Q3 Commentary, October 2019

Macro Overview
And the quarter started with such good news! On July 1st the US and China agreed a truce as the latter agreed to buy more US agricultural products and in return President Trump suspended further tariffs and restarted certain Huawei dealings. Alas that was not to last and since then the economy has worsened as the cumulative actions of politicians have managed to manufacture another manufacturing recession. Corporate confidence has been eroded by automobile emissions regulation, trade wars and Brexit. Fortunately, as yet the Services and Consumer sectors are merely growing less fast and not following their manufacturing brethren into negative territory. However, manufacturing everywhere has been affected and why wouldn’t it be if managements don’t know what tariff or regulatory regimes they will be operating under?

Chart 1. US Manufacturing

Examples of the contraction include the volume of U.K. property transactions falling 31% in the first six months of 2019 compared to the prior year, U.K. manufacturing hitting its lowest level since July 2012, International Energy Agency slightly reducing their oil demand forecast for the year, German Industrial Production contracting at the worst rate since 2009, Chinese Industrial output growing at the lowest level in seventeen years, Japanese Manufacturing PMI staying below 50 for the fourth consecutive month, US Purchasing Managers Index for July hitting the lowest level in ten years whilst the US Manufacturing PMI had its first reading below 50 since August 2016.

Not pretty reading!

As there is circular cause and effect with the above it is no coincidence that corporate confidence readings fell in each of the U.K., Europe and the US. Neither, in my mind, is it a coincidence that in their second quarter updates nearly 60% of all European companies mentioned trade wars whilst in the US 70% of managements referred to tariffs.

What, in my opinion, differentiates this macro environment from prior slowdowns is that Central Banks have acted much quicker than they would have done in the past. They have also been more vocal (particularly in Europe) about chivvying governments to embark upon Fiscal expansion. Mr Trump is obviously going the other way and ear bashing the Federal Reserve to cut rates aggressively as his own fiscal expansion ebbs.

China, India, the U.K., Thailand and (the usually reticent) Dutch have already embarked on fiscal easing to varying degrees and the Germans are even beginning to talk the talk, pledging €50 billion when needed – they just don’t think it is required yet despite their manufacturing malaise.

Even as the ECB went “all in” with renewed rate cuts and stimulus ECB Chief Draghi commented “..it’s high time, I think, for fiscal policy to take charge”.

As well as US housing, US manufacturing pleasantly surprised in August whilst money supply in Europe has actually accelerated of late to over 5%. In China, retail sales continue to grow above 7% year on year whilst here mortgage approvals hit a ten year high in July. In addition, wage growth is still very strong across the developed world. So if authorities can stem the leakage from manufacturing to services there are still areas with growth potential. Better still they could give businesses and investors clarity on trade and thus re energise the manufacturing sector.

As if constant droning on about trade wars wasn’t bad enough, at the end of the period we had physical drones escalating the military situation between Saudi Arabia, rebels in South Yemen and their Iranian backers. This sent a previously struggling oil price up by the most in one day since 1991 (when Iraq was the reason).

The US and Saudi are obviously blaming Iran. Meanwhile the Chinese have ignored American sanctions and committed to a twenty five year oil purchase agreement with Iran (at a meaningful discount of course). In addition they have committed to spending $80 billion over twenty five years to rebuild Iranian energy infrastructure and are sending 5,000 security personnel to help protect Iranian energy installations. They are also paying for the oil in Chinese currency, not dollars. Unlikely to help placate the US but reminds them China is not easily intimidated.

Amidst all of this I am tempted to side with Bank of America CEO Brian Moynihan who said that the most likely thing to cause a full blown recession was simply the fear of a recession itself (rather than a big economic event).

With all this doom and gloom I would like to try and instil a sense of perspective; Semiconductors, Energy and Autos have been at the epicentre of the Manufacturing slowdown. Each sector is already one year into such and signs of a bottom are (tentatively) emerging. We will expand on this below.

Chart 2. Worldwide Semiconductor Revenues (year-to-year percent change)

It was in September last year that we met the CFO of Microchip, a leading analog semiconductor company. At the meeting he expressed incredulity that his peers would not admit to seeing a downturn. Three months later all shared his gloom.

Of late there have been signs of stabilisation with inventories more under control and several companies saying the sell in rate is below the sell out rate therefore inventories are likely to improve further.

Similarly we can see the collapse experienced already by German automakers.

Chart 3. German car production in the last decade
Do we really think Chinese and Indian auto sales are going to remain depressed forever given the very low rate of per capita ownership and usage compared to developed economies? As I have mentioned previously, emission standard and subsidy changes are responsible for a good part of the slowdown and policy in both these large markets have already become more industry friendly. It is likely German auto production is in the process of bottoming (Brexit and increased trade wars notwithstanding) and will see a gradual recovery as Q4 progresses.

By the end of the year we will have had two consecutive years of falling global automobile sales so there is hardly a bubble here.

My view is that if investors and business leaders see stabilisation in these two very important parts of the industrial process then an overall improvement can follow.

Energy expenditures are already slowing year to date after an upcycle lasting only one year so this is another area where we can expect to see stabilisation going into 2020.

The “B” word continues to inflame with PM Johnson promising to “do or die” regarding an October 31st deadline and proroguing Parliament for longer than expected.

Ultimately all investors care about is whether it’s a deal or no deal Brexit with most adding the avoidance of a Corbyn Government to their wish list. The latter concern seems to be alleviated every time Mr Corbyn speaks about his policies. Whilst politics has surprised many, including me, of late it is not clear to me a majority of the country sees Mr Corbyn as a solution, even if Mr Johnson is seen by many to be a problem.

I would therefore be very surprised at an outright Labour Government being returned in the next election.

With regards to the ultimate Brexit outcome I remain hopeful the economic set back of a no deal will be avoided but am certainly not confident enough to bet big on it.

Whilst corporate debt levels are uncomfortably high to my way of thinking, I must accept that at the current meagre interest levels and with terms of loans being stretched out that this is unlikely to come home to roost anytime soon. Likewise consumers around the world are being helped/bailed out by the low rate regime and thus unless unemployment rises significantly default rates should not spike.

Markets

“Not for the faint hearted” would be an accurate description of market gyrations over the quarter as currencies, gold, bonds and equities all had significant intra period price movements.

China let the Yuan go above the psychologically important 7 level versus the dollar in retaliation to further tariffs whilst the Yen and Dollar remained firm as relative safe havens in an uncertain world. The Pound was one of the more volatile currencies falling nearly 5% by mid August before recouping most of the loss as markets re assessed the chances of a hard Brexit.

The table below shows performance of several key asset classes during Q3 2019;

Figure 1: Percentage change in markets and currencies in Q3

BlackRock U.K. Equity Income co- manager Adam Avigdori recently observed “…today there are c.150 companies in the FTSE All Share yielding more than 5%. The vast majority (c.80%) are companies whose revenues are predominantly derived domestically from the U.K. economy … it is likely some of this yield is not sustainable – specifically we have doubts in the retail sector and property – however, we believe most of it will be. And whilst the U.K. yield has got higher, yield compression in virtually all other asset classes (not Argentine bonds) has continued.” 5% yield constitutes a 25% return over five years without any capital appreciation or dividends reinvested. This is why a longer term perspective is required in volatile times.

There is an emerging narrative that is being increasingly quoted by financial commentators. It goes along the lines that investors have swapped around the long-standing roles of equities and fixed interest (bonds) whereby we now buy the former for income and the latter for capital gains.

According to Alliance Bernstein the last year has witnessed the biggest ever Asset Allocation switch out of equities and into bonds. It has, by their estimation, amounted to over $1 trillion dollars and happened at a time when the starting yields of bonds were very low. That is the extent of fear in the market place. As you know we were fearful at the end of 2017 but we expected a meaningful slowdown, not Armageddon, as many investors now fear.

Activity & Positioning

We said in our previous note that the summer usually offers up an opportunity or two amidst heightened volatility and once again it came to pass. “Sell in May and go away…” certainly had some resonance this year. As intimated then, we did proceed cautiously and added incrementally to our holdings in India and Japan whilst balancing risk by taking some profits in Merian Gold & Silver and Blackrock Continental European Income Fund as they both had benefited from being accorded safe haven status.

With Brexit ongoing we still haven’t committed more cash to the U.K. although we have our buy list ready. The decision is so binary that we are erring on the side of caution. I would rather do that than be even more at the mercy of politics. We will be trading on the day regardless of the outcome as opportunities will arise either way. This binary nature of the outcome was highlighted at the recent JP Morgan conference where their chief economist said Sterling will fall to $1.10 in a no deal and will trend up to $1.42 fair value if a deal is reached.

I have said above that Central Banks have acted earlier than they usually do in trying to stave off a general recession. I have also mentioned that the manufacturing sector is already in a recession. I think it is quite likely we are very close to the trough in the sectors mentioned above and all this loosening of policy could happen coincidentally with a cyclical upswing in these critical components of the manufacturing economy. How then will investors feel about their current economic slowdown obsession? Obviously the extent of any rebound will be influenced by Brexit and Trade War developments but the odds of a recovery are surely rising and further deterioration is likely to be limited and in any case nothing like 2008-2009.

Furthermore, I don’t know about you but I have read more about the importance of the inversion of the two year to ten year US Bond yield curve than I have about any other economic indicator of late. As per the great rotation into Bonds this year it implies investors are certainly more set up for a recession than they usually are ahead of time. So that brings me to another big difference between now and prior periods. The Fed started cutting rates seven months after raising them for the last time in December 2018. Before the last crises the Fed actually raised rates after the 2 to 10 Year inverted and didn’t cut for about 19 months after the final raise. Back then Central Banks were worried about energy led inflation. This time, if anything, they have their eye on deflation and are very keen to avoid such, as are governments.

Figure 2:  Portfolio changes in Q3 – RJIS

 

Conclusion

So when one combines the facts some parts of manufacturing have been in a decline for a while (the nascent recovery earlier in the year being sniffed out by the re- escalation of trade issues in May) and both Central Banks and governments anxious to avoid deflation, then there is a good chance things shall improve from here.

With most equity markets (key exception is the US) offering a yield premium of 250 to 400 basis points to their own government bonds and also a very big premium over corporate bonds, then my conclusion is that investors are being amply compensated for the extra risk and volatility.

Chart 4. French Equity Dividend Yield – French 10 Year Bond Yield (1870 – 2019)

Whilst I am very confident the strategy will deliver in most scenarios over the medium and long term I acknowledge it is unlikely to work near term in a hard Brexit, or if the US – China trade policy gets out of hand. However, all of the equity investor euphoria of late 2017 – early 2018 has evaporated and corporations have already scaled back. Governments and especially Central Banks are on the case regarding deflation. So from here I expect equities to outperform bonds meaningfully unless all the worst case scenarios come together.

I am therefore on the lookout to add to equities as opportunities arise whilst bearing in mind my responsibilities to contain volatility on the path to decent absolute returns over time.

On an important housekeeping matter this week it has been confirmed that the suspension of Woodford Equity Income is ongoing and early December remains the likely date of reopening.

The fund has restructured over £1 billion of the £3.4 billion portfolio with efforts ongoing to make it very liquid by the re opening date. This has had a big impact on portfolio holdings which should abate as time goes on. Woodford reiterate a domestic bias will be retained to take advantage of the value highlighted above.

As previously mentioned I will not commit either way on the fund until I see what is in it and what changes to ongoing liquidity have been implemented.

Best Regards,

 

Ian Brady

Chief Investment Officer

1st October 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.

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