Quarterly Portfolio Update – Q3 2019

What a difference 6 months makes. In our Market Overview two quarters ago, we were using phrases such as “challenging time for investors” and “several markets enter a bear market”. Fast forward to today and it feels like as if that has all been forgotten.

We have seen all our MPM portfolios reach their all time highs since their launch in May 2014, whilst passing their 5 year milestone. We are once again at the stage of equity markets breaking all time highs. Whilst we are pleased to see markets making this kind of process and our portfolios generating such strong performance, we want to avoid being short termist and not forget about the volatility at the end of 2018.

That isn’t to say it was totally plain sailing this quarter; the US-China trade war once again reared its ugly head, putting downward pressure on markets in May, but then as if forgotten about again in June.

What we are seeing in the markets now is unusual. Very unusual. As mentioned before, equity markets are breaking through all time highs, a pattern usually associated with a booming global economy … if anyone really has that feeling at the moment ?

On the flip side, we have developed market government bond yields in extreme territory at their lowest points ever, a pattern more commonly associated with a global recession.

So these two scenarios paint contrasting views. We think looking at the global economy, we are somewhere in the middle of these two scenarios (for now anyway).

The reason we are seeing these disconnects in the market is more to do with current Monetary and Fiscal Policy measures (big cheer for all those Central Banks!) rather than how market participants really view the economic world.

Who knows for how much longer we will see this juxtaposition, it could remain for quite some time yet.

Speaking of all things odd, the British public were treated to a view behind the Tory curtain when Mrs May announced her resignation and the chance for one of many willing volunteers to take her place. After several rounds of voting and a couple of spellbinding televised leadership debates, the list has been whittled down to just two, Boris Johnson and Jeremy Hunt. At time of writing, Tory members are casting their votes (with a deadline of 21 July) and the clear favourite seems to be Mr Johnson. It is perhaps somewhat disconcerting that the next Prime Minister will be decided by just 0.3% of registered voters, although the decision over Mrs May’s leadership didn’t even make it to a vote last time, so we guess that’s some kind of progress ..?

If it is Mr Johnson that becomes PM, all bets are off as to which way Brexit goes, a no deal is certainly more likely, but I am sure whoever is the next Conservative leader would rather arrange a better deal than Mrs May’s.

And so as to our positioning, whilst the committee did make some changes during the quarter, the details of which can be found later in this Update, we think it right to retain our slightly cautious and well diversified approach in our portfolios.

THE UK ECONOMY

with Steve Williams

There’s something unusual about the UK. Actually, there are a few unusual things about this great country of ours, but we want to focus on the outlook for inflation. The Consumer Price Index stands at 2.0%, exactly in line with the Bank of England’s target. Elsewhere, across the developed world, central banks are struggling to fulfil their mandates. Indeed, while consumer prices have been rising at an-above target pace in the UK, inflation in USA, Euro zone and in Japan has been locked into a sub-par trend for years. That is good news, comparatively. It is good news because it affords the Bank of England’s Monetary policy Committee some room for manoeuvre.

Inflation which is above target might limit the Bank’s ability to reduce rates. Meanwhile inflation which is below target might limit the Bank’s ability to increase rates.

Similarly, the Bank of England’s balance sheet (including all of the government bonds it bought in several rounds of quantitative easing) represents close to 20% of GDP, more or less in line with that of the Federal Reserve in the US. Compare that with bulging central bank holdings elsewhere; 45% for the European Central Bank, 100% for the Bank of Japan and a whopping 125% at the Swiss National Bank. Here too, the Bank of England looks to have plenty of room for manoeuvre.

Our fiscal position affords some room for manoeuvre too. The Office for Budget Responsibility reports that… ‘Public sector net borrowing has fallen sharply over the past decade, from its post-crisis peak of 9.9% of GDP in 2009-10 to 1.1% of GDP in 2018-19 on our latest forecast… we judge that the structural deficit will be a little higher than the headline deficit at 1.2% of GDP. It is therefore already below the 2% of GDP target ceiling the Chancellor has set himself for 2020-21’.

Admittedly, a deficit is not as good as a surplus but our finances are in much better shape than they were. And, of course, with Brexit still to come our economy will likely require some support while businesses and consumer adjust. That support which will be much more effective if monetary policy and fiscal policy are coordinated. Actually, some support might be needed sooner rather than later. It seems that economic activity has stalled in the second quarter of this year – something the Bank of England are alert to…

‘Growth in Q2 will be considerably weaker, in part due to the absence of that stock building effect and Brexit related, temporary shut downs by several major car manufacturers. Recent data also raise the possibility that the negative spillovers to the UK from a weaker world economy are increasing and the drag from Brexit uncertainties on underlying growth here could be intensifying. The latest surveys point to no growth in UK output’.

INTEREST RATES

Bank of England Base Rate

Prices in the bond market are consistent with a reduction in Bank Rate some time in the near future. Our best guess is that the Bank of England’s Monetary Policy Committee will vote to hold rate steady until a resolution to Brexit is clearer.

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.

Beyond the short term, the market is currently priced to reflect expectations for Bank Rate to stand at something like 0.5% in 3 years and 0.75% 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 strong start to the year for the pound, the second quarter saw Sterling effectively reverse this trend, plus a bit more, to leave the pound at almost its lowest point over the year to date. With the uncertainty surrounding Brexit continuing to shadow the currency as well as the domestic economy, markets and sentiment towards the pound waned, thanks in part to the lack of leadership in Government. Recent leadership debates still don’t seem to have any one of the potential leaders having a defined strategy surrounding Brexit – perhaps except for Boris Johnson. His willingness to allow the UK to leave without a deal in place, and the fact that he at the time of writing remains the clear favourite, has caused markets to panic. If we do see Johnson in and he does allow a no deal Brexit through, expect to see the green line on the chart below fall even further

THE GLOBAL ECONOMY

with Scott Mordrick, CFA

In the US, speculation about a rate cut has reached fever pitch. This is in stark contrast to where we were only a few months ago, but that’s how fickle markets, investors and central banks are nowadays.

The bond market prices the likelihood of anything but a rate cut later this month at close to 0%. Following that rebound in jobs data, a 0.25% cut in the Fed Funds rate (lowering the upper limit to 2.25%) is the clear consensus with the probability of a 0.50% reduction slashed from 30% a week ago to less than 5% today. In our view, expectations for a 0.5% cut were a little nutty.

Generally, rate cuts are not a good thing for stocks. That is because they tend to coincide with horrible slowdowns in economic output and, in turn, lower corporate profits. There are exceptions though. And whilst this could be once of those exceptions, it seems difficult to ignore that the world is entering the mature end of an economic cycle; inflation pressures are subdued, economic growth data is stabilising and future GDP estimates are being cut.

There are certainly headwinds for economic output and lower corporate profits, perhaps none more so at this point than the United States of America’s approach to trade. In May, President Trump took to Twitter (obviously) to announce plans to impose tariffs on Mexican imports and increase the range off goods that are taxed on import from China.

This naturally sent negative shocks through equity markets. But only a few weeks later and Donald had agree to indefinitely suspend tariffs on Mexican imports and to let the world know that talks with China were improving.

But it isn’t just the US economy and Chinese economy that are affected by these tensions. You have seen this filter through to other significant economic powerhouses (Germany and Japan to name but a few) whereby trade tensions and tariffs have impacted their exporting power and ultimately the economic growth of these countries.

UNITED STATES

Economic Overview

Good afternoon, and welcome. My colleagues and I have one overarching goal: to sustain the economic expansion, with a strong job market and stable prices, for the benefit of the American people.

That’s how Jerome Powell, Chairman of the Federal Reserve, opened the press conference following June’s meeting of rate setters on the Federal Open Market Committee. In our judgement, Mr Powell and his team are doing a fine job in that regard.

The US economy remains on a solid footing. Q1 this year was witness to surprisingly strong growth. Q2 brought about a much slower pace of output – with some notable volatility in all kinds of data releases – but not so slow as to indicate anything other than a return to trend rates of growth.

The most recent data, for example, comes from the Bureau of Labor Statistics which counts a total of 224,000 new posts in June’s non farm payroll report, up from 75,000 in May. June’s is a decent number but, at the same time, estimates for April and May were revised down a little bringing this year’s average monthly gain to 172,000 compared with 223,000 for last year. 172,000 newly recorded posts is lower than the average for 2018 but it is in line with that recorded in 2017 – something that we think adds weight to our assertion that the US economy is reverting to a moderate pace of growth following what was widely expected to be a temporary boost from The Donald’s fiscal stimulus last year.

The outlook is not without its challenges though. The trade war is not going away. Our hopes for a market-pleasing entente remain, but any such agreement will likely prove superficial. Global growth will, partly as a result of that rivalry and partly for other reasons, remain subdued.

Perhaps more importantly, US inflation remains subdued. Indeed, concerns about a ‘more sustained shortfall of inflation’ are increasingly expressed by voting members of the rate setting committee…

‘We are firmly committed to our symmetric 2% inflation objective, and we are well aware that inflation weakness that persists even in a healthy economy could precipitate a difficult-to-arrest downward drift in longer-run inflation expectations. Because there are no definitive measures of inflation expectations, we must rely on imperfect proxies. Market-based measures of inflation compensation have moved down since our May meeting, and some survey-based expectations measures are near the bottom of their historic ranges’.

EUROZONE

Economic Overview

Mario Draghi’s term as President of the European Central Bank comes to a close in October. Oddly, Christine Lagarde, the head of the International Monetary Fund (IMF), will replace him. That’s an odd choice in central banking circles because Ms Lagarde has no formal training in the field of economics and no background in central banking.

She’s not the natural successor to one of the more decisive central bankers of our generation.

The field of candidates was not a weak one either. Benoît Cœuré, a member of the ECB’s executive board, would have been our first choice with Claudia Buch, vice president of the Bundesbank a close second. Notwithstanding our choices, it’s difficult to justify overlooking Jens Weidmann, the Bundesbank president. But posts among the European Union’s elite institutions are not, it seems, filled on merit.

Instead those positions are traded among the political classes behind closed doors. As far as we can tell, a German in a top post here automatically disqualifies a German for a top post there and, of course, roles have to be found for a French national, an Italian, a Spaniard and, if at all possible, one soul from among the little countries for the sake of appearance.

From our own narrow perspective, the problem with Ms Legarde’s nomination, coming out of the blue as it has, is that we don’t really know what to expect; she has no prior relevant established pattern of behaviour to study.

That said, she has, in her role at the IMF, previously displayed support for Mario Draghi’s innovations. She is, we think, a dove.

In any case, with headline inflation still some way from the 2.0% target it is clear that a hawkish stance might not be the appropriate one. According to the ECB’s own analysis…

‘Market measures of longer-term inflation expectations have fallen somewhat… The forward profile of market-based measures of inflation expectations continues to point to a prolonged period of low inflation with only a very gradual return to inflation levels close to, but below 2%’.

The deterioration in the outlook for inflation is not what we would call severe, but it does coincide with below-par prospects for output growth. ECB staff project growth in gross domestic product to register increases of just 1.2% this year and 1.4% in each of the following years.

It is for that reason that we speculate that Mario Draghi’s last act as President will be to open the taps on bond purchases again – or at the very least institute further rate cuts.

Such a course of action will likely tie his successor into doing more of the same for the foreseeable future.

JAPAN

Economic Overview

The Japanese economy is experiencing its longest period of sustained expansion since the second world war. Indeed, beginning in December 2012 the pace of growth has sustained trend rates of growth which are comparable with those of other advanced market economies. In the five years to the end of 2012 gross domestic product increased just 0.5% on average compared with 1.3% since.

There has even been some progress, of sorts, in the Bank of Japan’s decades long battle with deflation. The headline rate of inflation, as measured by the year-on-year rate of increase in the Consumer Price Index, measured 0.7% during May. Prices have increased at a positive rate for each of the last 32 months.

Prime Minister Shinzo Abe’s ‘three arrows’ package of reforms – monetary activism, fiscal flexibility and structural reforms of the labour market – are, in our view at least, the foundations for that improvement.

The first arrow hit the 30th governor of the Bank of Japan, Masaaki Shirakawa, back in 2013. He was replaced, 3 months after Shinzo Abe’s landslide general election victory, by Haruhiko Kuroda. Kuroda wasted little time in transforming the bank of Japan’s policy response.

The second arrow struck a near mortal blow to the country’s budget deficit bringing it down from 8.3% of GDP in 2012 to something like 2.4% today.

But it is the third arrow that holds the key to Japan’s longer-term prospects. At the heart of those reforms is an attempt to reduce obstacles to employment (by encouraging more women to join the workforce, to challenge Japan’s traditional seniority-based wage system and dismantle firm’s right to impose mandatory retirement at age 60) and to lift productivity in the face of a declining labour force.

Indeed, Japan’s demographic situation presents what Shinzo Abe describes as Japan’s ‘biggest challenge’. Japan’s working age population has decreased by more than 10% in the last two decades. That compares with a decline of just 2% in Germany and positive rates of change among other G7 nations.

The third arrow isn’t just the more important one in our estimations, it is also the more difficult one; involving, as it does, protracted negotiations with long-established traditions and deep-rooted vested interests in the status quo. All of that will take time.

Luckily, time is something Shinzo Abe appears to have. That is unusual for a Prime Minister in Japan. (In the 10 years prior to the current incumbency in 2012, we count 7 changes in government. That compares with just 2 in the UK, 2 in the US and 2 in Germany). The next general Election is due on or before 22 October 2021 and, looking at the ruling party’s approval ratings alongside those of the opposition, it seems likely the key policies of Abe’s reforms will be sustained beyond then.

ASIA PACIFIC

Economic Overview

China’s economy is slowing. Gone are the days when double-digit growth was the norm. Now, the behemoth Dragon economy is expanding at something like 6.4% if you believe the official estimates. Expectations among economists, at least according to a recent Reuters poll, is for growth to slow further to an average of 6.2% in 2019.

It is our contention that China’s economy is bound to slow. That’s not necessarily a bad thing if it is, as we hope, associated with a rebalancing of the economy from an early phase of explosive growth – increasingly reliant on unproductive debt – to a more sustainable consumer-driven model fuelled by increased real wages. In other words we hope for an orderly slowing in China’s trend rate of growth – one which sees employment rates maintained at high levels and which maintains improvements in living standards for the maximum breadth of her citizenry.

A disorderly slowdown, by contrast, has far reaching consequences. Back in 2007, China’s then Premier, Wen Jiabao characterised Chinese economic growth as ‘unstable, unbalanced, uncoordinated and unsustainable’. The necessary adjustments – difficult enough in the best of times – were, quite understandably, delayed by the onset of a global financial crisis. Instead of reining in debt, the taps were turned higher.

Fast forward to today and we see some improvements. Consumption contributes more to GDP now than investment. Household consumption in China amounts to something like 40% compared with something like 35% a decade ago. That, incidentally, is certainly low by our standards – consumption makes up closer to 70% in the UK and US for example – but it is low too by comparison to that in South Korea (50%) and Japan (nearly 60%).

The danger is that China/US trade dispute further delays progress toward a rebalanced economy. Indeed, there is a risk that China’s policy response induces a reversal in what progress has already been made. In this regard, the World Bank notes that…

‘In particular, risks of a sharper-than-expected slowdown in China remain significant because of a difficult external environment alongside notable domestic challenges. Total non-financial-sector debt in China is above levels seen at the peak of previous credit booms in other major EMDEs and some advanced economies’.

Now, we ought to point out that the gloomy picture we are presenting is not entirely representative of the World Bank’s baseline expectations which call for growth to slow gently from 6.6% last year to 6.0% in 2021, but we do think the risks they point to are worth of attention…

‘High corporate indebtedness in sectors with weak profitability is of particular concern. Policymakers’ continued reliance on credit expansion to support growth may exacerbate domestic risks by adding further leverage to its already highly leveraged corporate sector, while also contributing to rising debt in the household sector. In addition, a sizable portion of recent stimulus has taken the form of expanding local government special bond quotas. This form of stimulus may eventually become less effective because of diminishing returns to investment, and may further amplify domestic risks. More than half of the 2019 stimulus has taken the form of tax and fee cuts, whose impact on growth may be less predictable than that of changes in public investment’.

EMRGING MARKETS

Economic Overview

Back in April, the International Monetary fund envisaged ‘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’.

As far as we are concerned very little has changed. We still see little to disagree with in there, though we remain keen on the prospects for Latin America, at least from the narrow standpoint of equity investment because we’re keen to diversify away from China a little.

Of course the ‘excluding Turkey’ clause is one that continues to catch our attention. We’re not so keen to diversify away from China as to include any material shift to investment in Turkey.

President Erdogan’s agenda doesn’t extend to anything approximating sound economic stewardship. His dismissal, in the wee hours of the 6th July, of Turkey’s chief central banker is testament to that. Murat Cetinkaya’s policies had likely helped to bring inflation down from the mid-twenties to the mid-teens, affording Turkey some credibility in the eyes of potential investors. Not so in the mind of President Erdogan though. The Economist reports that, in exchanges with the chief rate setter, the autocratic President ‘told him several times to cut interest rates… [asserting that] …if rates fall, inflation will fall.

PROPERTY

UK Property Market

The Nationwide House Price Index (HPI) revealed that annual UK annual house price growth remained below 1% for the seventh consecutive month in June, at 0.5%.

Robert Gardner, Nationwide’s Chief Economist notes:

“Survey data suggests that new buyer enquiries and consumer confidence have remained subdued in recent months. Nevertheless, indicators of housing market activity, such as the number of mortgages approved for house purchase, have remained broadly stable.

Housing market trends are likely to continue to mirror developments in the broader economy. While healthy labour market conditions and low borrowing costs will provide underlying support, uncertainty is likely to continue to act as a drag on sentiment and activity, with price growth and transaction levels remaining close to current levels over the coming months.”

Meanwhile, in the commercial sector:

“The Q1 2019 RICS UK Commercial Property Market Survey results show conditions remain highly varied at the sector level. Indeed, solid fundamentals continue to drive growth in the industrial segment while the struggling retail sector shows little sign of improvement. Alongside this, anecdotal evidence suggests the Brexit impasse is, to a greater or lesser degree, weighing on investor and occupier decisions across the board.

With regards to the outlook for rents, contributors are still anticipating further growth across both prime and secondary areas of the industrial market over the next twelve months. For offices, there remains a clear split between prime and secondary, with the former expected to deliver steady rental growth while projections are marginally negative across the latter. Expectations are pointing to a further fall in both prime and secondary retail rents at the twelve month and three year time horizon”.

PORTFOLIO UPDATE

with Scott Mordrick, CFA

The second Quarter of 2019 effectively carried on where Q1 left off; making solid ground across the piste of our portfolios, albeit at a slightly slower rate of return than what was seen in the first three months of the year. As can be seen on the following pages, all of the portfolios outperformed their respective benchmarks over Q2 and nearly every portfolios is at least 1% ahead of their respective benchmarks over the year to date. As at the end of June 2019, whilst passing their 5 year milestone, all 11 portfolios were at all time highs (when observing month end values).

Positive Contributors
The key contributors to the strong performance seen during Q2-2019 were:

  1. Our Favour view on Global Bonds and in particular the performance of the two M&G Global Bond funds. Sterling weakened during the quarter, increasing the value of these assets for sterling investors. The M&G Global Macro Bond got further uplift from Global Developed Government Bond prices rising and the M&G Global Convertible bond fund got a kick up as equity markets rallied, boosting the convertible “option” on these bonds.
  2. Our Like view on European and Asia Pacific equities. For Sterling investors, Europe and Asia Pacific equities were the two best performing markets over Q2 2019.
  3. Our Disfavour view on Property, which was the only sector to lose money during the quarter.
  4. Our allocation to commodity, particularly physical gold, with the gold spot price rallying c10% during the second quarter.

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

  1. Our allocation to shorter duration bond funds (i.e. funds that invest in bonds with a shorter time to maturity than the average). As bond prices rise (which we saw during the quarter), it is the bonds with a longer maturity that tend to perform better.
  2. Our allocation to value equity (versus growth stocks). Growth stocks and growth orientated managers fared better during the quarter as investors continued to favour companies that sit in growth industries (i.e. Technology and Healthcare) as opposed to value industries (i.e. Financial Services and Utilities). Our exposure to value/growth style mangers is approximately 50/50 across all regional equities.

Portfolio Changes

  1. During the second quarter, the committee agreed to reduce the allocation to Specialist funds (by removing the Financials fund) and increase the allocation to US equities.
  2. On a fund level, the committee agreed to add the Vanguard Global Emerging Markets fund (an active fund managed by three different managers, each given a portion of the fund to run in their unique investment style) replacing the First Trust Emerging Market AlphaDEX Fund.
  3. The committee agreed to increase the weighting to the unhedged M&G Global Convertibles and reduce the weighting to the hedged NB Floating Rate Income Fund.