Quarterly Portfolio Update – Q1 2019

What had been a fairly flat year to the end of Q3 2018 for the portfolios and markets, turned negative for the calendar year due to the market downturn witnessed in Q4 2018.

The last quarter certainly proved to be a challenging one for investors. We saw several markets enter a bear market during December 2018 (for reference, a bear market is defined as one where the index falls 20% from its high). One of the most affected was the NASDAQ (the US Stock Market consisting of mainly Technology companies), which had, up until this point, been the index that had powered the bull rally.

So what caused the sell off? There are a couple of reasons that one could look to blame for the heightened volatility in markets. The first is the ‘inverted yield curve’. An inverted yield curve (in this case it is the US Treasury yield curve) can often be seen to forecast slower economic growth and precede recessions. An inverted yield curve is where a US Government bond (Treasury) with, for example, 2 years left to maturity provides an investor with a better yield (return) than a US Government bond with, for example, 10 years left to maturity. And it is this relationship (2 Year vs 10 Year US Treasuries) that is most frequently observed by believers of the predictive nature of the yield curve. As yet, this relationship has not inverted (i.e. the 10 Year Treasury pays still pays slightly more than the 2 Year), but it has gotten mighty close. The other reason is the ongoing trade war between the US and China, which we’ll discuss in more detail in the Global Economy section.

And these two points of concern will spill over into, at the very least, Q1 2019. On top of these, we have to add Brexit into the mix.
Within each of these three themes, varying aspects will appear more or less pivotal in the following weeks and months. And, of course, exchange rates, interest rates and stock prices will wax and wane in their fashion, as events bump our understanding of what might be. That much is certain.

Equally likely is that you will hear, or you will read, that ‘markets dislike uncertainty’. When you do, roll your eyes please. Insofar as markets could manifest approval or disapproval, we’re pretty sure they wouldn’t dislike uncertainty. Markets owe their very existence to uncertainty. Without it, we wouldn’t need markets.

We will concede that markets cannot help to solve all of the world’s ills – but we do know that markets represent the most successful system we’ve devised for coping with conditions of uncertainty in a great many walks of life. Of course markets don’t always deliver a happy outcome for all parties at all times (prices can go down as well as up) but the broader picture is one of huge economic benefit.

It is worth highlighting that the ‘market’ volatility recently seen isn’t something new. Sure, the VIX index (the index that measures volatility of the US stock market) rose, but the highest close in Q4 2018 was lower than that observed in February this year and comfortably short of the volatility seen in 2008-09.

So it is for these reasons that, despite the concerns around heightened market volatility, we think it right to retain exposure to ‘markets’ in our portfolios, albeit retaining a slightly more cautious and a well diversified approach.


with Steve Williams

The UK has a market economy that is nearly unparalleled in it’s development. Important capital indicators – like the aforementioned exchange rate, interest rates and stock prices – are constantly in flux, influenced by events in real time.

Those fluctuations might appear to be part of the problem, but they are really part of the solution. If, for example, savers the world over fear for the future of the British economy our exchange rate will fall. In turn, a lower exchange rate offers overseas investors a discount on UK assets, reduced relative labour costs, an improved current account and it makes British manufactured goods and services more competitive. All of that happens very quickly and does not require intervention from policymakers.

There are other aspects of the British economic landscape that contribute to its resilience. We have a legal system enshrining rights to ownership of property with the full weight of 1,000 years behind it. We have a vigorous political system, a free press, some of the best educational institutions in the world, more Nobel Laureates than any country barring the USA (and nearly twice that of the French), enviable cultural clout and, in the main, a healthy long-living populace with a predilection to work hard and shop hard.

It is quite reasonable to debate whether the UK will be the best place to invest money over the next few years – just as we could argue the same for the USA, Germany or Japan. But what is more certain is that the UK is a good place to invest.

Brexit, whatever the outcome, won’t change that.

Actually, while we are on the subject of investment in the next few years, we are now more keen to hold domestic stocks.

For a start, they’re cheaper than they were last year – value stocks are down 9.5%, blue chip stocks are down 7.5% and the middle- and smaller-sized company stocks are down 13.1% and 15.6% respectively. In addition, domestic stocks are yielding 4.6% in the aggregate.

However, it would be foolish not to acknowledge what are significant risks to the downside in the near term. The broader backdrop too is one of elevated market valuation.


Bank of England Base Rate

The pace at which interest rates are rising in the US is not something us Brits can really relate to. Sure, there was an interest rate in August of 0.25%, but that leaves our base rate sitting at just 0.75%, some 1.75% of the interest rates from across the pond. Although it could be worse for cash savers, the European Central Bank have kept the deposit rate the same for nearly 2 years, at -0.40%!

Once again, the projected path for UK interest rates depends a lot on the way the UK breaks from the European Union (if at all!). But it is safe to say markets remain subdued when it comes to pricing in future rate rises. Current overnight index swap forward rates (what we use as a guide for how markets see interest rates moving) looks to be pricing in one rate rise of 0.25% sometime in the middle of 2020 (to a whopping 1% per annum) and then another 4-5 year wait before another 0.25% rate rise.


Pound Sterling

The last quarter saw the Sterling Trade-Weighted Index fall 2%, it’s lowest month end value since August 2017. Looking at the exchange rates in the table on the right, compared to one year ago, sterling is off over 5% against the dollar (£1/$1.35 this time last year) only 2% against the Euro (£1/€1.13 this time last year) and nearly 8% off against the Yen (£1/¥152 this time last year). It is perhaps the next three months where we could see volatility in Sterling pick back up, but which way the market moves to generate this volatility is the question. Of course, it is almost entirely based on whatever the outcome is in relation to Brexit.


with Scott Mordrick, CFA

In the Q4 2018 Market Outlook, we began this piece with the strap line “The trade war rages on!”. We’re here to report that 3 months have passed and this caption still rings true. The 10% tariffs first imposed by both China and the US in the middle of September still remain. It could have been even worse, with the threat of an increase of the tariffs, with the Americans threatening to increase them to 25%. However, on 02 December, US President Donald Trump and his Chinese counterpart Xi Jinping agreed to halt new trade tariffs for 90 days to allow for talks, after meeting a post-G20 summit meeting, in the first face to face meeting between the two leaders since the trade war began. The White House commented that “China will buy a ‘very substantial’ amount of agricultural, industrial and energy products”. However, warning shots were also fired in said press release “If at the end of this period of time, the parties are unable to reach an agreement, the 10% tariffs will be raised to 25%”.

Meanwhile it isn’t just overseas where President Trump is finding ‘enemies’. According to his most recent tweets, he may need to look no further than his country’s central bank and Mr Jerome Powell, whom he has privately discussed the possibility of firing (this sentence can’t stop us from picturing his waggling finger whilst muttering those words from his Apprentice days). In December the Fed agreed to raise rates by 0.25% to a range of 2.25%-2.5%. To perhaps calm both the markets and Mr Trump, the Fed has lowered its “dot plot” (which is its median rate projection). They now expect just two interest rate rises this year as opposed to the previously expected three. Perhaps this is also a reflection of more subdued GDP growth forecasts, both in the US and around the world, which were revised down for both 2018 and 2019. According to the world bank, global economic growth is expected to slow, with advanced economies GDP forecast to fall to 2.0% for this year, down from an estimated 2.2% for 2018.

And it isn’t just developed economies that are experiencing lower growth forecasts, China plans to lower its economic growth to 6% for 2019 at its annual parliamentary session in March, down from its 2018 target of 6.5% .

In Europe, we saw the end of the dispute in December between Italy and the EU after the Italian Government agreed to delay some spending measures. This agreement has done little to allay concerns about the country’s economic stability, with banks and financials still looking, at best, weak.


Economic Overview

There are those that are utterly convinced that the US yield curve will invert in a matter of weeks or months. Taking it one step further, there are those that are similarly convinced that an inverted yield curve will be unfailingly followed by a recession. Further still, a recession will occur not more than 18 months hence.

Now, we’re not minded to dismiss that view. We think it entirely plausible that such a sequence of events may come to pass. But we are not wholly persuaded by a narrative which is, by now, very widely held. There are a couple of reasons for our scepticism of the predictive nature of the curve.

First the yield curve doesn’t demonstrate a flawless track record. We count 15 recessions in the USA over the last 100 years. Only 9 of those were preceded by an inversion of the 10-year/2-year rate. The full set of signs reads; 10 inversions with 9 subsequent recessions and 6 ‘missed’ recessions meaning that the yield curve scores 56%. Mind you, if we restrict our analysis to just the last 50 years that score rises to 100% because all 7 recessions in that timeframe were indeed preceded by an inversion.

The other reason is that the bond market just isn’t what it used to be. Recessions aren’t caused by an inverted yield curve, inversions do little more than predict recessions. That predictive power – comprising the ‘wisdom of crowds’ – comes from the aggregated behaviour of those that participate in the bond market. Some of those participants are more active than others, contributing ‘wisdom’ disproportionately. Today, the Fed is a significant participant. The Federal Reserve Bank of Dallas calculates a market value for US treasuries at something like $15.4 trillion while the Federal Reserve Board of Governors values the debt it holds at $2.2 trillion. That’s around 15% of the market. Importantly, the Fed is what we would call a passive participant and it could be that the Federal Reserve, in rightly engaging a policy of quantitative easing, has inadvertently diminished the effectiveness of one of the more reliable economic indicators.

Setting the complexities of the yield curve aside, it seems likely the US economy is indeed slowing. Q3 2018 was witness to growth in the region of 3.5%. It looks likely that the fourth quarter will come in at 2.5%. And, looking ahead there’s a good chance that Q1 2019 comes in at a surprising low level – the consensus comes in at something like 2.3% but we think the risks are weighted to the downside of that.

The prospects for the US economy for the year are muddied by a great deal of uncertainty attached to the current round of Sino-US trade negotiations, and in particular whether or not the full threatened 25% tariff on Chinese imports comes into force. In any case, trade talks are a sub-set of what we think is the geopolitical struggle of this generation – that between China and the USA. China’s rising economic and military power has been unchecked by the USA. That is changing. A new arms race – focussed on emergent technologies – is apparent. In the main, it will manifest in the form of tariffs, sanctions and other regulatory exclusions designed to ringfence US innovations. The US will not shy away from conventional projections of might too. Closer diplomatic support for Taiwan and ongoing cooperation with Japan will play a pivotal role in that regard.


Economic Overview

Twenty years ago, on 01 January 1999, the Euro was introduced in electronic form for 11 of the 15 countries that, back then, made up the European Union. We’d say it has been a success. We mean, it’s still here isn’t it. Quite how far we’d go in describing the Euro as a success is another thing. We certainly wouldn’t travel quite the same distance as Sabine Lautenschläger, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB. In an interview with Deutschlandfunk, she asserts that monetary union has ‘definitely been a success’. ‘We should not forget…’ she preaches ‘…that the EU, and therefore the Euro, has also been immensely important in preserving the peace that we have enjoyed in the Euro area, in the EU, for the past 70 years’.

Now, we enjoy living in an era without continent-wide conflict as much as the next man or woman, but we’re just not sure the Euro is one of the key determinants of that peace. Mind you, if we’re wrong and the Euro really is the key to avoiding catastrophe, then rising Euro scepticism – in France, Italy and even to some extent in Germany too – ought not to be taken too lightly. It is lucky, then, that Sabine Lautenschläger believes that Euro scepticism can be soundly defeated. All we need do is ‘…explain that the Euro simplifies trade between Euro area countries and brings economic prosperity and jobs’. Well, that ought to be enough for the Germans where the Euro area very likely has brought a new level of economic prosperity. But the problem is that the Italians have some experience of the counterfactual, as do the Greeks. Others have noticed too.

Still, the Euro persisted even during 2011-12, when the ‘Euro crisis’ threatened a spectacular round of sovereign defaults for the PIIGS.
Mario Draghi’s promise, on the 27 July 2012, to do ‘whatever it takes to preserve the Euro’ signalled the moment that policymakers began to take the threat seriously. New loans and restructured old loans played their part but the Euro was really saved by the ECB’s gigantic programme of asset purchases. Beginning in March 2015, the ECB has allocated around €2.6 trillion of newly issue reserves for the purchase of Euro zone bonds of one kind or another. Net purchases continued all the way through to December last year. One of the more immediate effects of the ECB’s policy of quantitative easing has been to force government bond yields lower. The 10-year rate for Italian bonds was ~7.5% during the crisis but held at less then 3.0% while the ECB was hoovering bonds. Portuguese, Spanish, Irish and Cypriot bonds are similarly yielding less than 3.0% today.

A less immediate effect, and another important objective for the ECB in the aftermath of the 2008 financial crisis, has been to ward off deflation. Indeed, early in 2015, the headline rate for the Harmonised Index of Consumer Prices fell 0.6% year-on-year. The most recent data calculates inflation at a little over 1.5%. As it happens, 1.5% is sharply lower than nearer 2.0% a month earlier.

Monetary policy remains unusually accommodative in the Euro zone. Net purchases may have ceased but the giant central bank will not be selling any of the bonds it has amassed and it will continue to buy new bonds with the proceeds of coupon and maturity payments, maintaining a steady balance sheet in the process. Additionally, the main policy rates of interest lie at, or less than, zero and, if the bank’s promises are anything to go by, they aren’t going to budge from there until at least the summer of this year.


Economic Overview

Barring the odd quarterly contraction, the Japanese economy is on track to match the country’s longest post war recovery. The most recent data point to 71 recession-free months of output growth stretching back to December 2012. That compares with a record 73 months.

Of course, a sustained increase in gross domestic product is a good thing, but other key indicators – such as the Consumer Price Index and wage growth measures – cloud the view. First though, the good news…

Prime Minister Shinzo Abe’s ‘three arrows’ package of reforms contained, amongst other things, a set of initiatives intended to transform the Japanese labour market. And while ‘transform’ may be pushing our definitions a little, it is easy to argue that there have been some very positive moves in that regard. For a start, unemployment currently stands as low as 2.5%; a 25-year low. And while Japan’s working age population has shrunk by 4.7 million in the last six years or so, the Wall St Journal reports that the number of people in work has actually increased by 4.4 million over the same period.

Policymakers efforts to encourage more women, more older folk and, to some extent, more foreigners into work is key to that success. A stronger labour market ought to encourage competition among employers and that, in turn, ought to encourage stronger wage growth. Stronger wage growth may, in time, help the Bank of Japan to achieve its 2.0% inflation target and at that point Japan can very likely close the book on two decades of economic malaise.

But we are not there yet.

Headline inflation over in Japan is currently measured at 1.4% year-on-year. Underlying that, core inflation (which excludes volatile food and energy prices) is estimated to have increased at just 0.4%. That is a mile off the target rate. Mind you, some inflation is better than none and the damage wrought by years of deflation might now be mended.

The one key indicator we would like to see improve is the Real Wage Index. Wages, after inflation, were down 2.8% in 2014, down 0.9% in 2015, up 0.7% in 2016 and down 0.2% in 2017. The 2018 figure is not yet in but we’d hazard a guess at a low positive increase over the year. Still, we are yet to see a sustained increase.

And, on that front, trouble is brewing. As part of the government’s efforts to address its huge fiscal deficit it has scheduled an increase in consumption tax (the equivalent of our VAT) from 8.0% to 10.0% for October 2019. Policymakers have delayed that increase twice before because of the havoc it brought in the form of plunging retail sales with a knock-on effect on economic output and falling inflation.

As an aside note that Japan’s debt-to-GDP ratio stands at 253%. That compares with Greece at 179% and Italy at 132%. (In case you’re wondering the comparable figure for the US is 105%, the UK is 85% and Germany is down at 64%).

We think it not unreasonable to conclude that there are grounds for optimism for the outlook for Japan – certainly compared with the outlook at the same point in recent years.


Economic Overview

There’s a reason Chinese stocks have fallen into a bear market; the broader Chinese economy is slowing. Evidence for that is contained in the most recent Purchasing Managers’ Index reports for the manufacturing sector.

December’s PMI from official sources stands at 49.4. Coming in below the neutral 50.0 mark, the survey’s respondents are indicating that manufacturing output is contracting a little. At the same time the unofficial report, compiled by Markit/Caixin, has fallen to 49.7. Taken together we can conclude, loosely, that output is falling at both large, state-owned firms (the focus of the official report) and smaller, private enterprises (as reflected in the unofficial report).

We take it that both external and domestic demand for Chinese goods is subdued, as is consistent with a slowing global economy. A Sino-US trade dispute is at least partly responsible for all of this, but there is good reason to believe a slowdown in Chinese output growth is inevitable. If we’re right, policymakers face a choice – they can continue with moves to deleverage a debt-ridden economy and accept an orderly slowdown as output moves to more sustainable levels, or they can encourage further borrowing to underpin high rates of growth today and risk a more spectacular, disorderly slowdown in future. In so far as we can tell, China is responding to the US challenge by encouraging even more lending.

A week or so ago, for example, China’s Premier of the State Council of The People’s Republic of China, Li Keqiang, ordered three of the largest state-owned banks to allocate as much as 30% of new lending to smaller Chinese businesses. And that lending was to be granted at specially low rates of interest.
That’s fine, assuming that the beneficiaries of those loans are businesses with good ideas likely to be fruitful enough to repay the debt. But something tells us that won’t be universally true. And of course, the lending banks have little choice but to make the loans as ordered.

Beyond the build up of bad debt and the inevitable misallocation of large pools of capital, China has another problem looming on the horizon. Here’s how Stratfor, a geopolitical intelligence firm, summarise the problem…

“Chinese society is on the verge of a structural transformation even more profound than the long and painful project of economic rebalancing, which the Communist Party is anxiously beginning to undertake. China’s population is aging more rapidly than it is getting rich, giving rise to a great demographic imbalance with important implications for the Party’s efforts to transform the Chinese economy and preserve its own power in the coming decade… The crux of China’s demographic challenge lies in the fact that, unlike Japan, South Korea, the United States and Western European countries, China’s population will grow old before the majority of it is anywhere near middle-income status, let alone rich. This is historically unprecedented, and its implications are made all the more unpredictable by its coinciding with the Chinese economy’s forced shift away from an economic model grounded in the exploitation of inexhaustibly cheap labor toward one in which young Chinese will be expected to sustain the country’s economic life as workers and as consumers. A temporary reprieve from the demographic crisis will be difficult but possible with reform, but a long-term solution is far out of reach”.


Economic Overview

The International Monetary fund sees ‘mixed prospects’ for medium term growth across the emerging markets….

Projections remain favourable for emerging Asia and emerging Europe, excluding Turkey, but are tepid for Latin America, the Middle East, and sub-Saharan Africa, where—despite the ongoing recovery—the medium-term outlook for commodity exporters remains generally subdued, with a need for further economic diversification and fiscal adjustment.

We can’t see anything to disagree with in there. We still remain cautious on the prospects of Emerging Markets, particularly with the slowing of global economic growth in the developed economies and the possibility of a persistent strong dollar. However, Emerging Markets tends to be the space that generates the greatest amount of return (in positive markets, at least), so to completely disregard the sector would be foolish. Any further allocation to the space would likely be done at a slow and steady pace.


UK Property Market

The Nationwide House Price Index (HPI) revealed that annual house price growth slowed to its weakest pace since February 2013, at just 0.5% for the calendar year, down from 2.6% in 2017.

Robert Gardner, Nationwide’s Chief Economist notes:

“This marks a noticeable slowdown from previous months, where prices had been rising at a c2% pace… Indicators of housing market activity, such as the number of property transactions and the number of mortgages approved for house purchases, have remained broadly stable in recent months, but forward-looking indicators had suggested some softening was likely.

In particular, measures of consumer confidence weakened in December and surveyors reported a further fall in new buyer enquiries towards the end of the year. While the number of properties coming onto the market also slowed, this doesn’t appear to have been enough to prevent a modest shift in the balance of demand and supply in favour of buyers.”

Meanwhile, in the commercial sector:

“The Q3 2018 RICS UK Commercial Property Market Survey results point to a fairly subdued trend across the occupier market, with respondents citing Brexit uncertainty as weighing on occupier decisions to a certain extent…

At the headline level, occupier demand fell slightly for a second consecutive quarter, with the net balance coming in at -9% (compared to -8% previously). Nevertheless, this average reading is still concealing significant disparities between the three traditional sectors of the UK market. Indeed, demand for industrial space continued to increase, albeit at a moderated pace, thereby extending a run of uninterrupted growth going back to 2012. At the same time, interest from tenants in the office space remained little changed. At the other end of the spectrum, demand from businesses looking to take-up retail space continued to fall for a sixth quarter in succession”

And it is these concerns regarding UK Commercial Property that led us to remove any exposure to UK Commercial Property in the portfolios (our only exposure to Property is to a global Property fund). Indeed, we have already seen 2 asset managers swing the prices on their funds (by ~6%) on the back of cooling interest in the sector. We expect more asset managers may well follow suit in the coming month.