Quarterly Portfolio Update – Q4 2019

With some waxing and waning during the last three months, Q3 2019 was another positive quarter for developed equity markets, whilst emerging markets lost money over the period.

That isn’t to say it was all plain sailing for developed market equities, the start of August saw what looked to be the start of a market sell off, with UK equities losing nearly 6% in just the first four days of trading.

It wasn’t just equity markets that had a good quarter, as bond yields continued to squeeze. This is a trend that has continued at an alarming rate, such that more and more debt is now generating negative yields. At the end of 2018, there was a total of $8.3 trillion dollars of debt in circulation that was offering a negative yield; as at the end of August 2019, this figure has more than doubled to $17 trillion (with approximately 3/4 of this Government debt).

So how does negative yielding debt occur? Well it is possible for Governments and corporations to issue debt offering a negative yield (in August, Sweden was the third country to issue a 10 year bond with negative yield, having previously only been issued by Germany and Japan).

But what has been more commonplace has been bonds that were issued with a positive interest repayment have seen their yields turn negative.

Bonds are normally issued with a start price of £100 per bond, this price can vary during the life of the bond but, assuming the issuer of the bond does not default, the bondholder will receive £100 back at maturity. At the moment, many of these bonds are trading significantly above this £100 level such that when somebody purchases one of these bonds, the amount of capital loss they will suffer (as they only receive back £100 per bond despite paying, say £120) is more than the interest to be received over the remaining lifetime of the bond. Hence a negative yield.

But why do investors do this? Three reasons really. Firstly there are speculative investors who believe these already negative bond yields will turn even more negative and aim to profit on this continued rise in bond prices. Second, those with significant assets (i.e. large institutions) need as close to a safe haven as possible to park their money (it is unlikely the FSCS £85,000 compensation limit will cover it!). Thirdly there are those that are effectively forced buyers of these assets, such as pension funds, who need to match their future liabilities and do so by buying a ‘guaranteed’ income stream.

And this trend of downward pressure on bond yields is something that we expect to continue seeing. Right now there are only a handful of developed economies whose 10 year Gilt yields are positive, the UK and the US being two of them. We expect that as demand increases for safe havens, investors may well have a preference for bonds that are still generating a positive yield (hence our decision to slightly increase the duration on Gilts).

The committee made a couple of changes during the quarter, notably the aforementioned change to Gilts and the increase in allocation to gold in favour of property. We still think it right to retain our slightly cautious and well diversified approach in our portfolios.

THE UK ECONOMY

with Steve Williams

Following a decline of 0.2% in GDP growth during the second quarter, there was a chance that a second and consecutive quarter of contraction would give rise to headlines heralding a recession. Assuming that we don’t see a significant revision in what is naturally volatile data, a recession now seems unlikely.

Last week, the Office for National Statistics published its monthly estimate for gross domestic product, updating the series to the end of August. The most recent month brought a disappointing decline of 0.1% but it also brought about an upward revision in July’s estimate, from 0.3% to 0.4%.
Output during the three-month period up to and including August is thought to have increased 0.3%. Now, 0.3% hardly represents a breakneck pace of increase but it’s far from a reverse. The consensus now calls for positive growth when the full third quarter data is compiled; the estimates I have seen range from 0.1% all the way up to 0.4%.

Elsewhere, the Bank of England has a credibility problem. In recent months, monetary policy statements have suggested that a rate rise is just as likely as a rate cut. The following passage, taken from the most recent statement on 19 September, is typical of that sentiment…

‘In the event of a no-deal Brexit, the exchange rate would probably fall, CPI inflation rise and GDP growth slow. The Committee’s interest rate decisions would need to balance the upward pressure on inflation, from the likely fall in sterling and any reduction in supply capacity, with the downward pressure from any reduction in demand. In this eventuality, the monetary policy response would not be automatic and could be in either direction’.

All of that makes sense, of course. After all, the Monetary Policy Committee is tasked with steering inflation between 1.0% and 3.0% and it is entirely appropriate that risks to the upside are met with increased interest rates. But the devil is in the detail.

For a start, inflation currently stands at 1.7%. That’s below the 2.0% middle ground and a full 1.3% lower than the higher limit in spite of a 3.0% decline in sterling’s trade-weighted exchange rate over the same period. There is, then, a reasonable amount of wiggle room already.

But there’s even more than that. A lot more. It’s not difficult to push our scenario further and imagine circumstances characterised by a precipitous drop in sterling and supra 3.0% inflation. In fact, we don’t have to employ much imagination at all since that is what happened in the real world just over a decade ago. When the financial crisis struck back in 2008, participants in the market for foreign exchange were particularly concerned about the outlook for the UK. It was a financial crisis after all and Britain, more than any other country in the world, represented finance. Sterling dropped like a stone. Between January 2007 and December 2008 the pound shed more than 30%. CPI inflation rocketed.

In September 2008 CPI inflation was measured at 5.2%. By that time the Monetary Policy Committee had already reduced Bank Rate from a peak of 5.75% to 5.0%. Within six months, Bank Rate was slashed all the way to 0.5% where it remained until the middle of 2016.

The outlook is, of course, hugely uncertain but the Bank of England will not meet a no-deal Brexit with a series of increased interest rates

EXCHANGE RATES

Pound Sterling

Had this section been written on the 1st day of Q4 2019, it would have discussed the fairly benign Sterling market over the last three months and how Sterling had fallen slightly (with the trade weighted exchange falling 0.7% over the period). However, a lot can happen in a short space of time, particularly in the currency market with Brexit involved. Last week (Week commencing 7 October), the pound capped Thursday’s gains against the dollar with another 2.0% on Friday to bring about a 3.5% increase. Gains against the Euro were to closer to 3.0% and against the Canadian dollar the pound climbed around 2.5%. But it was against the yen that the pound really shone, with a near 5% gain. But we wouldn’t be surprised if these short term gains are reversed again; it only needs any hope of a Brexit deal to be dashed which, given where UK politics is at the moment, is more than possible.

THE GLOBAL ECONOMY

with Scott Mordrick, CFA

The much anticipated interest rate cut was finally delivered in the third quarter In the US. But it wasn’t just one, following the July cut, there was a further cut in September, perhaps somewhat due to the concerns about their domestic economic growth and weak data published in August 2019.

The US Federal funds rate is now set at a range of 1.75 – 2.00%, which is still the highest interest rate in the developed world, far higher than, for example Europe, where during the third quarter the ECB took Europe further into the realm of negative interest rates.
The central bank lowered its key policy rate from -0.4% to -0.5%, in a bid to boost inflation and jump-start the European economy. And there is good reason for this; Germany, the region’s largest economy, teetered on the verge of recession during the quarter. The ongoing global trade disputes clearly took its toll on the automobile industry, which has struggled since the start of the year.

And of course, the trade war does continue. In September, further tariffs were applied to more than $125 billion of Chinese goods by the US Government. China naturally retaliated by slapping tariffs on $75 billion of US products. However the noises emanating from the White House (through Twitter of course) are that a deal is close.
Even if that is true (which let’s be honest is no guarantee; we have seen this all before), there is no denying that this war has already had an impact on local businesses in both countries and an impact on International Relations between the two countries.

In Japan, Shinzo Abe declared victory in Japan’s national elections with his party winning a majority of seats in the upper house of Parliament. However, his ruling coalition fell short of a two-thirds supermajority, dashing the chances of becoming the first man to revise the country’s pacifist constitution.

Japan’s constitution, written by US occupying forces after World War II, says that the nation will “forever renounce war” and will not maintain “land, sea or air forces”. Mr Abe has long sought to remove (or at the very least soften) the stance to bring Japan in line with other countries.

In spite of this, the win means that Mr Abe is set to become the longest serving Prime Minister in Japan’s history. So some more time for him to implement Abenomics with his “three arrows” of monetary easing, fiscal stimulus and structural reforms.

UNITED STATES

Economic Overview

There are two important measures of inflation in the US. The Consumer Price Index (CPI) is the more familiar to us over on this side of the Atlantic. On this measure, the most recent reading suggests that inflation is rose 1.7% compared with the same time last year. But it is inflation as measured by the Personal Consumption Expenditure (PCE) index that is the more important; that is the one the Federal Reserve reference with regard to the 2.0% target. The most recent PCE report insists that year-on-year inflation is running at the cooler rate of just 1.4%.

There is a big difference between the two. Not so much in absolute terms but certainly in terms of policy. The Federal Open Market Committee has, for some time, expressed a concern that inflation has been running at a pace well below the target. Indeed, PCE has averaged 1.4% over the last seven years or so and it is one of the reasons the Fed has cited in cutting rates of late. But while PCE remains muted, inflation has trended higher on the CPI measure – so much so that the most recent increase in CPI marked the sharpest shift in more than a decade.

Ordinarily, we ignore the CPI release and focus more readily on PCE. But we don’t feel comfortable doing that today. Other measures of inflation that don’t share the celebrity attached to the CPI and PCE measures are singing a song not dissimilar to CPI and we are beginning to worry that PCE may be understating inflation a little or that accelerated increases in CPI inflation is a precursor for the same in PCE. Economists polled by the Wall Street Journal expect CPI to trend from 1.7% in the most recent reading to 2.0% come the end of December. If the PCE measure does join that particular choir soon, the Fed will have one fewer reason to dial down rates.

As it stands, we expect another 25 basis point cut in 2019 and we are not alone in that. Prices in the bond market reflect a 76% chance of a rate cut at the October meeting. A further rate cut in December is not altogether unlikely.

But if the US economy grows at a moderate pace for a while longer, unemployment remains at or close to a 50-year low and inflation does creep back toward target, how easy will it be for the Fed to maintain lower and lower rates? All things being equal, and given a prolonged period of inflation-undershoot, we think the Fed could reasonably defend a relatively passive role in the light of a limited overshoot (say up to 2.2%) but only for a short period of time.

For the first time in a long time it is not automatically clear in which direction, and to what extent, US inflation is headed. Unfortunately, both the equity and bond markets are hyper-sensitive to that outlook.

EUROZONE

Economic Overview

The European Union’s statistics body, Eurostat, counts unemployment at 7.4% among economically active citizens inside the Euro zone. On the face of it, that’s very good news because it represents the lowest level since May 2008. The bad news is, of course, that unemployment at 7.4% is still very high – even if it is much lower than the 12.0% rates of 5 years ago. Indeed, there are something like 12.2 million without jobs. The highest numbers of unemployed can be found, not surprisingly, in Greece (17.0%), Spain (13.8%) and Italy (9.5%). The lowest numbers are in the Czech Republic (2.0%), Germany (3.1%) and Poland (3.3%). The real tragedy, though, lies below the headline and it tells of sky-high rates of unemployment among the young. Youth unemployment stands at close to 1-in-3 in Italy (27.0%), Spain (32.2%) and Greece (33.0%).

What the Euro zone needs, if it is to deliver higher standards of living for its citizens, is growth. Unfortunately, growth is in short supply. Gross domestic product, across the Euro zone as a whole, rose just 0.2% during the second quarter, down from 0.4% in the opening quarter of the year. The European Central Bank’s (ECB) survey of professional forecasters reveals expectations for growth of just 1.2% in 2019 and 1.3% in 2020. In our view, the balance of risks are, to put it mildly, to the downside. That’s the kind of growth that is unlikely to see unemployment rates fall much below where they are today. And it is a pace of growth which is unlikely to spur a much-needed pick-up in inflation.

Inflation is running at 1.0%; well below the ECB’s c2.0% target. Worryingly low levels of inflation have been met with further promises from the behemoth central bank to buy more bonds, this time in open-ended fashion, in an attempt to force interest rates still lower. That the ECB has been successful in lowering rates is beyond doubt; even the Greek government is now able to issue debt at negative rates and German bonds are yielding negative returns right along the full extent of maturities up to 30 years. But the ECB can only do what the ECB can do. Unfortunately, repeated calls from Mario Draghi for other policymakers, at the sovereign level, to join with stimulus of their own have long been ignored. Until those requests are met with meaningful action, the Euro zone will remain in the doldrums.

JAPAN

Economic Overview

The Bank of Japan is stuck between a rock and a hard place. It has tried a zero interest rate policy (ZIRP) added quantitative easing (QE), qualitative easing (QQE), negative interest rates (NIRP) and more recently it has effected yield curve control (YCC). Nobody can accuse the Policy Board, with Haruhiko Kuroda at the helm, of not trying. But an alphabet soup of policy tools has not yet nourished higher rates of inflation. The headline rate of inflation is running at just 0.3% in the year to August, down from 0.5% in July and 0.7% in June. Quite naturally, policy makers in Japan an wondering out loud about the inefficacy of their attempts and the potential ill-effects of maintaining negative interest rates over the long-term. It is not easy to see what more policy makers can do. Mind you, it might not be long before we see some more movement. The statement released after September’s Monetary Policy Meeting (MPM) contained the following passage…

‘Given that, recently, slowdowns in overseas economies have continued to be observed and their downside risks seem to be increasing, the Bank judges that it is becoming necessary to pay closer attention to the possibility that the momentum toward achieving the price stability target will be lost. Taking this situation into account, the Bank will re-examine economic and price developments at the next MPM, when it updates the outlook for economic activity and prices’.

Actually, by the time of the next MPM, we’ll also have some indication about how this month’s sales tax increase (from 8.0% to 10.0%) might be effecting the broader economy. This tax increase has been a long time in the planning. The first part of the increase (from 5.0% to 8.0%) came back in 2014 and promptly sent the economy into recession, scaring the government into delaying the final part of the hike. With luck, the impact of the hike this time around will be mitigated by, among other things, a cash-back payment for purchases paid for with credit/debit cards rather than cash. Time will tell.

ASIA PACIFIC

Economic Overview

With year-on-year growth in the region of 6.2% during the second quarter, Chinese gross domestic product is expanding at its slowest pace in nearly 30 years. There is little doubt that the country’s trade war with the US is hurting.

Actually, we have to confess that we regard the Chinese economy with increasing nervousness.

But it’s not the current slowdown that concerns me particularly. Slowing output growth is likely an inevitability and, if it is associated with a transition from ever-increasing and ever-more inefficient investment to growing worker-incomes and greater consumption, it is no bad thing. Instead, it is the immediate policy response that worries us. More, faster construction and boosted bank lending push against that much-needed transition.

Mind you, it does look as if the policy response about which we are so critical is actually working. Last week, we learned that manufacturing output improved during September as measured by both the official and private (Caixin) Purchasing Managers’ Index (PMI) surveys.

The official PMI, mainly covering larger, state-owned enterprises moved from 49.5 in August to 49.8 in September. Meanwhile, the unofficial PMI, sponsored by Caixin and which focuses on smaller, privately-owned businesses, moved from 50.4 in August to 51.4 in September. The former is indicative of a pace of contraction which is slowing and the latter represents a much healthier and positive rate of expansion.

Dr. Zhengsheng Zhong, Director of Macroeconomic Analysis at Caixin observes that…

‘The recovery in China’s manufacturing industry in September benefited mainly from the potential growth of domestic demand. The trade conflicts between China and the U.S. had a notable impact on exports, production costs and confidence of enterprises… Central policymakers have recently been emphasizing the strong growth in the domestic market. Faster construction of infrastructure projects, better implementation of upgrading the industrial sector, and tax and fee cuts are likely to offset the influence of the subdued overseas demand and soften the downward pressure on China’s economic growth’.

EMRGING MARKETS

Economic Overview

Those that are keen to diversify emerging market exposure, have got their work cut out. Following recent reviews, the major emerging market indexes, from the likes of FTSE Russell and MSCI, are increasingly dominated by Chinese exposure. At close to 35%, and with the potential for that to rise still higher, Chinese stocks represent more than twice the 15% in South Korean stocks, the next largest component, and much more than the 18% in India and Brazil combined.

Investment in emerging market stocks is a risky venture but those risks are exaggerated if it is dominated by a single jurisdiction, much more so than is the case when investing in the developed markets. Currency risks, political risks and liquidity risks are all geared up as regional diversity winds down.

And the pace of Chinese growth is winding down too, just as growth in India is gearing up. The Organisation for Economic Cooperation and Development forecasts growth of 5.7% during next year in China and 6.3% in India.

India has the further attraction, when set alongside China, of being a democracy. Adding a little more India to your emerging market exposure is not bad thing, if nothing else it adds a diversity of political systems.

PROPERTY

UK Property Market

The Nationwide House Price Index (HPI) revealed that annual UK annual house price growth remained below 1% for the tenth consecutive
month in September, at just 0.2%.

Robert Gardner, Nationwide’s Chief Economist notes:

“Indicators of UK economic activity have been fairly volatile in recent quarters, but the underlying pace of growth appears to have slowed as a result of weaker global growth and an intensification of Brexit uncertainty. However, the slowdown has centred on business investment – household spending has been more resilient, supported by steady gains in employment and real earnings.

“The underlying pace of housing market activity has remained broadly stable, with the number of mortgages approved for house purchase continuing within the fairly narrow range prevailing over the past two years. Healthy labour market conditions and low borrowing costs appear to
be offsetting the drag from the uncertain economic outlook.”

Meanwhile, in the commercial sector:

“The Q2 2019 RICS UK Commercial Property Market Survey results show the well established trends of recent quarters remain firmly in place. Indeed, the retail sector continues to display firmly negative sentiment in the face of the structural shift towards increased online spending. Meanwhile, solid demand growth is still being reported across the industrial sector, with this pattern evident across all parts of the UK…

At the headline level, near term rental expectations were broadly unchanged compared with Q1. As such, this measure continues to suggest all-sector rents will dip marginally over the coming months. That said, all of the negativity is stemming from the retail sector, which posted a net balance of -53%, while the outlook appears relatively flat for office rents. Meanwhile, contributors envisage the industrial sector delivering further solid near term rental growth.”

PORTFOLIO UPDATE

with Scott Mordrick, CFA

It was another positive quarter for all of our portfolios, with all of them (slightly) outperforming their respective benchmarks. Nearly every portfolio is over 1.5% ahead of their respective benchmarks over the year to date. August was the only negative month for portfolios (but only for MPM050 and higher) as we saw an equity sell off as tensions over the trade war escalated.

Positive Contributors
The key contributors to the strong performance seen during Q3-2019 were:

  1. Our Disfavour view on Property, which had a fairly static/slightly negative quarter (when most other assets made money over the period)
  2. Our preference for Large Cap equities in developed markets. Developed Markets comfortably outperformed against Emerging Markets and Large Cap Companies outperformed against Small Cap companies during the quarter.
  3. The performance of our value fund managers, particularly in developed markets, as they comfortably outperformed more growth orientated managers.
  4. Our continued allocation to commodity, particularly physical gold, with gold increasing by over 7.5% over the third quarter (in sterling terms).

Negative Contributors
There were some positions which detracted value during Q3-2019:

  1. Our preference for shorter dated Gilts over longer dated Gilts (this is a stance which was, to some extent, reversed in August. But some of the Long Dated Gilt outperformance happened in July, at which point the committee were still overweight short duration.)
  2. The performance of our Target Return funds, which produced flat or slightly negative returns during the third quarter of 2019, when almost all other growth strategies generated positive returns over the period.

Portfolio Changes

  1. In August, the committee agreed to increase the duration to Gilts, by reducing the allocation to Short Dated Gilts and increase the exposure to Medium Dated and Long Dated Gilts.
  2. Additionally in August, the committee agreed to reduce the allocation Commercial Property and increase the allocation to Physical Gold.
  3. In September, the committee participated in the additional fund raise of Merian Chrysalis and increased the weighting in favour of Asia Pacific Equity.