Q3 2017 Commentary

Macro overview

The US continued to recover from the torpor of the first quarter as evidenced by very high and rising consumer confidence, ISM Manufacturing Index at a six year high and non manufacturing performing well too, with a latest reading of 55.3. In Europe both Investor (IFO) and Manufacturing confidence rose to cyclical highs.

Meanwhile in the UK the Confederation of British Industry (CBI) manufacturing survey fell, the IHS survey saw firms optimism, re following year activity, fall to its lowest level since 2011 whilst there have been numerous warnings from the Bank of England with regard to segments of consumer debt and the yields available on commercial property (BOE Financial Stability Report). However, because consumers are still borrowing at a 9-10% clip (ex mortgages) retail sales have performed reasonably well, further boosted by tourists taking advantage of the weak pound.

As most of our inflation is imported, construction spending weak, debt high and wage growth low many found it a strange time for the Bank of England to be hinting so strongly that an interest rate rise is imminent!

Macro Outlook

A leading bond manager recently commented that UK GDP growth was weaker in 2015 than it was in 2014, weaker in 2016 than it was in 2015, weaker in 2017 than it was in 2016 and likely to be weaker in 2018 than 2017 as the benefits of a weaker pound end in twelve months time (assuming Sterling bottomed in early September). I am not so sure it will slow significantly from 1.5% as I think the UK government will step in at much below this rate of growth. I also think that (as an inverse of Sterling) inflation is in the process of peaking so there will be some relief to real incomes. However, I do think that with current economic policy 1.5% is about the correct level of sustainable real growth – so revenue increases will be hard to come by.

Across the pond it seems as if the Republicans are trying to rally round tax cuts as a way of portraying at least one significant victory ahead of the November 2018 elections. Whilst there are still big divisions within the Party between the balanced budget caucus and those who believe a near term increase in deficits will be offset by higher tax receipts down the road (as a result of faster GDP growth) it is my belief something will be passed and that it will result in a rise in the 2018 and 2019 deficits. Economists still cannot agree on whether the tax cuts (from much higher levels) enacted by Reagan helped boost growth so there is no chance of a consensus as to how the long term will pan out from here. As this will be happening coincidentally with the Federal Reserve selling c$900 billion of bonds into the market (i.e. over the next two years) it is very likely to put upward pressure on bond yields. Capital Economics forecast 50 basis points, the Fed themselves 100 basis points.

The Chinese have tightened liquidity somewhat but credit continues to rise faster than GDP and the Communist Party Conference is soon upon us (the most pressing reason growth had to be maintained until now). We obviously cannot be sure what the leadership will do next but post conference, with power cemented, would seem like an opportune time to accelerate the reform from old, credit intensive industries to newer consumer facing ones. A decent start has been made on this in the basic industry sectors but the reacceleration of growth since 2015 has been via the old way of housing and infrastructure. So this means the odds of some kind of slowdown in Chinese growth are higher over the next twelve months than they were for the year just gone.

The Japanese economy has been steady, if unspectacular, and analysts are continually frustrated by the lack of wage growth as highly paid retirees are replaced by cheaper entrants into the workforce. Mr Abe has called a snap election as the opposition is in disarray and looks very likely to secure his position for a longer tenure. This will mean loose monetary conditions are likely to persist in Japan for a longer period than in the West.

Markets

Currencies and commodities provided the action for much of the quarter as Government Bond Yields increased ever so slightly (i.e. bond prices edged lower) whilst UK equities lagged their equity brethren in the face of Sterling strength.

At the lows of early September the Dollar had fallen by 14% year to date against the Euro, 10% against Sterling and over 7% against the Yen. It has also fallen versus the Chinese Yuan. Fed talk of an imminent tapering of quantitative easing has caused a mini rally since then.

Risk markets spent most of the quarter hunkering down in the face of negative headlines (few of which affect short term profits) e.g. North Korea, Trump, terrorist acts, Brexit impasse and so on.
But then late in the quarter, equities rallied sharply and bonds sold off as Central Banks’ attitude towards removing some stimulus seemed to harden, commensurate with economic numbers holding up okay in Europe, Japan, China and the US. Numbers in the UK were somewhat weaker but not overwhelmingly so.

European High Yield Bonds saw the spread on their bond yields (to compensate for inherently higher risk versus government bonds) fall to the lowest level since Lehman Brothers went bust in 2008 as investor confidence in Europe soared.

In August iron ore prices hit a four month high whilst oil prices (Brent) rose 18% over the quarter.

The Bank of America/Merrill Lynch Fund Manager Survey in September showed that fund managers are now most overweight European and Emerging Market equities as well as Bank shares. Cash is also at high levels. They are most underweight Sterling and the Dollar (and corresponding equity markets) as well as Energy shares. Overall fund managers are slightly overweight equities and underweight bonds.

The table below depicts the change in price of selected asset classes during the 3rd Quarter of 2017:

All prices are in local currency.

Activity, Positioning & Outlook

The table below illustrates asset allocation trades in the period since 30th June 2017:

After being relatively quiet on the trading front year to date valuations on Sterling, Japanese Equities and oil finally reached levels which tempted us into asset allocation changes. The pounds decline post Brexit has only been exceeded in magnitude in the 1970s (when we had to have an IMF rescue) and in 2007-08 when many considered our banking system insolvent (hence the government nationalisations). Furthermore on Purchasing Power Parity the pound just seems cheap, as our trips abroad validate. So we decided to switch all of our European exposure into a hedged class of share.

With regards Japan, the market has become cheaper as profits have hit all time highs whilst the market remains slightly below where it was in 2015 (see charts below). Dividends and share buybacks have also increased in testimony to the improved corporate governance in the country. A cheap asset class with improving fundamentals is our ideal investment hence we added to our positions. In the Income portfolio strategy we executed this via an unhedged Income fund as the Yen usually acts as a safe haven in tough markets and thus we wanted this ballast for investors in this portfolio strategy, even though we think the Pound is cheap (the rest of our Japanese exposure is hedged).For Growth and Income & Growth portfolio strategies we added to our current hedged Japanese vehicle.

Record Earnings

We added to our exposure to Energy via ETFs after the oil price fell to a level that suggests US shale investment will be curtailed (thus limiting further supply). In addition excess US inventories are witnessing meaningful depletions and OPEC seems unusually keen to impose quota discipline. So with a low price, peaking medium term supply and better than expected demand, re entry into the asset class (at a price below where we sold last year) seemed opportune.

Conclusion

In broad terms very few financial assets are cheap. This is a natural consequence of ten years of excess liquidity flowing through global markets (QE, negative real interest rates etc). We are now entering the stage where the rate of excess liquidity creation is slowing and by the end of 2018 it is likely (but not certain) to be over.

This means a hitherto significant tailwind to financial markets is in the process of turning into a headwind and five year returns from here are likely to be more modest than the prior five. However, as there is a chance that fiscal easing and structural reforms will ameliorate at least some of this negative impact, opportunities to make money can still be found. As both fiscal spending and structural reform are aimed at accelerating economic growth and Central Banks own a far higher percentage of bond markets than they do equity markets, we consider it highly likely that equities will produce superior returns in coming years. So that is where we remain focussed, augmented by short duration corporate bonds and covered call writing strategies.

We will revisit government bonds should yields provide us with potential for a decent real return. To us this implies at least a 100 basis points increase from here in most developed markets (which implies a 7-14% capital loss from here for current holders). Likewise when commercial property once again delivers a decent net yield (the Bank of England recently warned that the yields on commercial property were ‘low by historical standards’) we will again invest in this asset class.

No one can properly discount the exact nature of Brexit or potential fallout from military conflict on the Korean peninsula. Likewise for when China addresses their credit growth issues or what exact policies Trump finally gets enacted.

What we can do, however, is invest on a ‘balance of probabilities’ basis and keep some powder dry in case events transpire against us. And that is exactly what we are doing in our pursuit of generating decent absolute returns whilst taking measures to limit interim drawdowns.

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.

You can download the full commentary here.

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