May Day had several meanings this year as the first few days of the month significantly wrenched business confidence and changed the shape of financial markets. Firstly the Sino-US talks collapsed and then Mrs May’s Brexit bill was defeated for the last time, resulting in the PM announcing her intention to resign thus formally starting the much prepared for race to be next Conservative Party Leader.
Since then Confidence surveys, particularly business ones, have weakened whilst international trade and related industrial production have languished. Chinese Manufacturing PMI, Japanese Tankan Survey, US and UK Construction figures plus the German Investor sentiment index could all be classed as lowlights since then. However, French PMIs and wage data in each of US, UK and Europe have all been resilient.
Central Banks have reacted, almost in concert, to this with each of the Federal Reserve, People’s Bank of China, Bank of Japan, Royal Bank of India, European Central Bank and Bank of England at least talking about easing monetary policy. China and India have actually done so.
I was a big fan of the QE which was enacted just after the financial crisis as it greased the wheels of a seized up financial system and helped kick start the stalled global economy. However, I am not so sure about this round. Yes it does send a message that Central Banks will do practically anything to avoid another recession but business confidence and trade have stalled this time because of policy, not market dynamics. The initial cause of the slowdown, as we have written about several times, was the Chinese government induced credit contraction which had a knock on effect to Asian and European export dependent economies. Then the simulative US tax breaks were due to diminish making a rebound elsewhere more important. Signs of stabilisation were emerging in several places even if the more targeted, domestically focussed nature of the latest Chinese stimulus means it was less eye catching than previous efforts à la 2009 and 2015-16. The latest wrench in the economic works, however, is due to businesses and supply chains not knowing what rules or tariff regimes they are working under. Small cuts in interest rates or Central Banks purchasing incremental bonds at scant or even negative interest rates will be of little help in such an environment. It will probably make more companies borrow cheaply at low interest rates to do accretive share buy backs (thus boosting share related management compensation) rather than going to the bother of building a new factory, increasing R and D or employing expensive new staff amidst policy uncertainty. The US has imposed or threatened tariffs/changed the terms of trade with China, India, Canada, Mexico, Japan, Iran and the EU over the last year or so whilst the EU and U.K. are still at an impasse on our trading relationship. The US has also sanctioned two of the leading Chinese technology companies (ZTE and Huawei). Regardless of the merits of each or any of these policies it is bound to have had a detrimental impact on export related businesses that have historically utilised international supply chains and by definition rely on foreign customers.
The truce agreed between Trump and Xi at the G20 is a welcome development as it has de-escalated tensions but real corporate optimism is unlikely to develop until there is more policy certainty. Still, at least there is hope.
However, in spite of the above, most countries domestic services have been resilient and China has recently taken steps to encourage purchases of cars (a Chinese official on July 1st said that Chinese car sales had picked up dramatically following a change in government policy). Furthermore, in May Europe enjoyed its first year-over-year increase in automobile purchases in nine months. Therefore, if the truce lasts it is very likely we will witness an improvement in industrial production and trade flows over the next few quarters. This will still be choppy as in some industries (e.g. semiconductors and auto parts) buffer inventory has been built to counter tariff imposition. However, the overall trend will be up.
Brexit is more likely to happen on October 31st and at the moment both contenders for the Tory leadership are playing to the audience of 160,000 who will choose the winner. The next audiences the victor will face are a parliament that is at best uncomfortable with a hard Brexit and an electorate that is split roughly 60:40 against a crash out. This is despite most people just wanting to move on from the saga. The CBI is also dead against a no deal outcome. I would proffer that most Conservatives think that what is even more important than their preferred Brexit outcome is keeping Mr Corbyn out of Number 10 and policies to that end will be paramount. However, my only certainty is that whether we achieve a deal or not there will be significant fiscal stimulus enacted in the U.K. over the next twelve months. The Chart below highlights how investment in the U.K. has lagged since June 2016.
Chart 1. Brexit risk has hit CAPEX; Q1’s increase likely will be a blip
Source; Pantheon Economics
The nectar of easy money has overwhelmed policy bitterness during the quarter although the internal dynamics of markets have changed considerably. Bonds, bond proxies and safe havens have leapt to the forefront of performance (starting from behind as of early May) whilst small caps and economically sensitive stocks and markets have lagged significantly. Inflation expectations have dropped, indeed by considerably more than inflation itself. Trade issues have been at the centre of this.
Chart 2. With a ceasefire in the trade war, the Fed will become the market’s driver
Source; Gavekal Data/Macrobond
It should be noted that equities have rallied despite EPS forecasts being reduced, often by meaningful amounts, across the globe. We would expect further EPS reductions as the May policy impasses mentioned above have sapped confidence and investment further.
However, the market is trying to discount a recovery six months out and positive statements by Micron on memory semiconductors and a reprieve on Huawei are being given more import by investors than anticipated near term shortfalls. Neither should it be forgotten that the US administration recently asked over 300 large US companies to provide their comments on the likely impact of tariffs. Whilst I haven’t been privy to such I am willing to wager, given public comments by several CEOs, that the vast majority have asked the government to refrain from upping the ante further. One would hope they will listen but given the latest salvo at Europe coming within 72 hours of an alleged truce with China it is unlikely to be a smooth path – even if common sense does ultimately prevail (as I think it will).
Sterling weakened considerably over the last two months whilst the Swiss Franc and Yen have exhibited particular strength. Gold, frustratingly, took a while to get going but is finally doing its job in uncertain times.
Oil has been particularly volatile, rising by over 20% through late April before falling victim to trade and growth concerns and round tripping all the way back to where it began the year. It has firmed up a little again of late and the Saudi-Russian agreement to extend production cuts by a further nine months should help febrile sentiment further.
The table below shows performance of several key asset classes from close on the 31st March until close on 30th June.
Figure 1. Percentage change in markets and currencies from 31st March to 30th June 2019
Activity & Positioning
I had set the portfolio up to benefit from the U.K. finally leaving the EU as planned on (or close to) March 31st and Sino-US relations being conducted in a way that didn’t damage either protagonist too much (or the global economy for that matter). As both presumptions suffered setbacks I had to enact some trades to balance our twin goals of participating in upside while protecting from the worst of any downside. Fortunately, the strong rally through April enabled me to lock in some decent profit in both U.K. and US assets. The other activity was selling Woodford Income Focus in order to provide some protection from any fallout the suspension of his Equity Income Fund may cause. This money was re-allocated to funds that are overweight U.K. facing assets as I still think such assets offer compelling long term opportunities, even as I accept it is unlikely to occur until Brexit is clarified.
Overall, despite the rally in most financial assets year-to-date, investors have consistently pulled money out of active equity funds and continued to allocate money into bonds. Indeed markets have moved to substantially price in a period of prolonged disinflation and in some instances (e.g. Japan, Small Cap, Bond Proxy versus Cyclicals differentials) an outright recession. In June, US Fixed Income ETF’s raked in a record $24.5 billion – 45% higher than the previous monthly record. Unless trade negotiations falter again then I do not think a recession is likely. We are already over one year into the third decline in global exports since 2010 and already policy is once again being enacted to counter this. Both China and Europe enacted car emissions reforms last year which caused huge ructions in the market. By Q3 these will be diminishing. The UK has been in Brexit torpor whist India has been through a non-bank liquidity crunch, demonetisation and an overhaul of the tax system. The latter country is mostly through these issues and coming out the other side whilst we will have more clarity in a few months. So the world has not been in uninterrupted sunny uplands these last few quarters and a lot of lustre has already been removed.
The US administration would like the dollar to fall in value somewhat and most commentators agree it is an over owned and overvalued currency. The Fed is likely to cut rates at least once. Added together, a virtuous circle could emerge where a weakening (even slightly) dollar eases liquidity concerns internationally which in turn boosts economic activity. Whilst by no means certain this is what happened as the globe emerged from the prior two industrial downturns mentioned above and when sentiment at the time was just as gloomy as today.
The fact that June saw the second biggest drop on record with regards equity allocations in the Bank of America Merrill Lynch survey backs up the depth of prevailing bearish sentiment. The survey added that investors haven’t been this pessimistic since the crisis of 2008.
Given the above, between now and year end I still expect equities to eke out further gains whilst bonds are likely to recede from the limelight as Armageddon is once again avoided and the decades high yield premium on equities attracts investors once more.
Domestic U.K. shares are still incredibly cheap, even more so in relative terms after the latest move in markets. However, I will increase from here in several discrete tranches given the continuing political uncertainty and the fact that the fallout from Woodford likely has two or three more months to run. However, I do reiterate I want to have more in domestic UK equities at the end of the year due to a weak pound, attractive valuation under ownership and imminent fiscal stimulus. Below you can see the trades we enacted since the last meeting. All trades were done to reduce risk.
Figure 2. Q2 2019 Portfolio changes – RJIS
Although I was very optimistic on equities at the beginning of the year and still expect some markets to eke out gains I have to confess a lot of the progress I expected has already been achieved in European and US Indices. There is a little more to go for in Asia whilst Japan and the UK could play catch up if politics plays out in a benign fashion.
Bonds of all ilks have done far better than I expected as the trade impasse and resulting resumption of weak industrial numbers have caused yields to drop far more than inflation.
As mentioned above, equities have moved despite widespread profit downgrades and Q2 is unlikely to be pretty after the falloff in confidence since the first week of May. This could give rise to near term turbulence.
However, US inflation has already picked up from the Q1 shortfall and policy is again being put in place to prevent the natural slowdown we had been expecting since late 2017 to morph into something worse.
I would imagine that with a little over one year until the US Presidential election and the visible damage the last two trade skirmishes have caused to industrial, agriculture and technology sectors that actions will be toned down over the next few quarters.
Elsewhere policymakers will act to contain and then reverse the trade related slowdown that is currently upon us.
We will therefore put money to work when opportunities arise, as markets often throw up such opportunities during summer.
Chief Investment Officer
5th July 2019
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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.