Q3 2016 Commentary

Macro overview

Even though Rio hosted the Olympics during this quarter it certainly had no monopoly on record setting. The UK experienced record falls in Services Purchasing Managers’ Index and Manufacturing in July and then record rebounds in August. We also witnessed record low bond yields in several sovereign bond markets, including Germany, Japan and the UK (some gilts briefly sported negative yields. Pre 2008 this would have been given longer odds than Leicester City winning the Premiership). The Bank of England also pleased markets by enacting further QE, including entering uncharted territory by including corporate bonds in the assets it intends to purchase.

The Japanese authorities were keen to join the financial carnival with the government announcing a 28 trillion Yen fiscal boost. However, investors turned into party poopers when they worked out there would only be 7.5 trillion Yen of new fiscal expenditure. This will boost GDP by, at the most, 1% in the first 12 months after its enactment. The announcement came less than a week after the Bank of Japan had similarly disappointed investors despite nearly doubling its ETF buying spree to 6 trillion Yen. The upset was caused by the Bank of Japan standing pat on both interest rates and bond purchases whilst apprehension resulted from the announcement they were carrying out a comprehensive assessment of the efficacy of their policies to date. The result of this assessment has just been published and Bank of Japan has, in effect, reduced the emphasis on bond buying and are going to try and fix the bond yield on the 10 Year Bond Yield at zero percent by promising to buy all such bonds offered at that price. This is so they can have negative short term rates and a still positive yield curve thus not hurting bank profitability further. Some are viewing this as the beginning of the end of quantitative easing but we can only wait and see what further action the government and Bank of Japan take in November. In the meantime economic activity and inflation have remained weak, partly due to the strength of the currency.

The US has seen economic growth accelerate somewhat after three quarters of torpor but the evidence is not as overwhelming as it should have been. Wages growth, consumer confidence and consumer spending have been decent, with the former rising over 3% year to year. Whilst industrial production started the quarter well it has trailed off as of late and retail sales have not attested to the aforementioned consumer strength. Housing and automobile activity have also been anaemic in the quarter so the catch up from prior weakness is only happening gradually. Indeed during the September Federal Open Market Committee Meeting the Fed lowered their assessment of potential US GDP growth to the lowest on record.

Chinese data has been mixed over the quarter, with one good and one disappointing release for each of credit creation, purchasing managers indices, exports and imports. However, sentiment had been so bearish that investors have taken heart from the fact that there has been no renewed economic slowdown or financial crises. Time has also been bought by the government forcing banks to convert Local Government Financing Vehicles into longer dated, lower interest bonds.

However, in our view a slowdown will occur within six months as housing and government investment have returned as the main drivers of the economy and wage growth has fallen from a multi year average of 10% to only 4% now. This latter point will impact retail sales, which have also been growing at 10% or more for many years.

To illustrate the point, the value of property transactions has increased by 40% year to date with prices up 17% and floor space increasing 21%. Forty Five percent of all corporate borrowing in China over the last year has been to property developers. With regards government spending, a slowdown is assured as 3.5 trillion Yuan had been spent by mid year out of an annual total of 6.2 trillion Yuan. Private sector investment is up only 2.8% year-onyear, far slower growth than in the preceding years. So although we still do not see Lehman style crises in China the only way to refocus the economy on a sustainable path is to dramatically slow the rate of credit creation and overall rate of growth. Until the government does this the economy is going to lurch from corporate induced slowdown to government inspired, debt fuelled reacceleration. All this is within the context of an economy that now needs 3 units of additional credit to induce one extra unit of economic growth. This is up from only 1.5 unit of credit required ten years ago and such an increase almost always foreshadows a sharp slowdown in growth, often accompanied by a credit event of the type we hope China avoids.

Europe has slowed in the quarter with Industrial Production falling 1.1% in July (as one would expect post Brexit) and August Purchasing Managers’ Index declining a touch as well. Inflation also undershot expectations, which is a worry for the ECB. However there has been no ratchet down in activity as the Consumer has kept spending, as highlighted by July’s Retail Sales advance of 1.1%.

Markets

Markets have been very firm this quarter as investors breathed a sigh of relief that any Brexit inspired disaster was not imminent and Central Banks throughout the developed world became more dovish/less hawkish.

Currency markets have caused most angst as the Yen refuses to go down and has indeed strengthened after each of the last five Bank of Japan meetings, implying traders think the authorities are impotent in light of other policies driving real interest rates higher in Japan and therefore attracting capital. The Chinese authorities have had more success in controlling movement of the Yuan/RMB although it has taken significant action to engineer such an outcome. The offshore interbank rate (SHIBOR) surged to 23.7% from 8.7% to prevent it weakening against the dollar.

Indeed we should take this opportunity to inform that interbank rates have been increasing around the globe of late, partly as a result of change in the way the USA regulates its money market funds. The US rate is now close to its highest level since 2009 and some suggest this has resulted in a de facto tightening of financial conditions. Following on from this, the last month has not been good for government bond markets after the all time low yields achieved in August.

The Pound has been weak across the board despite both UK equities and fixed interest performing well.

Equities have been strong on the back of the aforementioned liquidity injections and the fact European and Emerging Market companies have produced more positive earnings surprises than has been the case over the last few years. Investors have also decided that that the nitty gritty of Brexit impact will not be known until next year and the full impact until even later, so there is no point worrying about it now.

The table below shows capital changes in selected major indices to date as of the close of Asia on 26th September:

Outlook & Positioning

We have not made many changes over the quarter as we had repositioned our strategies at the end of the last quarter. Whilst we have enjoyed the appreciation of our portfolios over the quarter we do not want to get too carried away. Once again Central Banks have had to come to the fore to entice investors further along the risk curve in the hunt for yield and we are of the opinion this cannot last forever. It defies economic logic that fixed interest instruments which offer no interest can continue to generate positive returns. Therefore we anticipate a sizeable back up in interest rates across the spectrum over the next few years, unless global GDP growth collapses in a way we do not foresee. Richard Woolnough, who manages the M&G Optimal Income Fund, has gone negative duration for the first time ever in his UK Gilt portfolio. Such a dramatic move from a leading investor highlights both the lack of value and the risks inherent in the asset class.

There has been more talk of fiscal stimuli picking up the mantle globally and this should mean equities outperform bonds from here. However, there may be a dislocation as liquidity is reduced within financial markets in order for more money to go into the real economy. Hopefully this will be transient period and a more robust macro environment will make both pricing and earnings growth more attainable for most companies.

There are, of course, a myriad of obstacles which could trip markets up in the coming quarter including the Italian referendum, US election (although only once in my career has this actually caused a problem and that was in 2000, when the result was challenged), renewed concern about the Chinese housing bubble and increased government intervention and more worries about the efficacy of Bank of Japan policies. Brexit is not likely to be a concern until Article 50 is invoked and investors can actually weigh up actions and consequences.

On the flip side Asian, US and European earnings should show synchronised growth this quarter for the first time in years while Mr Hammond’s inaugural budget is likely to include some fiscal stimulus in the UK, which could whet investors appetite for stocks.

Given the above we will look to pick up bargains on any weakness and trim anything that we consider too pricey should optimism prevail in the coming months.

Retaining a significant cash holding allows us to embrace volatility and not be afraid of it. If enough assets become cheap enough we will happily run down our cash levels, as we have done in the past.

The table below illustrates the changes we have enacted to our portfolio strategies over the course of Quarter three 2016:

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.

You can download the full commentary here.

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