Benoit’s analysis and arguments suggest that the most successful investors are those that best manage risk, nicely summing up the process we adopt on behalf of our own clients here at Ash-Ridge.
Last Quarter Review
Despite both Federal Reserve Chair Janet Yellen and several other key members of the Federal Open Market Committee (FOMC) talking up the strength of the US economy and the potential threat of future inflation, US interest rates remained unchanged during the quarter. Inflation continues to be modest at just 1.1% despite unemployment remaining tight at just 4.9%, while (real as opposed to nominal) GDP in the second quarter was revised up slightly from the previous reported 1% to 1.4%, with the annual real GDP falling to just 1.3%, well below the average of 3.21% since 1948, and what might be expected from an American economy supposedly nearing full strength.
The Bank of England (BOE) by contrast cut interest rates from 0.50%, where they have been since 2009, to an unprecedented historic low of just 0.25% on the 4th August, and suggested rates could go lower yet in the aftermath of the Brexit decision. Additionally the BOE expanded its quantitative easing (QE) by a further £60 billion to £435 billion which will include the purchase of up to £10 billion of UK corporate bonds, citing concerns about the weakness of sterling and the threat from the UK’s possible loss of access to the European Union’s single market as reasons for its actions. Interestingly the UK’s GDP numbers improved as shown in the table below, while inflation remains a modest 0.6% and unemployment at 4.9% suggesting if anything a positive impact post Brexit thus far!
Meanwhile the Bank of Japan (BOJ) left interest rates unchanged at -0.1% at its September meeting, while advising it would introduce yield curve control in its bid to defeat inflation and kick start the economy. Effectively it will be doing everything in its powers to push inflation rates to more than 2% per annum, in an attempt to reverse an almost three decade long deflationary trend, that commenced following the collapse of the benchmark equity index Nikkei 225 after hitting its all time high of 38,915.87 in December 1989.
The European Central Bank (ECB) left its benchmark interest rate unchanged at 0% for the fifth time at its September meeting, while confirming the EU’s version of QE, namely its monthly asset purchases of €80 billion will continue until at least March 2017. Economic growth in the EU area improved slightly in the third quarter, but unemployment at more than 10% remains stubbornly high.
As the table below shows, anyone following the old stock market adage “Sell in May and don’t come back until St Leger’s Day” would have caught a nasty chill this year as most global equity markets as well as developed government debt markets produced unseasonably good returns! The various UK market indices were amongst the star performers with the benchmark FTSE 100 up 6% but the mid and smaller company indices (which of course had suffered badly in June from the Brexit result), did particularly well with the FTSE 250 up almost 10% and the FTSE Small Cap up almost 13% over the three month period.
|Key Economic & Market Data||2016 Q2 GDP||12 month GDP||Base Interest Rate - End Sep 2016||Equity Index - Last Quarter||Equity Index - Last 12 Months||Sovereign Bond Index - Last 12 Months|
|NB. GDP Data shown is to the 30th June 2016; Interest Rate, Equity & Bond Index Data is to the 30th September 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.|
As ever it is extremely challenging when trying to discern possible economic and market developments to ignore the ever- present market “noise”. As we head into the final lap of the US Presidential election in November, it can be all too easy to become caught up in the rhetoric surrounding the likely winner and the implications for main street, Wall Street, and the wider world!
The reality is that the outcome is unlikely to have much impact (at least in the short term), since monetary policy from the Fed will probably stay center stage, although we may (probably sooner should Trump triumph) see fiscal stimulus enter the economic arena before the end of the next four year cycle if markets signal the former has become impotent, and can no longer be relied upon to keep bond and equity markets elevated. While fiscal stimulus to rebuild America’s ailing infrastructure seems an obvious win-win to many neutral observers, getting political buy in for such explicit expenditure that would have to be eventually paid for by the tax payer remains politically sensitive, while the more subtle monetary stimulus through expanding the Fed’s (now fragile) balance sheet can be done under the political radar!
Few would deny the concerns for the ever expanding debt side of virtually every global government’s balance sheet, which surely cannot continue indefinitely as most independent research suggest that once the GDP to debt ratio exceeds 90%, it becomes economically unsustainable. This was demonstrated in the exhaustive research undertaken by Carmen Reinhart and Kenneth Rogoff in their best selling book, “This time is different”, with the implied conclusion that of course it never is!
Currently the US government debt to GDP ratio is 104%, which should be ringing alarm bells, while it is just as worryingly high in the Euro Area (104%), and little better in the UK (89.2%). However the fact that Japan’s debt to GDP ratio is a staggering 229% and has been above 90% for the best part of two decades suggests the theory may be flawed, unless as often argued, the Land of the Rising Sun is a unique case, due to very little of its debt being owned by foreigners.
In the UK, the majority in the city of London will have been dismayed to hear Prime Minister Theresa May at the Tory Party Conference at the end of September steadfastly refuse to compromise upon the Brexit result, while promising to honor the electorate’s decision to take back full control of immigration and sovereign law making from Brussels. This of course will likely mean Britain being refused automatic access to the single market, which could have some major repercussions in the view of many who favored staying in the EU.
The Prime Minister is quoted as saying. “The process we are about to begin is not about negotiating all of our sovereignty away again”, while also implying that Article 50 would be triggered before the end of March 2017, which will then give the UK and the EU two further years to hammer out a new arrangement. The Investment Association, on hearing the news questioned the ability of Britain’s fund managers to continue being able to manage the £1 trillion of assets on behalf of mainland European investors.
While this is undoubtedly a concern for markets, it must be remembered that we are probably a couple of years away from the final outcome and that in reality the European Union has at least as much as the UK to lose from playing hard ball concerning the single market! As we have suggested before, London has many advantages for being the strategic European financial center linking the American and Asian markets, and this is most unlikely to disappear with the Brexit decision.
Meanwhile a recent article in The Economist newspaper titled “Taking it to 11”, suggests the law of unintended consequences is almost certain to be one result of the decision by some of the major central banks to purchase company assets in both bond and equity forms as part of the development of their QE programs. To quote The Economist article “three of the world’s most important central banks - BOE, ECB and BOJ – have dialed monetary policy up to 11, expanding their asset purchases from government bonds to embrace corporate debt and even equities.”
While the article accepts there are some sound logical arguments as to why these developments should have been expected from the central banks in their attempt to control interest rates, it also suggests there are potential unintended consequences including in the Euro Zone an unfair advantage being acquired by the companies whose debt the ECB has bought, since when they come to issue new debt they will be able to price their issues cheaper than their competitors. On the other hand the article suggests that in the UK, due to the much shallower corporate debt market (compared to the US), the BOE has been forced to make some odd looking inclusions in its portfolio, which begs the question, “Will the purchase of sterling bonds issued by Apple, Daimler or PepsiCo really lower the cost of capital for British finance?”
Much more worrying from an investment perspective are the claims of many such as fifty year city veteran Robin Griffiths recently that since 2009 the central banks have temporarily suspended the normal workings of the business cycle through their zero interest rate and various QE policies, while warning that the market will always eventually succeed in reverting to the mean! Robin and other market analysts are convinced that sometime in the next couple of years, and most likely in the second year of the new Presidential term (typically when the new incumbent’s honeymoon period ends), there will be another potentially severe bear market, but the good news is that he believes thereafter the arrival en-masse of the millennial baby boomers to the workforce will coincide with the commencement of a new secular bull market that on the back of technology breakthroughs could rival the great run of 1982 to 2000!
The likelihood is that between and now and Christmas, markets will be focused upon two major events. The first of course will be the US presidential election in November although as we suggested above, the outcome is unlikely to be of major concern to markets, at least in the short term, as monetary guidance from the Fed remains the key to the how the world’s largest economy, equity and bond markets perform. Possibly more important for the confidence of the markets will be how Europe’s policymakers resolve the chronic lack of capitalisation in European banks with the current Deutsche Bank crisis possibly just the tip of the iceberg!
There can be no denying that on most valuation metrics the US blue chip equity market is either fully or over valued, and the same can arguably also be said of US Treasuries, UK gilts, and most other developed market investment grade debt. Notwithstanding, the combined effects of continuing global deflation along with the determination of central banks to expand their bond buying programs in order to try and control interest rates, means there is plenty of potential for bond yields to go still lower (resulting in values rising), but the risks are asymmetric, should policymakers stumble!
Much more attractive we believe, and continuing to offer value are higher yielding value stocks in markets such as the UK and especially in the mid and smaller cap sectors, along with selectively smaller cap sectors in other developed markets, and some emerging market sectors. Additionally we continue to perceive on a longer-term cycle attractive values in the UK commercial property sector.
As ever, 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.