1st Quarter 2017

“All successful investing is based on foresight, but foresight alone is not enough. The other essential ingredient is a sense of values. What does it profit a man to foresee that a stock will treble its earnings, if he pays four times as much for it as it is worth on its present earnings? Answer: Nothing unless he can find someone else to sell it to for more than it is worth on its present earnings.”

These profound and timeless observations come from Thomas W Phelps’ classic 1972 book titled “100 to 1 In The Stock Market”, in which he documents how buy and hold investing is the surest way to financial success. Amongst other investing pearls of wisdom, he suggests “time is often an overlooked element in value”, and that “being right too soon is just as painful as being wrong.”

Thomas Phelps’ observations provide valuable food for thought as we reflect upon the last quarter, and calendar 2016, and ponder what the new-year ahead has in store for investors. While we remain acutely aware that this current business cycle expansion is now very long in the tooth (by historic standards) at ninety-one months, we are only too conscious (following the pleasantly surprising positive returns from developed market stocks this past year) of how costly being too early in increasing our defensive asset allocation could be to our capital preservation objectives within client portfolios.

Last Quarter Review

The last quarter of 2016 continued to shock pollsters and bookmakers, not to mention the American ruling classes, as the triumph of Donald Trump in the US Presidential election continued the rise of global populism that began with the unexpected Brexit referendum result back in the summer. Prior to the November 8th election, most talking heads in the financial media had warned a Trump victory would be disastrous for markets and the US economy, but within days of the result, investors begged to differ and sent most global equity markets soaring on the back of the anticipated tax cuts and massive fiscal stimulation promised by the incoming new President, who moves into the White House on the 20th January.

With the exception of China (-1.41%) and India (-3.50%), most other major equity markets have soared since the Trump triumph, led by the key American indices. From the 8th November to the 31st December, the S&P 500 was up 4.64%, the Dow Jones Industrial Averages was up 7.80%, and the Nasdaq 100 was up 3.65%.

The biggest winners however in US markets, were those invested in medium and smaller capitalized companies with a domestic (as opposed to international) focus, as the Russell 2000, rose a whopping 13.55% on the expectation that Donald Trump’s proposed policies of re-domesticating a large amount of foreign trade while restricting imports will especially benefit these stocks. Most international indices also did very well after November the 8th, with the FTSE 100 climbing 4.38%, the EuroStox 50 rising 8.58%, and the Nikkei 225 in Japan up 11.32%!

The dollar, which was already seemingly in a new bull market pre the Trump victory, gathered momentum after the 8th November on the back of a number of complex reasons related to the offshore Eurodollar market, including the expectation that several trillion dollars held by US corporations offshore (and thereby supporting emerging market economy development) would be encouraged home by the “Trumponomic” proposals. Consequently, a shortage of offshore dollars is likely to be problematic for most economies in Asia (ex Japan), Latin America and Africa, which partly explains the poor performance of their stock markets, while fuelling further gains for the greenback.

Government bond markets also suffered badly in the fourth quarter primarily as a result of investors believing Trumponomics will increase inflation, and this view was reinforced by the Federal Reserve (Fed) increasing base rates in America from 0.5% to 0.75% at its December Federal Open Market Committee (FOMC) meeting and suggesting it was likely to implement three more 0.25% interest rate hikes during 2017.

Key Economic & Market Data 2016 Q3 GDP 12 month GDP Base Interest Rate - End Dec 2016 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 3.50 1.75 0.75 +3.25 +9.54 +1.21
UK 0.60 2.20 0.25 +3.53 +14.43 +10.94
Euro Area 0.30 1.70 0.00 +9.35 +0.47 +3.18
China 1.80 6.70 4.35 +3.35 -12.31 +2.10
Japan 0.30 1.10 -0.10 +16.20 +0.42 +3.25
Germany 0.20 1.50 0.00 +9.23 +6.87 +3.99
NB. GDP Data shown is to the 30th September 2016; Interest Rate, Equity & Bond Index Data is to the 31st December 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

There can be no denying 2016 was an extraordinary year both politically and for global markets. You may recall our opening line to Ash-Ridge Asset Management’s first Market View of 2016, namely, “Winston Churchill once said, Politics is the ability to foretell what is going to happen tomorrow, next week, next month and next year - and to have the ability afterwards to explain why it didn’t happen”.

Looking back at how 2016 unfolded both politically and in global markets, it would appear our observations could not have been much more prophetic with the shock Brexit result, followed by the resignation of Prime Minister Cameron, and then by the extraordinary triumph of the maverick Donald Trump over traditional Republican challengers, before defeating incumbent Democratic President Obama’s anointed successor, Hilary Clinton. More importantly, and probably also more extraordinarily, the year was an exceptionally good one for investors in equities, especially where the bulk of portfolios were invested in UK companies.

Naturally following a phenomenally good year like 2016 for investors, the next year presents additional challenges, in respect of both existing headwinds, and potential new ones. The former include expensive valuations (in many markets), the ever increasing global debt (now believed to be in excess of $225 trillion when combining government, corporate, financial and private borrowings), and continuing deflation as a result of the shrinking Eurodollar market, while the latter include geopolitical trade tensions between the US and China as a result of the new Trumponomics era, the possible inflationary (or rather stagflationary) consequences of massive fiscal stimulation the incoming Trump administration intends, and depending upon the outcome of key national elections in Europe, the possible implosion of the Euro.

As ever with macro markets, trying to determine the outcome is fraught with risk and uncertainty, but the key, as so often in the past, appears to be getting the call on the direction and extent of any move in the US dollar right. However the complexity and sophistication of the shadowy Eurodollar market makes the challenge of calling the greenback’s direction and the extent of any move, arguably more difficult than ever.

Data from various sources such as the International Monetary Fund (IMF) and the Bank for International Settlements (BIS), suggest that the assets of the Eurodollar or offshore banking market peaked in 2007 and have been in decline ever since, by dint of modern global markets being driven by fiat debt, and reliant upon an ever increasing credit line to continue functioning. Accordingly, the only way the Fed and other central banks could partially alleviate the collapse of the Eurodollar market and the corresponding deflation, was via the creation of more debt through quantitative easing (QE) and other extraordinary measures such as zero interest rate policies (ZIRP).

The deflationary problems that the Eurodollar market has been experiencing since the collapse of Lehman Brothers and the debt crisis of 2008, are closely linked to developments in global reserves, which have been in decline since August 2014. Since then, global reserves have dropped from $13.04 trillion to just $11.06 trillion as of October 2016, despite the central banks and global policymakers best reflationary attempts through monetary policies such as QE, ZIRP, and more recently negative interest rate policies (NIRP).

If the shortage of Eurodollars persists or gets even worse during 2017 (which as we mentioned earlier is likely due to Trumponomics encouraging American companies with overseas interest repatriating dollars to the US mainland), it will almost certainly result in a continuation of the dollar bull market which as measured by the trade weighted index (or Dixie) rose 7.24% in the fourth quarter of 2016, including 6.61% in the eight weeks to the end of December following Trump’s election.

The other unintended and potentially more severe consequence of a shortage of offshore dollars is the adverse impact upon potentially every other trading nation other than Japan, the UK, the Eurozone and China, whom along with the US form the reserve countries (as defined by the IMF within its Special Drawing Right or SDR digital currency), and effectively are permitted to simply print yen, sterling, euros and yuan at will, while other countries are obliged to build dollar reserves instead through exports and or high domestic interest rates to keep their economies and currencies competitive. The complex and delicate relationship between the five reserve countries whom can simply create money from nothing to expand their balance sheets, and the remaining world countries appears to have broken down since 2014 as the huge amount of credit created by the reserve countries was not met by demand from their populations for goods from the exporting countries of the rest of the world.

Instead, much of the excess money created by QE and other programmes by the reserve countries went into the financial sectors, and inflated the value of stocks and bonds, while the demand for imported goods from the exporting countries has decreased dramatically, with many of those countries affected having to increase interest rates, and / or devalue their currencies in order to stabilize their economies. Naturally while a continuation of this trend offers further potential rewards for investors, the possible destabilization of many of the exporting countries is a major concern as they get caught in a vicious downward cycle of having fewer dollars to spend because sales to the reserve countries are in a slump, which is likely to make them want to pay off previous reserve country credit because export business is bad, while the "hot foreign money" will almost certainly be exiting at the same time, forcing a likely devaluation, while raising interest rates.

Forward Outlook

For the reasons explained above, we believe the key question for 2017 is whether the dollar bull market that has gathered momentum since the election of Trump will continue. Additionally it will be important to monitor how policymakers endeavor to manage the dollar’s strength, and resolve any potential Eurodollar crisis, and the likely havoc that would create in emerging markets.

The Christmas edition of The Economist posed some interesting questions when it asked what might be the big market surprises of 2017 in its Buttonwood article titled, “Seeing through a glass darkly”. We agree with its warning against getting overly excited about what Trumponomics might deliver both to the American economy and Wall Street markets, not least because the Trump administration’s proposed tax cuts and extraordinary fiscal stimulus have to be approved by Congress, which should never be taken as a given!

On the presumption Congress will (eventually) approve both measures, The Economist reminds us that it may still not be enough to propel US economic growth to the 3%-4% we would all love to see happen, since demographic and debt headwinds are phenomenal. Just look at the Japanese experience after endless monetary and fiscal stimulus over nearly three decades!

In effect The Economist is suggesting returns from stocks on Wall Street might disappoint this year, while a positive surprise could well be, that Treasurys do much better than expected should it transpire that economic data remains weak and yields end up coming back down. Its third suggested surprise is just as interesting and food for thought as it ventures that the European Union disintegration that most fund managers polled seem obsessively fearful of, doesn’t happen, in which case returns for those invested here could prove surprisingly good!

The Economist’s fourth potential surprise relates to a possible market shock emanating from a cyberwarfare attack, and causing temporary flash crashes. Its final suggested surprise relates to gold bullion and the likelihood that few investors will be holding the historic portfolio insurance due to its five and a half year bear market since peaking at $1900 an ounce in August 2011, but Buttonwood thinks sabre rattling by the US towards China and Iran this coming year could result in the yellow metal surprising everyone.

While we agree with The Economist that 2017 will be challenging for investors and that there are likely to be some surprises in store, we are also mindful of Thomas W Phelps’ timeless insights that being right too early can be just as painful as being wrong. For now we believe the long equity bull market that began in March 2009 has some legs left, especially in selective sectors within UK and European Equity markets where, on a relative comparison, valuations are attractive.

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 and asset allocations remain well placed to realise this potential and will continue to be effective in meeting client objectives. From all of us at Ash-Ridge Asset Management, we would like to wish you a healthy, happy, and prosperous 2017!