nor perfect and therefore it is only a small position. However, our purchase does demonstrate we are open to new ideas and seek various sources for delivering returns.

The final reason for holding cash is the positioning within our equity portfolios. We have a higher weighting towards cyclicals than we have had since 2009. By nature they are more volatile than the Unilvers’ of this world and therefore the added cash is a buffer against this extra volatility. We have shown several times in the past, most recently in February 2016, that we will reduce the cash dramatically when markets throw up opportunities.

We fully intend to do so again but by maintaining high levels in the interim we can rationally view market dislocations as opportunities to enhance long term returns rather than catastrophes of which we are victims.

Volatility is low, bond yields are very low and investor expectations with regards earnings are high therefore we view it as extremely likely that a buying opportunity will present itself during 2017 – be it because economies run too hot or too cold relative to investor perceptions, or perhaps due to political fallout. Whatever the reason we have the cash to take advantage of it whilst having enough risk assets already in the portfolios to enable us to deliver real returns should the ‘goldilocks’ scenario play out for an extended period.

Last year we were disciplined enough to put money to work at a time when consensus was agonising about a ‘China Crises’ and a disinflationary spiral. This year we will be disciplined enough to hold fire until our research shows us compelling value exists. Maintaining this discipline will help us towards our twin goals of achieving attractive real returns over time whilst keeping risk and volatility within agreed acceptable levels.

The table below illustrate asset allocation trades in the period since 31st December 2016:

Best Regards
Ian Brady
Chief Investment Officer
30th March 2017

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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