4th Quarter 2015

“In the short term the stock market is a voting machine but in the long run it is a weighing machine” are the immortal words used by Benjamin Graham, the man often credited as the father of value investing and a mentor to Warren Buffett, arguably the world’s most successful investor. We believe Graham’s adage has relevance at this time because most investment asset classes on an historic fundamental analysis have been overvalued for some time, and the big question is whether the setback of Black Monday 24th August was the beginning of a prolonged mean reversion to more realistic values, or just a hiccough in a continuing secular bull market.

Last Quarter Review

Most global equity markets fell markedly during the third quarter with the FTSE 100 in the UK and the S&P 500 in the US falling around 7%. Government bonds by comparison had a good quarter partly benefiting from a return to the “risk – off” mode as investors headed for less volatile markets resulting in the yields on the benchmark 10 year Treasury and 10 year Gilt falling from 2.35% to 2.05% and 2.02% to 1.78% respectively. These yields are now back to where they began 2015, while the US dollar bull market continued with the greenback especially strong against the currencies of emerging market and commodity exporting countries.

The strength of the dollar, which has been rising since the summer of 2014 was deemed to be largely responsible for the Chinese authorities in Beijing surprising markets on the 11th August by devaluing the yuan (or renminbi) by 1.9% against the US currency (to which it had been pegged for many years) leading to speculation that potentially much more was to come as China’s exports (which had fallen 14% over twelve months) have increasingly struggled against those from Japan and other Asian counties with weaker currencies. The sensitivity of developing countries to changes in policy at the Federal Reserve (Fed) became all too clear in 2013 during the “taper tantrum” when the announcement that it would slow and eventually stop its huge purchases of government bonds led to turmoil in emerging markets.

Higher US rates would add to the allure of American assets, potentially making the dollar even stronger, while the governments, households and firms in the developing world that have borrowed trillions of dollars in recent years, would find their interest and repayment costs increasing in local currency terms. Some of the currency pressures on commodity exporters and emerging markets whom have been suffering from a stronger dollar, eased following the Fed’s 17th September Federal Open Markets Committee (FOMC) meeting at which it was decided to once more postpone the long awaited increase in interest rates, which would effectively have confirmed America’s economic lift-off.

The decision to stay with the Fed’s zero interest rate policy (ZIRP) that has now been in place since the collapse of Lehman Brothers in 2008, surprised many investors, as did reference to the problems in China being one of the reasons. The key comment in the FOMC press release appeared to be “The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad.”

The Fed would appear to be still contemplating lift-off this year however as Chair Janet Yellen made clear in a speech the following week when she said, "Most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime this year.

Key Economic & Market Data 2nd Quarter GDP 12 month GDP Base Interest Rate at End June 2015 Equity Index Returns - Last Quarter Equity Index Returns - Last 12 Months Sovereign Bond Index Returns - Last 12 Months
% % % % % %
USA 3.90 2.70 0.25 -6.94 -2.65 +3.64
UK 0.70 2.40 0.50 -7.04 -8.47 +8.35
EuroZone 0.40 1.50 0.05 -9.45 -3.88 +3.94
China 1.70 7.00 4.60 -28.63 +29.14 N/A
Japan -0.30 -1.20 0.00 -14.07 +7.51 +2.54
Germany 0.40 1.60 0.05 -11.74 +1.96 +3.53
NB. GDP Data shown is to the 30th June 2015; Interest Rate, Equity & Bond Index Data is to the 30th September 2015; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices courtesy of Bloomberg

Current Considerations

The market reaction to the Fed’s decision to once more delay raising interest suggested that investors are getting fed up with waiting for the promised lift-off that never arrives or as one cheeky internet publication put it “There are only so many times you can get away with Yellen Wolf!” While previously the decision to delay raising rates would have typically resulted in equity and bond markets breathing a sigh of relief and rallying on the premise that the good times of cheap credit combined with improving economic data could continue a little longer before policy tightening sought to spoil the party, the feeling this time was more of the Fed has maybe lost its way, and possibly the economic recovery in the US we hear so much about is not as rosy as some of selectively chosen data from the mainstream press would have us believe.

In reality US and global equity markets increasingly appear to doubt the likelihood of interest rate rises from the Fed, Bank of England or any other central banks as successive new economic data around the world mostly continue to disappoint, while there would appear increasing discord among the central banking institutions as the Bank for International Settlements (BIS, whom many refer to the central bank for central banks) expressed disappointment at the Fed’s decision, while the International Monetary Fund (IMF) whom had advised the Fed against raising rates, applauded it.

The Economist in an article titled “Repeat prescription” seemed as bemused as everyone else commenting “This was supposed to be the year when the Federal Reserve would raise interest rates, which have sat between zero and 0.25% since late 2008. Shortly after the Fed allowed rates to lift off, pundits presumed that the Bank of England, which since March 2009 has held its base rate at 0.5%, a three century low, would follow.”

The Economist article brings readers back to reality by advising that in addition to the Fed stalling again, Andrew Haldane the Bank of England’s chief economist, is now talking about actually cutting rates further. The article also reminds investors that the few central banks that have raised rates post Lehman 2008, which includes the European Central Bank (ECB) and Sweden’s Riksbank, have subsequently had to reduce them again.

While recent speeches made by Bank of England (BOE) Governor Mark Carney have suggested the UK’s own lift-off away from the 0.5% interest rate that has been in place for several years might be imminent, the opposite appeared to be the case in comments made by Andrew Haldane in a presentation titled “How low can you go” during September at the Portadown Chamber of Commerce in Northern Ireland. Towards the end of his talk, he said, "the case for raising UK interest rates in the current environment is, for me, some way from being made. One reason not to do so is that, were the downside risks I have discussed to materialise, there could be a need to loosen rather than tighten the monetary reins as a next step to support UK growth and return inflation to target."

Credit has to be given to the various developed market central bank leaders in talking the talk when it comes to interest rate increases, while knowing in their heart of hearts, they are not going to be able to walk the walk, at least not in this business cycle (as indeed we suggested in the 2nd quarter market view “It is however all too easy to doubt the sincerity of the Fed's inference that base rates will rise either in June or September of this year”). More likely as we have alluded to previously, the Fed will have to unleash QE4 at some point in 2016 to once more prop up the economy and markets.

Meanwhile we believe much of the gloom and doom that has been spoken and written about China has been exaggerated. The 1.4 billion Chinese account for 13% of global GDP, while their consumption of the world’s resources is staggering, and includes 54% of all aluminium, 48% of all copper, 50% of all nickel, 45% of all steel, and 60% of all concrete, with the Middle Kingdom having consumed more concrete in the last three years than the United States did in all of the 20th century!

Additionally China uses 13% of the world’s uranium and 12% of all oil, while feeding so many people takes its toll on global crops as 30% of rice, 22% of corn, and 17% of wheat gets eaten by the Chinese. Interestingly renowned hedge fund manager Ray Dalio of Bridgewater Associates is convinced that China is going to be just fine albeit weaker as a result of the debt restructuring that it is currently undergoing in its state owned enterprises (SOE’s).

Ray thinks China should be able to achieve this because the debt is in its own currency, and there is a precedent with the US doing a similar restructuring on three separate occasions (1971, the Latin American crisis and the Savings & Loan crisis). Additionally he feels the recent stock market volatility first with the bubble and then the inevitable crash is just part of the growing pains an emerging economy has to go through before maturing again in the same way that the US and other developed markets have.

Arguably the way ahead for China to continue growing is to encourage the growth of its private sector, which has been one of the strongest parts of its economy both during the years of double digit GDP growth and in the more difficult last couple of years. As a recent special report on business in China in The Economist emphasised, the private sector has created almost all the new urban jobs in the past decade and now employs four–fifths of urban workers.

Private industrial firms have doubled the output growth of the state owned enterprise (SOE) sector since 2008 and the fact that the Middle Kingdom’s manufacturing sector remains the world’s most formidable is almost entirely down to private businesses, and thanks also to these, Chinese share of global exports grew from 11.5% in 2011 to 14.3% in June this year. The Economist identifies three key actions that the Beijing authorities need to do in order to help private firms take on an increasing share of the economic growth, namely accelerate the transition of the economy to being consumer driven, encourage innovation and entrepreneurialism, and redirect credit from state owned zombies to flourishing private firms.

The Economist concludes, “If China is to sustain strong growth – and with it the high employment that buttresses stability – the only option is to encourage more enterprise and innovation. Such dynamism will not come from stodgy state firms. It can be generated only by the China that works.” We have every confidence that the key decision makers in Beijing whom have steered China’s remarkable transition from third world also ran to an economic superpower will be studying carefully The Economist’s advice.

Forward Outlook

The Economist article titled “Repeat prescription” that we referred to earlier succinctly summed up the dilemma facing the Fed and global policymakers thus, “One fear is that the longer interest rates are held at emergency lows, the greater the potential for trouble when they do eventually go up. Several financial markets are distinctly frothy; some worry that the biggest bubble of all is the one that is supposedly least risky, that of sovereign bonds.”

And therein arguably lies the dilemma for the Fed and other central banks whereby if they raise interest rates in what appears an extraordinarily anaemic US recovery (according to the Atlanta Fed’s GDP Now model, as at October 1st US GDP in the third quarter was expected to grow by just 0.8%), it risks setting off a global economic recession (aided and abetted by a dollar bull market that is creating havoc among commodity exporters and emerging markets), and a likely bear market in over valued bond and equity asset classes (which its ZIRP and QE policies have effectively generated), while if it delays normalising rates, it will almost certainly prolong the equity and bond party but only at the expense of creating an even bigger hangover when asset price mean reversion eventually occurs since as Margaret Thatcher famously said “You can’t buck the market indefinitely”

For now however, we believe the Fed can continue to buck the market, and that investors retain their faith in it and other central banks, knowing that there is a strong possibility of QE4 at some stage in 2016. Accordingly we think now opportune to selectively increase exposure to sectors that following the recent correction offer attractive value, and these include UK medium and smaller companies, as well as selectively some developed market government debt.

We remain cautiously optimistic that our key preferred equity and fixed income asset classes can continue to deliver good risk adjusted returns for our investment portfolios despite increasingly volatile markets.