Q3 2018 Commentary

Macro Overview
Rates are going up; rates of interest, rates of tariffs and rates of inflation. Heart rates are also going up in the seats of power as Trade War, Brexit and nationalistic rhetoric builds across the Americas, Europe and China.

In a data intensive world there were several milestones in the quarter. A 95% devaluation and partial adoption of a crypto currency in Venezuela wins the prize for extremity but Argentina increased rates to 60% and Turkey to 24% as liquidity withdrawal hurt weaker Emerging Market players. Meanwhile the Indonesian Rupiah fell to its lowest level against the dollar since the 1998 Asian crisis and both India and South Africa saw their currencies impacted significantly.

US wage growth recently hit a nine year high and, unsurprisingly, almost simultaneously Two Year Treasury Bond Yields hit a ten year high.

Japanese workers fared even better, with bumper bonuses taking total pay increases to a twenty three year high, whilst here in the UK both wages and CPI accelerated.

All of this happened despite increasing acceptance that global growth has peaked, with the slowdown being particularly acute thus far in Emerging Markets and Europe.

In July, Chinese Fixed Asset Investment growth decelerated to a record low of 3%. From 2002 to 2016 it had always grown double digits. Retail Sales growth also slowed, as did the Caixin Purchasing Managers Index. However, this is not lost on the authorities and they have cut interest rates, as well as reducing both corporate and income taxes. We should stress these moves are aimed at controlling the slowdown (especially in the face of US tariffs) and don’t have the scale or goals of the massive 2015 stimulus.

Europe has suffered the triple whammy of a slowing China (bad for exports), a strong Euro (bad for exports) and sentiment being hurt by the threat of a tariff war with the US (bad for exports). Fortunately, domestic demand and supply of credit are still good and, in fact, except in comparison to last year’s incredible (for Europe) growth, this would be viewed as an excellent year in which growth will approach 2% – still above trend. Furthermore, recent releases have pointed to a stabilisation of growth and the Euro has been falling for a while now against the dollar. Indeed of late, the Citigroup Economic Surprise Index for Europe has risen above that of the US after being below almost all year.

The US is only slowing from an exceptional 4.2% in Q2 to a bit over 3% in Q3 and is thus still way above trend as the impetus from tax cuts and deregulation remain strong. Rising interest rates and a strong dollar will add to the hangover but for now the drink is still flowing (although both autos and houses have suffered weakening sales as higher rates bite).

Mr Abe has maintained power in Japan and the economy seems to be rebounding from earlier weakness, as evidenced by double-digit growth in both machinery orders and economy-wide capital expenditures.

We can’t really leave Macro without addressing Brexit and Trade. The former is nearing the end game but history suggests any deal will be last minute. We then need to get it through parliament, which if anything seems harder than securing a deal. However, my central thesis is that common sense will prevail on both counts, if more to keep Corbyn out than because any deal is viewed favourably. This outcome is by no means certain, just most likely.

The trade issue is, in my opinion, about more than trade. It is primarily about slowing China’s ascendancy and thus will be a long running feud with the occasional detente.

Some economists I met recently thought that Germany was the next target on the Trade War hit list after the midterms. They added that zero tariffs on autos are not a goer, as the US currently imposes 25% tariffs on light truck imports. Without these, the US auto industry would not be profitable at all! However, if a tariff war ensues, German car companies and US consumers both have a lot to lose.

Finally, as investors begin to wonder whether we are at the end of deflation, I would like to offer up two anecdotes which I have never seen before. Firstly, Ryanair employees in several different countries have coordinated action against the company. Secondly (on a very small scale), workers at J D Wetherspoon, TGI Fridays and McDonalds have agreed to strike together for better conditions. These are very small beginnings but are indications we may have passed the point of labour being at its weakest. Combined with a world of lower migration and higher tariffs, the odds of an inflation regime change are rising.

Markets
Markets have proven resilient this quarter as economic growth and company earnings have battled interest rates and geopolitics. They also had finished the prior period on a weak note and all but the S&P remain below their peaks in January.  The US and Japan have been the clear winners in the third quarter, as China and the UK have been at the sharp end of politics shenanigans. As mentioned above, bonds have not provided their usual safe haven benefits whilst the pound has battled back after a battering early in the quarter.

The table below depicts the changes in selected assets since close 29th June 2018 until morning on 26th September 2018.

Macro Overview Rates are going up; rates of interest, rates of tariffs and rates of inflation. Heart rates are also going up in the seats of power as Trade War, Brexit and nationalistic rhetoric builds across the Americas, Europe and China. In a data intensive world there were several milestones in the quarter. A 95% devaluation and partial adoption of a crypto currency in Venezuela wins the prize for extremity but Argentina increased rates to 60% and Turkey to 24% as liquidity withdrawal hurt weaker Emerging Market players. Meanwhile the Indonesian Rupiah fell to its lowest level against the dollar since the 1998 Asian crisis and both India and South Africa saw their currencies impacted significantly. US wage growth recently hit a nine year high and, unsurprisingly, almost simultaneously Two Year Treasury Bond Yields hit a ten year high. Japanese workers fared even better, with bumper bonuses taking total pay increases to a twenty three year high, whilst here in the UK both wages and CPI accelerated. All of this happened despite increasing acceptance that global growth has peaked, with the slowdown being particularly acute thus far in Emerging Markets and Europe. In July, Chinese Fixed Asset Investment growth decelerated to a record low of 3%. From 2002 to 2016 it had always grown double digits. Retail Sales growth also slowed, as did the Caixin Purchasing Managers Index. However, this is not lost on the authorities and they have cut interest rates, as well as reducing both corporate and income taxes. We should stress these moves are aimed at controlling the slowdown (especially in the face of US tariffs) and don’t have the scale or goals of the massive 2015 stimulus. Europe has suffered the triple whammy of a slowing China (bad for exports), a strong Euro (bad for exports) and sentiment being hurt by the threat of a tariff war with the US (bad for exports). Fortunately, domestic demand and supply of credit are still good and, in fact, except in comparison to last year’s incredible (for Europe) growth, this would be viewed as an excellent year in which growth will approach 2% - still above trend. Furthermore, recent releases have pointed to a stabilisation of growth and the Euro has been falling for a while now against the dollar. Indeed of late, the Citigroup Economic Surprise Index for Europe has risen above that of the US after being below almost all year. The US is only slowing from an exceptional 4.2% in Q2 to a bit over 3% in Q3 and is thus still way above trend as the impetus from tax cuts and deregulation remain strong. Rising interest rates and a strong dollar will add to the hangover but for now the drink is still flowing (although both autos and houses have suffered weakening sales as higher rates bite). Mr Abe has maintained power in Japan and the economy seems to be rebounding from earlier weakness, as evidenced by double-digit growth in both machinery orders and economy-wide capital expenditures. We can’t really leave Macro without addressing Brexit and Trade. The former is nearing the end game but history suggests any deal will be last minute. We then need to get it through parliament, which if anything seems harder than securing a deal. However, my central thesis is that common sense will prevail on both counts, if more to keep Corbyn out than because any deal is viewed favourably. This outcome is by no means certain, just most likely. The trade issue is, in my opinion, about more than trade. It is primarily about slowing China’s ascendancy and thus will be a long running feud with the occasional detente. Some economists I met recently thought that Germany was the next target on the Trade War hit list after the midterms. They added that zero tariffs on autos are not a goer, as the US currently imposes 25% tariffs on light truck imports. Without these, the US auto industry would not be profitable at all! However, if a tariff war ensues, German car companies and US consumers both have a lot to lose. Finally, as investors begin to wonder whether we are at the end of deflation, I would like to offer up two anecdotes which I have never seen before. Firstly, Ryanair employees in several different countries have coordinated action against the company. Secondly (on a very small scale), workers at J D Wetherspoon, TGI Fridays and McDonalds have agreed to strike together for better conditions. These are very small beginnings but are indications we may have passed the point of labour being at its weakest. Combined with a world of lower migration and higher tariffs, the odds of an inflation regime change are rising. Markets Markets have proven resilient this quarter as economic growth and company earnings have battled interest rates and geopolitics. They also had finished the prior period on a weak note and all but the S&P remain below their peaks in January. The US and Japan have been the clear winners in the third quarter, as China and the UK have been at the sharp end of politics shenanigans. As mentioned above, bonds have not provided their usual safe haven benefits whilst the pound has battled back after a battering early in the quarter. The table below depicts the changes in selected assets since close 29th June 2018 until morning on 26th September 2018.

Activity, Positioning & Outlook
I reiterate the point that we are at a point of historical change in the international order and this makes the already difficult task of forecasting almost impossible.

The US administration is taking an unusual strategy of fighting (economically) on as many fronts as it possibly can. Such a strategy inevitably fails in war and its results in economics are likely to be sub optimal over time as well. Contemporaneously, China is trying to deleverage without slowing economic growth by too much – following a period during which they have taken on debt at a rate which caused all emerging markets before them to incur serious economic problems.

Europe and the UK have their own issues which need not be repeated here.

All this is occurring at a time where the biggest buyers of bonds (Central Banks) who were price insensitive, turn into net sellers for the fist time in a decade. To put this in perspective, on some months the ECB bought back seven times the amount of bonds that had been issued by European governments. It beggars belief this did not distort the price of European Bonds as well as leaking into UK and US bond markets.

We therefore must be very judicious in what we do and drill into what is currently discounted in asset prices. The US is furthest along a normalisation of its bond market and we can observe that yields on 10 Year Government Bonds have more than doubled in just over two years. I see little reason why this won’t happen in each of Europe and the UK. If someone had predicted in January what would happen to growth, politics and the stock markets in the UK and Europe over the next eight months, I bet they would have wrongly predicted that bonds would have provided significant positive returns, as opposed to the mostly negative returns that transpired.

Two further rate rises from the Fed are a given and the ECB is committed to tapering in Q4 so liquidity will continue to leave the market. Gilts may have a short term rally on news of a hard Brexit but is unlikely to be long lasting as tariffs and barriers to trade are inherently inflationary, as is reduced immigration. A more amicable Brexit will be equity friendly but not so for Gilts.

We have kept to our plan of gradually adding to the UK on weakness – doing so in three tranches. Many Domestic UK stocks are cheap and have decent profitability and dividend growth prospects. However, we will only add incrementally from here as our risk discipline means we want to limit any further Brexit inspired downside. It is likely that we would use such downside as a buying opportunity, as the market would react quickly and life will continue post Brexit.

The other trade we enacted was to initiate an initial position in physical gold which has sold off meaningfully over the last few years. We bought as it could act as a hedge in a risk off environment or in one where either the US dollar weakens or one where the market starts believing more in rising inflation. We are happy there is more than one way we can profit from this trade.

Our frustration on Japan is a broken record but as the tables below from Neptune Asset Management shows, the fundamentals are fine.

Harpsden Q3 2018

With fundamentals and valuations still in our favour we will run the position but not add unless significant weakness occurs, as this is a volatile sector.

We have financed some of our incremental purchase from cash and from our Income ETF in the US as the dollar is both highly valued and a crowded trade, whilst US equities have outperformed on a rate of absolute and relative earnings growth which are very unlikely to be repeated next year. We could be a little early but incrementally recycling some of this money makes sense as the market is pricing in little probability of policy error from either the Federal Reserve or White House, whilst investors seem to be pricing in risk in practically all other markets globally.

I would not hold my breathe on US regulators actually imposing any sanctions on the big platform technology companies anytime soon but headline risk will occur from time to time. There is more risk in Europe and, in fact, the Chinese have imposed significant pain on their technology sector by restricting revenue from new game releases and pushing for limits on how long children spend on their phones. Such concerns, along with issues at both Apple supply chain companies and memory semiconductor providers, has meant the technology sector returns have been a lot more heterogeneous this year than last.

One thing to watch out for in coming quarters is profit warnings from Multinationals who are facing disruptions to their global supply chains.

Indeed in the quarter it was the traditional defensive stocks that provided much of the upside.

Healthcare has picked up significantly this year and we have been sorely tempted to buy earlier in the year, as valuations were muted and profits improving. This is usually the ideal recipe for us but we avoided temptation (wrongly thus far) as the sector is on Mr Trump’s hit list and we could be one tweet away from significant share price dislocation. This is a scenario we want to avoid for our clients. We will, however continue to search for opportunities in what is an attractive sector longer term due to demographics.

The table below illustrates asset allocation trades in Q3.

Harspden Asset Allocation Trades Q3 2018

Conclusion
In conclusion, we continue to take advantage of opportunities as they arise but are wary of fully committing on the basis that global liquidity is tightening and geopolitics is exerting an influence on economies on a scale seldom experienced. Therefore, keeping some powder dry and moving incrementally seems to be the most judicious way of participating in upside whilst avoiding full participation in any sudden (or protracted) downdrafts that may occur.

Current Asset Allocation

Harpsden Asset Allocation Q3

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.

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

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