3rd Quarter 2017

“I believe, from my studies and the studies I’ve read of Eugene Fama, Ken French, Harry Markowitz, and Bill Sharpe, that markets are nearly micro-efficient. There is no similar macro-efficiency. Instead they are frequent objects of wild swings and speculative euphoria that defy rationality.” – Paul Samuelson, Nobel Laureate writing in “Asset Management” in March 1998

It is sobering to reflect that, as a highly distinguished and respected economist, Paul Samuelson was acutely mindful of the challenges of asset allocation. We devote much time at Ash-Ridge in endeavoring to understand the big picture in the knowledge that effective asset allocation, if able to be maintained, will have a greater impact on risk adjusted returns than the selection of individual portfolio holdings.

Last Quarter Review

The last quarter provided mixed results for global equity markets as the reality of what the Trump administration will or will not be able to achieve sank in. The Federal Reserve meanwhile, felt sufficiently confident on the evidence of US data to raise interest rates by 0.25% at its FOMC meeting in June stating that “the labour market has continued to strengthen and economic activity has been rising moderately so far this year“.

Wall Street continued to hit new highs, as the Dow Jones Industrial Average reached 21528.99. The S&P 500 rose 2.57% over the quarter and is up an impressive 13.27% since President Trump was elected on the 8th November 2016.

The UK economy continued to grow steadily at an annualised GDP rate of 2%. There are however signs that the UK is beginning to show signs of weakening economic growth as investment slows and inflationary pressures begin to bite. UK consumer prices increased at an annualized 2.9% in May, (compared to 2.7% in April), and is the highest inflation rate since June of 2013.

The June national election in the UK resulted in a smaller parliamentary majority for the Conservatives who are now having to rely upon the Democratic Unionist Party (Ulster) to help carry the day at Westminster. Markets were however unperturbed, indeed, the outcome could potentially provide for a Brexit deal that is more beneficial for the City of London than might otherwise have been negotiated under the original less flexible option.

Across the Channel, investors sighed with relief when centralist Emmanuel Macron beat pro “Frexit” challenger Marin Le Pen in the French Presidential election. A removal of political uncertainty in several European community (EC) countries during 2017 combined with the increasingly encouraging economic data coming from Germany, and the Euro block have seen European markets provide some of the best results for investors during 2017.

Key Economic & Market Data 2017 Q1 GDP 12 month GDP Base Interest Rate - End Jun 2017 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 1.40 2.10 1.25 +2.57 +15.46 -1.88
UK 0.20 2.00 0.25 -0.40 +12.43 -1.31
Euro Area 0.60 1.90 0.00 -1.69 +20.15 -2.76
China 1.30 6.90 4.35 -0.93 +8.97 +0.00
Japan 0.30 1.30 -0.10 +5.95 +28.62 -3.05
Germany 0.60 1.70 0.00 +0.10 +27.32 -3.45
NB. GDP Data shown is to the 31st March 2017; Interest Rate, Equity & Bond Index Data is to the 30th June 2017; 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 used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign

Current Considerations

In a heavily indebted world, where total corporate, personal and government debt is now estimated at somewhere north of $230 trillion, it is never safe to say that the future looks rosy from an economic perspective. There is however undoubtedly an air of optimism apparent in most asset markets helped by a steady improvement in real GDP numbers in US, increasing from an annualized low of just 1.3% twelve months ago (second quarter 2016) to an expected 2.7% last quarter (based on the Atlanta Fed GDP Now forecast as at the 30th June).

It is with noting that, demographically, the US has recently entered a potential “golden era” whereby middle aged Americans outnumber the under thirty-five (millennial) generation, and due to last until 2028. A comprehensive research paper titled “Demography and the Long-Run Predictability of the Stock Market” written in 2002, showed that on the previous two occasions this occurred (1950-65, and 1982-2000), economic growth in the US as represented by GDP was consistently higher, resulting in parallel secular equity bull markets.

Additionally, despite increasing political obstacles on Capitol Hill, there remains optimism that the Trump administration will succeed with its proposed tax reforms and fiscal infrastructure spending. The combined demographic and fiscal dividends could eventually persuade the 50% of Americans who don’t currently own equities to begin scrambling to catch up, while a large percentage of the $70 trillion globally sitting on deposit or cash equivalent accounts (as identified by BlackRock last autumn) could provide the additional impetus to generate a once in a generation “melt-up” on Wall Street similar to that experienced in the roaring twenties that peaked in 1929, or more recently the Nasdaq tech bubble which saw stock prices go parabolic in the late nineties before peaking in 2000!

On a relative valuation basis, UK and European stocks are trading at a discount to their American peers, which suggests they potentially offer good value. After a slow recovery, 2016 and 2017 has seen European equities bridge some of the gap, but there remain plenty of opportunity and, we believe, continue to perform well going forward.

In France, Emmanuel Macron’s presidential victory has been further endorsed by the parliamentary majority of 355 seats (out of 577) secured by his La Republique en Marche party and its centrist party ally Modem in the June elections. This should allow Macron to embark upon necessary reforms to rejuvenate the French economy, and help drive the European Union economically.

From a political perspective, all eyes will now turn to the German national election on the 24th September, when current incumbent Angela Merkel, will face competition from Martin Schulz from the Centre Left party, and Frauke Petry from the far right. The expectation is that Merkel to prevail but with immigration a key issue (as it was with the Brexit referendum in Britain in 2016), nothing can be taken for granted despite Germany’s consistently strong economic performance under her leadership.

After the German elections this autumn, the next big political obstacle for the EU to negotiate will be Italy and its national election to be held in 2018. Italy also arguably poses the biggest threat to the continuing economic recovery in Europe by dint of its recurring banking woes.

For now at least, the recent crisis in the Italian banking sector appears over thanks to taxpayers in Italy being forced to bail out the troubled Banca Popolare di Vicenza, and Veneto Banca in north eastern Italy. Once the European Central Bank (ECB) declared on the 23rd June that the two Italian banks were failing, the Italian government quickly stepped in and sold their “good assets” to the country’s second largest lending institution, Intesa Sanpaulo, for just €1, while the “bad assets” went into a separate account overseen by the authorities.

Investors for the most part were happy as the Italian stock market rose, but as an article in The Economist suggests, “the bail-out has sown confusion-and consternation – about the euro zone’s new, and scarcely tested, system of treating failing banks. After the ECB’s declaration, responsibility passed to the Single Resolution Board (SRB), a separate agency set up by the commission.”

Earlier at the beginning of June, the European Commission had approved in principle the rescue of the world’s oldest bank, Monte dei Paschi di Siena, which is Italy’s fourth largest lender. This is expected to cost €8.8 billion with Italy providing €6.6 billion of this according to the Bank of Italy.

Meanwhile the world, and especially countries with US dollar trade surpluses, will have been breathing a sigh of relief at the recent weakness in the trade weighted value of the greenback (the DKY index), which over the quarter has fallen by around 5%. President Trump in his manifesto vowed to eliminate the US’s trade deficit however, this will be seen to be an unrealistic ambition if America also wishes the dollar to remain the global reserve currency as a return to surplus, were it possible, would create an acute shortage of greenbacks, and chaos in the foreign exchange markets.

Forward Outlook

While the political and banking risks are an ever-present consideration, we continue to believe that Europe will continue to improve economically.

Additionally we feel that some sectors of the UK, including higher yielding mid and small- caps, remain attractive from a valuation perspective, albeit they can be expected to remain sensitive to the value of Sterling and the ongoing Brexit negotiations as they unfold. With UK interest rates likely to be headed up in the medium term due to inflationary pressures, we remain cautious of UK gilts, and corporate debt.

In the US valuations, especially in respect of some of the larger tech companies such as Facebook, Amazon, Apple, Netflix and Google (or FAANG as many commentators refer to them) are very high on historic comparisons. However opportunities selectively exist here too, and with the potential of the fiscal and demographic dividends we referred to, it makes sense to retain reasonable maintain exposure here also.

The current weakness in the US dollar is to be welcomed from a global perspective as it reduces the possibility for now of a global dollar shortage developing and potentially forcing some of the emerging markets to raise interest rates and or devalue their currencies. It seems unlikely the dollar’s current weakness will continue longer term, not least because the Fed continues to raise interest rates in the US, but the longer the dollar weakness continues the more attractive potentially many of the emerging markets will become and especially Chinese mainland stocks (A shares) which are now included by MSCI for the first time in its emerging markets index and which could result in more than a trillion additional dollars finding their way into stocks over the next few years.

Selectively there are also some attractive global bond opportunities although we remain cautious while the Fed continues its tightening process.

As always, risk is at the forefront of our advice and, whilst it often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed and effective in meeting our client’s needs.