Q2 2018 Commentary

Macro Overview

Well that was a quarter and a half! Tariffs actually implemented with many more being considered; new governments in Spain and Italy with a mini bond market tantrum in the latter; proper currency tantrums in Turkey and Argentina; a slew of other emerging markets raising interest rates; an OPEC agreement to raise oil supply and continued lack of progress on Brexit. Amidst all of this the People’s Bank of China went the other way and cut rates in order to ease liquidity as shadow (unregulated) banking was curtailed and deleveraging continued. This was simultaneous with each of Chinese retail sales, industrial production and fixed asset investment slowing, as well as new export sales falling every month throughout the quarter. The Federal Reserve raised US rates as expected and sounded more hawkish than normal.

Perhaps this is because US was the only region likely to have experienced accelerating growth as the short term benefit of tax cuts kicked in. Indeed the Financial Times reckon the repatriation of cash held overseas by US corporates was responsible for more liquidity tightening outside the US than both tapering and rate increases by the Fed combined.

However, the U.K. consumer has made a comeback too even as manufacturing slowed dramatically. The British Retail Consortium announced a May rise in expenditure of 4.1% that was the best since January 2014, whilst a rise of 5.1% in spending on Barclay’s cards augmented this rosy picture. Undoubtedly weather helped but rising real wages (at last) also contributed.

All the tariff shenanigans are unhelpful at a time global trade is slowing as depicted in the chart below (source; Capital Economics).

Statistics from the World Trade Organisation show that weighted average tariffs in the US are 2.4% versus 3.0% in Europe and 3.1% in Canada. So, no big deal at the aggregate level. However, the US are looking at each individual category and wanting them adjusted in their favour one by one. This will naturally lead to retaliation but the US is taking the view they will win as other regions have more to lose as their exports are a larger share of GDP than America’s.

Amidst this banks are still lending; US banks increased theirs by 4.2% in April as opposed to 4% the prior month whilst those in Europe saw lending increase at 3.1% versus 3% prior. In the U.K. Consumer Credit rebounded strongly to £1.8 billion after an unusually large fall to £400 million the prior month.

Markets

Investors have turned increasingly skittish and have redeemed significant amount of monies from Emerging Market stocks and bonds and European equities. Some of this money has been recycled into the US as it is considered at least the relative winner in a trade war and has the best short term momentum. There has still been a net outflow from risk assets – and at record rates from the afflicted regions. This follows near record inflows earlier in the year!

EPS (Earnings per Share) estimates have risen dramatically in the US year to date whilst in Japan they have fallen dramatically – to the extent that sub 3% growth is expected in the year to March 2019 after double digit growth last year. Japanese downgrades are due in part to Yen appreciation and several analysts think they are now overly conservative (10%+ growth considered attainable) whereas US companies will struggle to continue beating at the pace of Q1! 2019 will be particularly tough for US companies as tax cuts anniversary and dollar strength takes a toll. However, it may be a while before investors worry about this if there are more immediate problems elsewhere.

Europe has seen EPS estimates edge up to just over 6% growth and the U.K. has picked up strongly of late to an estimate of 10% plus growth, helped by the renewed weakening of Sterling.

As seen in the chart below the sharp decline in confidence of business leaders has not impacted the optimism of equity investors – yet! This may help explain that whilst Geopolitics took centre stage during the period, financial markets generally advanced and recovered what was lost in the first quarter.

The table below depicts the change in price of selected asset classes as of close in the US on June 29th:


All prices are in local currency.

Dollar strength and Sterling weakness were features of the period as investors favoured traditional safe havens.

Activity, Positioning & Outlook

A gentle re-acceleration in the developed world from the sluggishness of Q1 is underway but geopolitical storm clouds are darkening the skies. Any company involved in the global supply chain must be reviewing its expenditure plans until it becomes clearer which tariffs will be levied on what and by whom. Daimler (although some think spending on new emissions standards is the real reason) and Harley Davidson have already been public about how tariffs are or could affect their businesses. The President’s vitriolic response to the latter may prevent some from public disclosure but it stands to reason capex and investment will slow for a while as policy is formulated and digested.

JP Morgan reckons that, by the end of the year, half of the countries in their Emerging Market coverage list will have raised interest rates. With the US continuing to raise rates and the ECB tapering, there is quite a withdrawal of global liquidity going on. We must remember that tariffs/trade wars are inherently inflationary as protagonists in effect want to bring the prices of cheaper imported goods up to the levels of domestic producers.

It may be that within equity markets more domestic plays perform better. This is already beginning in the USA and very marginally in the UK.

There has been a lot of press about the global yield curve flattening for the first time since just before the financial crisis and that flattening yield curves usually presage recessions. Whilst risks have risen and global growth has slowed we need to note that at least part of the reason the global 2 year to 10 year curve has flattened is because the US has issued a lot of short dated bonds of late (thus increasing short yields) and the US is a large weighting of the total. However, we do need to keep a watch on this potential rise in real yields (interest rates minus inflation). The US has positive real yields of about 0.5% (although some economists maintain the US has never had a recession with real yields below 3%). The U.K., Europe and Japan still have significantly negative real yields, due to QE.

Last year we were inactive between February and May due to lack of volatility. This year has been the opposite as we added significantly to holdings near the February low and subsequently reduced some of our more cyclical exposure after the ensuing rally.

I have said since November that economic growth was going to slow ex-US and that financial market volatility would rise. We are therefore happy to be opportunistic and reduce cyclicality when given the chance. This policy is likely to continue. I am looking to reinvest in recovering domestic plays and less cyclical companies who are not under undue pressure from secular forces. Many Healthcare and Staples have underperformed since 2016 so I am investigating such areas.

Bonds are still not interesting and are still not feeling the full pressure of market forces due to ongoing QE in Japan and Europe. Therefore the worst is still ahead for non US bonds.

The tables below illustrate asset allocation trades in the period since March 31st 2018:

RAYMOND JAMES

What we have done is reduce a little cyclicality from the portfolio after a meaningful rally in resource stocks and many US Consumer Cyclicals too. The fact that some of more economically sensitive shares have rallied in the face of softening has enabled us to lock in some meaningful profits whilst at the same time reducing risk.

The UK and Japan are still the two unloved markets despite the corporate sector in both countries being in decent shape. Our JO Hambro Japan fund has been a disappointing performer despite the fact that their portfolio companies delivered 33% EPS growth in the last fiscal year and increased dividends by 18%. Another 12% Earnings growth is expected for the year to March 2019 and if this is delivered performance should rebound significantly. Likewise we spoke with the managers of Unicorn UK Income and Ethical Income funds which are UK Mid Cap growth orientated. They remain encouraged by what is happening at the company level (and have had 8 onsite meetings with holdings of late) but complained that year to date the UK has seen performance dominated by resources and mega caps (due to weak Sterling) and that the positive outlook for their holdings is not currently reflected in share prices. Several UK managers have similar gripes about their UK facing holdings so I am confident there will be some decent relative performance from this area in the period ahead. Unless, of course, we subject ourselves to a very hard Brexit.

Conclusion

As mentioned before, investing is not straightforward at the moment as equity markets are balancing near term profits momentum with a profound change in the way global trade is conducted. This is at a time where the global economy is coming off of a period of growth that was above sustainable levels.

For Fixed Income markets we still have negative, or way below normal, real yields in most of the world and the biggest buyers in the market (Central Banks, who are not price sensitive) beginning to curtail their purchases. By next year they will be net sellers for the first time in a decade.

For alternatives, structures remain opaque and the industry has struggled in aggregate to generate adequate returns over the last few years. Perhaps it is due to post crisis regulation limiting their use of leverage as well as their clever algorithms closing out each others competitive advantage ever more quickly. For whatever reason this asset class is hardly a ‘no brainer’. Property is similarly difficult with low net yields, a shift away from retail dwellings and a reliance on foreign buyers for incremental purchases.

At the moment equity markets are still discounting an acceptable, if not perfect Brexit and a global trading regime not too different from today. Bond markets are assuming positive GDP and low inflation continue ad infinitum. Also priced in is that China will avoid debt problems that have affected every other emerging country that has grown debt at the rate China has. So we need a lot to go right. This is not to say it won’t but we need to be aware of the risks.

Given the above we want to maintain a decent weighting in equities to benefit from dividend compounding (and equity yields are above bond yields in many geographies) and from capital appreciation if we manage to traverse the hazards mentioned above. Furthermore, I think voters have made it clear that they are fed up with the status quo and reflation (a la the US) is the only way to bring them onside. If voters have higher wages and better access to services then immigration becomes less of an issue. Such policies tend to favour equities more than bonds. However, to have a maximum weighting would be irresponsible as ramifications from the new global trading order are unknown, valuations are not compelling and dollar liquidity is being drained from the system. So we will retain a cash buffer and use it to both offset our underweight in bonds and property and to put to work when the inevitable bouts of volatility present opportunities for investing with attractive risk rewards.

By doing so we will be able to participate in upside whilst protecting your monies from the harshest effects of economic or geopolitical mishaps. This is how we will compound your returns over time.

Best Regards

Ian Brady
Chief Investment Officer

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 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.

Copyright ©Harpsden 2018 (unless otherwise indicated). All rights reserved

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