Quarterly Portfolio Update – Q2 2019

Following the significant market sell off at the end of the last quarter, it was somewhat of a pleasing sight to see markets reverse some of these losses during the first quarter of this year.

It wasn’t just equities that rallied, the first quarter saw bond yields fall sharply (and consequently bond prices rise). The yield on a 10-Year Gilt (UK Government Bond) fell from 1.3% at the end of 2018 to just 1.1% at the end of March. Similarly, the yield on a 10 year US treasury fell from 2.7% to 2.4% over the same period. All the while, the yield on a 3 month Treasury remained unchanged over the quarter, leading to an ‘inversion in the yield curve (we cover the Yield Curve inversion in further detail later in this Portfolio Update).

There were several reasons that markets acted the way they did during the quarter. In the US, we saw an end to the Government shutdown (implemented by, who else, President Trump) as he tried to get through the house his funding for “the Wall”. There was also a clear change in sentiment from the US Federal Reserve. Having previously hinted at a couple more interest rate rises for 2019, from the current Fed Interest Rate of 2.5% to 3.0%, the Fed appear to have now changed their tune and have talked down any chance of a rate rise this year. In fact, the market is betting on an interest rate cut this year (not a view that we subscribe to).

Of course, being a member of the Federal Reserve is a far more precarious role these days, what with the President tweeting that it is their fault that Stock Markets are not “5,000 to 10,000 points higher” because of their actions.

Speaking of the Federal Reserve, there is currently a vacancy on the board of directors, for which Trump is expected to nominate Stephen Moore, a decision which has been heavily criticised due to Moore’s apparent lack of knowledge and experience, and his opposition to mainstream economic theories.

The weight of Brexit remains firmly around the UK’s shoulders, with delays being announced beyond March 2019. This uncertainty didn’t stop UK equities rallying in line with the rest of the world, particularly the more domesticated stocks. All focus now turns to Halloween – the next Brexit deadline, as to whether there will be a soft-Brexit, No Deal Brexit or No Brexit at all.

Whilst there were reasons to be cheerful and for markets to be buoyant, it would be remiss of us to ignore the other fundamental reasons why sentiment fell significantly at the end of 2018 – global growth concerns & the US-China trade war. There were concerns that we would see a slowdown in global growth (this is perhaps one of the strongest reasons the US Federal Reserve has changed its tune). In fact, the International Monetary Fund (IMF) has cut its forecast for global growth for 2019 to 3.3%, the lowest since the 2008 Global Financial Crisis. With regards to the trade talks, Mr Trump has reiterated these have been progressing well, but we will wait and see if there are not yet more tariffs slapped on Chinese and US goods – a situation which would undoubtedly cause yet more strain on global growth. For these reasons, we think it right to retain a slightly cautious and a well diversified approach in our portfolios.

THE UK ECONOMY

with Steve Williams

The Office for National Statistics is the only major-economy statistical authority to publish monthly estimates for gross domestic product. The most recent reckoning rates a 0.5% increase in output during January. That’s good news, especially since it follows a 0.4% decrease in December.

Growth over the most recent three-month period amounts to 0.2% and has been invariably described as ‘stalled’ or ‘stalling’. Given the flipping and flopping over Brexit though, we’d say the British economy is displaying a pleasing degree of resilience.

So too has the UK stock market. We’ve seen some underperformance vis-à-vis other major stock markets but nothing that ought to be of concern to a seasoned investor. Indeed, we will confess that we are still really quite keen to hold domestic stocks.

It looks to us that UK stocks (alongside selected eurozone investment, and German stocks in particular) offer a significant risk premium at current prices.

There’s good reason for that, of course; a great deal remains uncertain. And everyone is obsessing on that uncertainty. Here’s what the International Monetary Fund have to say in their most recent Economic Outlook, for example…

‘The baseline projection of about 1.2% and 1.4% growth in the United Kingdom in 2019–20 is surrounded by uncertainty. The downward revisions relative to the October 2018 WEO reflect the negative effect of prolonged uncertainty about the Brexit outcome, only partially offset by the positive impact from fiscal stimulus announced in the 2019 budget.’

This baseline projection assumes that a Brexit deal is reached in 2019 and that the United Kingdom transitions gradually to the new regime. However, as of mid-March, the form Brexit will ultimately take remained highly uncertain.

Of course, from the narrow perspective of the long-term investor, uncertainty begets opportunity

INTEREST RATES

Bank of England Base Rate

Our best guess, given an analysis of today’s market prices, is that the Bank of England’s Monetary Policy Committee will vote in favour of a 0.25% increase in Bank Rate sometime in 2021. Mind you, to say that there is an unusual amount of uncertainty attached to that forecast is to understate it. The market just cannot see past the next few weeks. A ‘smooth’ Brexit deal will accelerate the rate-rise schedule quite dramatically.

Beyond the short term, the market is currently priced to reflect expectations for Bank Rate to stand at something like 1.0% in 3 years and 1.25% in 5 years from today.

We are moving – at a glacial pace – from a period characterised by ultra-low interest rates to one characterised by plain-old low interest rates.

EXCHANGE RATES

Pound Sterling

After a fall in the value in Sterling in the last quarter of 2018, the start of 2019 saw Sterling appreciate significantly in value against other currencies. The trade weighted exchange rate grew by over 3%. This strengthening in Sterling is undoubtedly attributable to the fact that Brexit has been prolonged even further by the UK Government. Despite this surge in value over the quarter, Sterling (on a Trade Weighted basis) remains nearly 10% off its value as at the day before the referendum. As always, it will be the fall out from Brexit that will have the largest impact on how Sterling performs over the coming months.

THE GLOBAL ECONOMY

with Scott Mordrick, CFA

There are all kinds of things to be said about the US yield curve, but the hot potato is an ‘inversion’ which saw the yield on the 3-month US treasury bond register a higher rate than that on the 10-year treasury; an reversal of the normal relationship which sees longer-term rates higher than shorter-term rates. Cue panic about an imminent recession.

We have to admit that we are not especially concerned about the 10y-3m inversion. While it persisted for 5 days, it wasn’t matched at the 10y-2y level – where the spread remains positive– nor have
we seen a similar inversion in the corporate bond market.

Indeed, on a slightly different note, credit spreads look horribly tight to us still and that is not consistent with a significantly poor outlook as implied by bond market participants. For those reasons (and others), a recession in the US during 2019 is not our baseline expectation.

Having said that, we’re not taking the 10y-3m inversion lightly. It’s a mixed picture but our reading of a lot of the academic research on the subject is that the 10y-2y inversion is the more accurate of the many inversions that might signal trouble. But accuracy even there is not perfect and where it does have a strong record the inversion has to persist, on and off, for something like 90 days – a condition way off being met.

No matter, we can still expect equity markets to shift nervously while an inversion does persist. More generally, the inversion phenomenon’s track record has been established during what we’d call ‘normal’ market conditions. We’d argue that QE has changed the dynamic.

It may also be the case that inflation targeting (as the primary goal of independent central banks) might have similarly altered the market dynamic too. There is, for instance, some evidence to suggest that the ‘term premium’ has been wafer-thin for a while now, and unusually so. Quite how or why is more controversial than the observation itself but if that is indeed the case we’d say the inversion-recession hypothesis is fatally flawed in today’s markets – we think the whole thing hinges on there being a functioning term premium.

Naturally, we’re nervous of suggesting that ‘this time is different’ – and, we don’t think we are saying that exactly – but here’s ultimately what we have a problem with….. the broadly held market narrative is that an inverted yield curve will precede a recession (which further implies that a recession will be preceded by an inverted yield curve).

UNITED STATES

Economic Overview

We are sceptical about the relationship between the 10y-2y yield curve and the probability of a US recession. We think there is a good chance that either a recession will occur without a preceding inversion or that an inversion may occur without a proceeding recession.

Despite these concerns regarding the US yield curve, we remain unconvinced of the case for a near-term recession.

February’s paltry 33,000 increase in non-farm payrolls was a bit of a shocker but no matter, that’s all forgotten now. March’s report recorded a much invigorated increase of 196,000 and came with the added bonus of a small upward revision to the prior two months’ numbers. Incidentally, March marks the 102nd consecutive monthly jobs market gain; by far the longest recorded winning streak.
Meanwhile unemployment held steady at 3.8% and wage growth came in at 3.2%; a healthy clip, but a little less alarming for the overly-sensitive inflation hawks than the 3.4% increase last month.

We don’t see any bad news contained in this month’s report. We’ve had a good look at and it appears not-too-hot and not-too-cold. Moreover, it looks indicative of a US economy which is reverting to trend rates of growth following a temporary boost last year.

EUROZONE

Economic Overview

If the initial estimate from Eurostat is accurate, eurozone inflation fell from 1.5% in the 12 months to February to 1.4% in the 12 months to March. That is some way off the European Central Bank’s target of close to, but less than, 2.0%. Worse still, core inflation – which excludes changes in the more volatile energy and food sectors – fell from 1.2% to just 1.0% and if we further exclude booze and fags, prices are rising at just 0.8% on the latest figures.

Lifting a little of the gloom is industrial production (the non-services, non-construction, non-government part of the economy). The most recent report records and increase of 1.4% across the eurozone as a whole during January. That compares favourably with expectations for something closer to 1.0% and a fall of 0.9% in the prior month. If we were feeling super-optimistic we’d suggest that might be indicative of some budding improvement. It’s just too early to tell though.

In the meantime, we have to admit to being slightly nervous of the prospects for the eurozone economy in the medium-term. Germany is, more often than not, the exception but it is apparent more broadly that inflation is too low, unemployment (and underemployment) is too high and sovereign finances are far from secure. Add to that a central bank – with zero/negative policy rates and a huge balance sheet – that has all the wiggle room associated with those stuck between a rock and a hard place. Keep your fingers crossed for some sunshine, because the neighbour’s roof needs fixing.

And while we are not particularly excited about the economic prospects for the eurozone, we do feel the tiniest tingle for eurozone stocks right now. Paired with UK stocks, European stocks form our favourite area of the market right now.

JAPAN

Economic Overview

One emperor, one era. And so, as Akihito prepares to take the unusual step of abdicating the Chrysanthemum Throne, a new imperial age is dawning in the land of the rising sun. On 30 April, a little over 30 years after his ascension, Emperor Akihito will make way for his eldest son, the Crown Prince Naruhito.

It is, much like it would be over here, a big deal over there. Indeed, the Japanese government has legislated for a one-off 10-day holiday – from 27 April to 6 May – and which will be observed by all the organisations that make the Japanese stock exchange function. As a result, it will not be possible to trade in any Tokyo-listed assets for the duration of the holiday.

As a result, investors can reasonably expect an unusual level of volatility in the value of their Japanese holdings when the Tokyo Stock Exchange re-opens. While the Japanese market sleeps, markets across the world will continue to react to events as they unfold – including, for instance, a meeting of the Federal Open Market Committee in the US – and that might mean that the Japanese market has a lot of catching up to do.

We count 17 separate occasions over the most recent 50 years when the Nikkei 225 has moved more than 7.5% between open and close, and 77 occasions of 5% or more.

Mind you, none of those occasions incorporate a market closure of this length. Quite how far, and in what direction, the Japanese market does move when it re-opens is anybody’s guess. If normal market conditions prevail elsewhere, we suspect any subsequent shift will have the effect of putting investors in roughly the same position had the Tokyo exchange remained open. That might be up. Or it might be down.

Beyond the immediate, the outlook for the Japanese economy is fair – that is to say it’s not particularly gloomy. True, the most recent Tankan Survey, compiled by the Bank of Japan and broadly considered to be the more accurate of economic gauges, fell from +19 to +12 for large manufacturers and from +16 to +12 for all firms but we have a feeling we’ll see some stabilisation from here and, assuming we get some kind of accord in Sino-US trade talks, a reacceleration toward the later of the year. In any case +12 remains firmly in positive territory.

ASIA PACIFIC

Economic Overview

The US and China remain locked in negotiations which will govern trade between the world’s two largest economies. The timeline for those talks is a little ambiguous but we’re guessing we’ll have to wait another 4 to 6 weeks, assuming that all goes well.

We’re further guessing that some kind of accord will be reached. At least the right noises are being sounded. President Trump is reported as saying that this ‘…is an epic deal, historic if it happens… it’s the granddaddy of them all… it has a very good chance of happening’. Meanwhile President Xi has spoken of ‘new and substantial progress’.

The US-China trade talks are a little like our Brexit talks. It seems to us that a lot of businesses are waiting on a resolution before they can resume a fuller schedule of investment and/or production – both in China and the USA.

The Chinese economy has undoubtedly suffered; that, after all, is why the central bank has provided more liquidity support and reduced reserve requirements for Chinese banks. The Chinese have got good reason to strike a deal. At the same time, over in the US, we imagine that the 2020 Presidential election campaign will focus some minds too.

EMRGING MARKETS

Economic Overview

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

“In emerging market and developing economies, growth is expected to increase modestly. Convergence toward advanced economy income levels, however, remains slow for many of these economies, due to structural bottlenecks and, in some cases, high debt, subdued commodity prices, and civil strife.”

We can’t see anything to disagree with in there, though we have to admit to being a little keener on the prospects for Latin America, at least from the narrow stand point of equity investment. That might be because we’re keen to diversify away from China a little.

PROPERTY

UK Property Market

The Nationwide House Price Index (HPI) revealed that annual house price growth remained subdued at 0.7% for the year to March 2019.

Robert Gardner, Nationwide’s Chief Economist notes:

“UK house price growth remained subdued in March, with prices just 0.7% higher than the same month last year.

Indicators of housing market activity, such as the number of property transactions and the number of mortgages approved for house purchase, have remained broadly stable in recent months, even though survey data suggests that sentiment has softened.

Measures of consumer confidence weakened around the turn of the year and surveyors report that new buyer enquiries have continued to decline, falling to their lowest level since 2008 in February.

While the number of properties coming onto the market has 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 in recent months.”

Meanwhile, in the commercial sector:

“The Q4 2018 RICS UK Commercial Property Market Survey results continue to display mixed fortunes across the three traditional sectors. Indeed, the strong performance of the industrial sector remains in stark contrast to that of retail, driven by the structural shift in consumer spending habits. Meanwhile, survey participants continue to highlight political uncertainty to be holding back activity, with the lack of clarity causing decisions to be delayed.

Over the next twelve months, rental expectations remain comfortably positive across both the prime and secondary industrial markets, and are firmly negative across the board for retail… Interestingly, data from a Rightmove consumer facing survey shows that potential occupiers themselves do not envisage retail rents changing much over the same time frame… Prime office rents are still anticipated to
rise in the year ahead, although expectations have now turned marginally negative for secondary offices”.

PORTFOLIO UPDATE

with Scott Mordrick, CFA

The first Quarter of 2019 proved to be a good one for our portfolios, as almost all of them outperformed their respective benchmarks, and (with the exception of MPM000) the portfolios made profits in each month for the year to date. The more cautious portfolios (MPM000 to MPM040) reached all time highs at the end of March 2019. However, given the sharp sell off of equities in Q4 2018, the more aggressive portfolios are still a bit behind their all time highs.

Positive Contributors
The key contributors to the strong performance seen during Q1-2019 were:

  1. Exposure to UK Government Bonds (Gilts), which performed well during the quarter, in particular Gilts that are Inflation Linked.
  2. Exposure to UK equities, as most UK equity indexes had a strong quarter. The majority of our funds in this sector outperformed the benchmarks too.
  3. The performance of our overseas equity growth funds and in particular our allocation to Asian equities, which comfortably outperformed their respective benchmarks.
  4. The performance of our alternative funds.

Negative Contributors
There were some positions which detracted value during Q2-2019:

  1. Our short dated bond positions, as they underperformed against medium and long dated bonds.
  2. Some of our value equity funds, as growth stocks outperformed value stocks in Q1.
  3. Our allocation to physical gold, as the gold price fell during the quarter.

Portfolio Changes

The committee made no changes on an asset allocation level during the first quarter of 2019.

The committee did agree to change the fund selection in the Targeted Return/Volatility space at the March 2019 Investment Committee Meeting, by removing the Garraway Financial Trends fund and reinvesting the proceeds in the other three existing funds in this sector, the AHFM Defined Returns fund, the Kames Global Equity Market Neutral fund and the JPM Global Macro Opportunities fund.