3rd Quarter 2016

“Someone is sitting in the shade today because someone planted a tree a long time ago” is a famous Warren Buffett saying which reflects the sage of Omaha’s attitude towards building wealth, namely having a methodical value investing approach that is focused on long term objectives, and nurtured through patience and a refusal to be distracted by short term developments and noise!

Time of course will tell whether the largely unexpected (based upon the polls and bookmaker odds) decision of the British electorate in the 23rd June 2016 referendum to vote to leave the European Union turns out to be simply a short term distraction for the markets, or something more profound! The initial response of markets suggests the short-term impact will likely affect European bourses much more, as the Euro Stox 50 fell 8.62%, the German Dax fell 6.82%, and the French Cac 40 fell 8.04% on the day following the result.

By contrast, although the FTSE 100 index fell around 8% when markets opened on the day after the referendum, the index was down less than 3.5% at close, finishing the month 2% higher than the day of the vote. The FTSE 250 and FTSE Small Cap sectors fared worse as investors initial expectations for domestic focused companies waned, whilst on foreign exchange markets, Sterling fell dramatically; although much of this simply negated the previous large rise against the US dollar and other currencies in the run-up to the referendum in the expectation that the UK would vote to remain part of the EU.

Last Quarter Review

In the United States, the Federal Reserve (Fed) central bank left interest rates unchanged at both its April and June meetings. In the 15th June press release from the Federal Open Market Committee (FOMC), we were told the economic picture was mixed with improving growth while the labour market slowed. Household spending has strengthened, and the housing sector has improved, while inflation has continued to run below the 2% target, partly reflecting earlier declines in energy prices and in prices of non-energy imports.”

The FOMC sees no immediate threat from inflation. It reiterated its data dependent approach to interest rate increases as, “economic conditions evolve in a manner that will warrant only gradual increases in the federal funds rate.”

The Bank of Japan kept its pledge to increase the monetary base at an annual pace of about 80 trillion yen at its June meeting. Policymakers also decided to leave unchanged a 0.1 percent negative interest rate, despite deflation once more seemingly in control of the Japanese economy.

The threat of deflation is also a constant threat in the Euro area as consumer prices were expected to rise a meager 0.1 percent annualised to June, although industrial production did grow at a much improved, annualised 2% to April. Ironically even as the UK voted to leave the EU, European Central Bank (ECB) President Mario Draghi was renewing his call for closer Euro Area integration, saying it was necessary that other policy areas contribute more decisively in order to support the full benefits of the ECB’s unprecedented stimulus measures of €80 billion a month.

In the UK, The Bank of England announced on the 30th June it is prepared to take whatever action is needed to support the UK economy post Brexit, and is most likely to cut interest rates over the summer. The Bank will also consider a host of other measures to promote monetary and financial stability, hinting at more quantitative easing (QE) despite the UK being relatively strong economically with unemployment at just 5%, the lowest figure since October of 2005, and the employment rate at a record high 74.2 percent, with pay growth picking up.

As the table below shows, most global equity markets suffered more than the UK during the second quarter although we can have expected markets to have partially priced in the threat of the UK leaving the European Union during the first half of the year. During the quarter, the global deflationary trends continued to push yields lower on government debt including the 10 year US Treasury Bond which fell from 1.78% to 1.49%, and the 10 year UK gilt which fell from to 1.42 to a new record low of 0.867%!

Key Economic & Market Data 2016 Q1 GDP 12 month GDP Base Interest Rate - End Jun 2016 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 1.10 2.10 0.50 +1.90 +1.73 +6.41
UK 0.40 2.00 0.50 +4.92 -0.65 +9.01
Euro Area 0.60 1.70 0.00 -4.67 -16.34 +8.96
China 1.10 6.70 4.35 -2.51 -31.53 N/A
Japan 0.50 0.10 -0.10 -6.94 -22.93 +9.30
Germany 0.70 1.30 0.00 -2.86 -11.56 +8.16
NB. GDP Data shown is to the 31st March 2016; Interest Rate, Equity & Bond Index Data is to the 30th June 2016; 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

Market rhetoric can be extraordinarily bizarre to behold especially when you are involved closely every day. For example listening to some overly excited “talking heads” on an American financial channel, we were told the sterling crisis post Brexit had resulted in the pound falling 7.5% against the dollar in the second quarter, its “worst performance” in thirty years!

Naturally we could all be forgiven for thinking the worse upon hearing such news! Then we pinch ourselves, and remember what every major trading nation has been desperately trying to do since the credit crunch eight years ago in 2008, namely devalue their currency in order to get one ahead of their exporting competitors.

One commentator online this week remarked that Brexit had inadvertently done for the British economy and its exports going forward what David Cameron, Gordon Brown, Mark Carney and Mervyn King combined had failed to achieve in almost a decade of trying! Of course it is not all silver linings because as a nation’s currency falls and export profits rise, import costs increase. Britain has however prided itself on being a maritime trading nation and should in theory thrive on being able to hopefully negotiate lucrative new dual deals with numerous old commonwealth partners like India and Australia as well as of course one of our most important and oldest strategic allies, the United States, and the phenomenal opportunity that is China!

Understandably the largely unexpected referendum result dominated markets in the last week of trading during the previous quarter however, the welcome improvement in the outlook for the US economy helped ensure most markets powered through to a strong finish. Undoubtedly in the US this would have been helped by news from the Atlanta Fed’s “GDP Now model” (which historically has most accurately predicted economic growth) forecasting real GDP growth (seasonally adjusted annual rate) in the second quarter of 2.7 percent on June 29, up from its 2.6 percent prediction on June 24.

Although there had been much talk during the second quarter that Fed Chairman Janet Yellen, would increase US base rates further at some stage in 2016, many market pundits suspected she was reluctant to do so as the global economy heads into the latter stages of the current business cycle and growth world-wide remains less than scintillating. The Brexit result now provides Dr. Yellen with the perfect short-term argument for not raising interest rates again anytime soon, and almost certainly not before the US Presidential election in November.

Interestingly, former Federal Reserve Chairman Alan Greenspan (his tenure ran from 1987 to 2006) appeared on Bloomberg following the UK referendum and stated, amongst other things, that he was concerned markets were not factoring in sufficient inflation risk as seen in the extraordinary volume of institutional investments seeking solace in government debt; driving UK gilts in the 10 year benchmark issue to below 1% for the first time in history and on the US 10 year Treasury to just 1.48% with speculation that this could go to just 0.50% before the long three decades old secular bull market in government bonds is over. Dr. Greenspan said, ” I know if you look at human history, there are times and times again where we thought that there was no inflation and everything was just going fine.  It's not about to emerge quickly, but I would not be surprised to see the next unexpected move to be on the inflation side.  You don't have inflation now.  And you don't have it until it happens.”

Food for thought, but not a warning that Mark Carney, the BOE Governor will heed for now, as he made strong suggestions that interest rates in the UK are set to be reduced further and that additional QE or money printing of sterling is on its way. While the jury is arguably out on how successful or otherwise previous QEs have been in the US, UK, the Euro Region and Japan, there can be no denying that these actions have proved beneficial to bond, equity and property markets.

There is even talk of the Fed possibly introducing QE4 in the US during the second half of this year. However for some time many others have been advocating fiscal stimulus or “helicopter money” as an alternative to further monetary enhancements such as QE in the major economies.

Were this helicopter money to materialise, it is argued it could most efficiently be done through large infrastructure projects such as rebuilding and repairing roads, bridges, airports etc. in the US as an example. An article in the Buttonwood section of The Economist recently explored this, and concludes it would probably be less attractive than conventional QE because it would be harder to reverse, and could encourage lazy governments to become hooked upon it as an easier source of revenue, while ultimately resulting in much higher interest rates that would especially punish small firms and mortgage holders.

*Doubtless, as the long overdue downturn in the global business cycle eventually arrives, these options will almost certainly be revisited again in earnest! Some Keynesian economists have speculated that the application of successive monetary stimuli in the form of a series of QE, zero interest rate policy (ZIRP), and more recently negative interest rate policy (NIRP) has resulted in the business cycle being indefinitely delayed! *

We very much doubt this however as the business cycle that consists of the ebbing and flowing of economic expansion and contraction has existed in one guise or another since the dawn of capitalism (and probably long before!). The current expansionary phase began in June 2009, and since the “average duration” of the expansionary phase has according to the National Bureau of Economic Research (NBER) been just 58.4 months, we shall be keeping a careful eye on the data that make up the business cycle as we enter month 86 and counting!

Forward Outlook

For now markets appear becalmed following the supposed Brexit Black Swan. The quick and calm responses and comments of the major central banks, and most especially from the BOE have reassured investors, at least for now.

Focus will soon shift to the US Presidential election, and the implications of the outcome there. Some uncertainty will also surround the pivotal future role of London following the UK’s decision to leave the EU, but early indications suggest the potential fallout from both companies and staff relocating to elsewhere in Europe is likely to be much less than originally feared.

Our view is that London (which according to the semi annually compiled and highly respected Z/Yen Global Financial Centres Index, has been the top-ranked since 2007, except from March 2014 to September 2015, when New York City led) is just too important strategically for the most influential global companies, as well as many newer entrants not to want to continue operating here. The benefits of time zone, language, culture, corporate law and so many other advantages quite apart from lifestyle make London unlikely to lose its key position anytime soon.

*The question following the result of the 23rd June is whether we should now consider a reappraisal of our advised investment portfolios. The one area we have been giving immediate thought to is the forward outlook for Sterling (end June $1.32), in speculation that it could conceivably go to near parity with the US Dollar (as was the case in the mid eighties). We doubt, however, this will be the case, even with further UK QE to come, and would not be surprised to see Sterling appreciating gradually from here, especially against the Euro and other non US dollar currencies. *

Accordingly, whilst it is unlikely to be an opportunity to purchase foreign equity or bond markets cheaply, the post Brexit world will inevitably provide many attractive value opportunities, both at home and abroad. Whilst it may be necessary to undertake adjustments in portfolio allocation in order to maintain individual risk preferences, we are confident that our current fund selections remain well placed to realise this potential and that broadly diversified portfolios will continue to be effective in meeting client objectives.