Investment Strategy:  Fourth Quarter 2019 – General Market Review

Summary

  • Global growth is slowing and the risk of a shallow recession increasing in a number of countries. Inflation remains muted and the ‘lower for longer’ narrative remains the driving force in financial markets.

  • Central Bank monetary policy everywhere has become increasingly dovish. The US Federal Reserve Bank is now in a rate cutting cycle whilst the ECB is re-introducing quantitative easing.

  • The ability of monetary policy to stimulate economic growth has pretty much reached the end of the road. Fiscal policy needs to take over the baton from here.

  • Geopolitics remain very problematic. Trump has escalated the US/China trade war whilst Brexit remains a very dark cloud over the UK and the Eurozone.

  • Markets are looking for safe havens in the increasingly fraught political environment; Government bonds and gold fit the bill.

  • Equity markets have held on to the strong gains made in the first half of the year, putting their faith yet again in the ‘Fed put’ of lower interest rates to stave of recession.

  • The most significant moves last quarter were in bond markets where yields have collapsed following the volte-face in Central Bank policy and the global growth slowdown. Ultra-low yields and inverted yield curves indicate that the bond market is forecasting recession. Returns from long duration bond funds have been strong this year.

  • Both equities and bonds look fully valued, though sustained by the ultra-low interest rate environment. We do not expect bond yields to collapse further but to plateau and trade in a tight range in the coming quarters.

  • Sterling, as always, bounced around on Brexit sentiment and has held up better than the newspaper headlines would suggest.

  • The attack on the Saudi oil refineries marked a return of the ‘political premium’ to the oil price though the market remains in oversupply whilst global demand is slowing. ‘Safe haven’ gold has stormed through US$1500/oz, the highest level for six years.

  • Commercial Property is very much a yield rather than a capital growth story at this mature stage of the cycle.

Paranoid

Paranoia is defined as an instinct or thought process believed to be heavily influenced by anxiety or fear, often to the point of delusion and irrationality. Yep, sums up market sentiment these days. Financial markets are scared of their own shadow, fearful of recession, deflation, trade wars, a US/China cold war, Hong Kong, increased tensions in the Middle East, oil, Brexit, extremist politicians, the future of English red ball cricket and probably a few other things I’ve forgotten. Seldom have I known them more anxious, and rarely have I seen such extremes in asset class behaviour and valuations. The desperate search for safe havens has seen gold and bond prices soaring and high quality growth stocks outperforming economically sensitive value stocks by the widest margin anyone can remember. The bond market is very pessimistic about the outlook for growth but equity markets are still near all-time highs and surprisingly sanguine. This is, quite frankly, the most unusual of markets.

All about bonds

The price of the US 10 year Treasury bond is the single most important price in global markets, driving the behaviour of just about every other asset class. The collapse in yields this summer following the about-turn by the US Federal Reserve Bank and the ever increasing political tensions has led to a summer of volatility and confusion in global markets.

Typically investment commentators at this point make some sort of James Bond reference (markets are shaken and stirred) but you expect better from me. Instead I’ll quote the only joke I can find on Google about Government bonds which is ‘what is the difference between a bloke and a government bond’ the answer being ‘the bond eventually matures and earns some money’. Ha-ha, very woke of me to put in a ‘aren’t men weak and pathetic’ joke, thereby making me eligible to have written just about any recent drama series for the BBC, with the rather obvious exception of Peaky Blinders. The problem is of course that this joke is now out of date, men may still be weak and pathetic (discuss) but huge swathes of global Government bond markets have negative yields meaning that you give your money to the Japanese, German, Swiss, or French government now and in ten years’ time get less back. This doesn’t seem right.

Macro… Negative creep

Growth is slowing in the developed world with recession risk increasing though there is also plenty of evidence that this is maybe just a mid-cycle soft patch and should not have provoked such an extreme response from the bond markets. The US and China are still in relatively decent shape and the pessimism about Eurozone growth feels overdone. US unemployment is at a 50 year low of 3.7%, wages are growing at 3.2% and core consumer price inflation (ex food and energy) has risen to 2.4%. There may be a ‘technical recession’ of two (barely negative) down quarters in some countries, notably Germany, but the consensus for Eurozone growth for the next couple of years is still around 1% so nothing like 2012 and 2013 which saw negative GDP growth in both years. The ‘view from Mars’ would be that now is not the time to be aggressively cutting rates.

This though is far from a normal cycle. The re-escalation of the US/China trade dispute could not have been more badly timed and a no-deal Brexit hangs like the Sword of Damocles over the benighted continent. In the face of the slowdown Central Bank monetary policy has become increasingly dovish. After a series of interest rate rises over the last four years the US Federal Reserve cut the Fed Funds rate in July and September though Jerome Powell is saying that these are ‘insurance cuts’ and sees the US economic outlook as ‘still favourable’. In his last act as head honcho of the ECB Mario Draghi has gloriously stuck to his ‘doing whatever it takes’ mantra, reducing interest rates and re-introducing a quantitative easing asset purchase plan. There has also been a host of rate cuts in the emerging economies including Brazil, Mexico, Russia and Turkey whilst China has loosened policy as well. A lot of firepower has been unleashed but arguably this is the last hurrah and the ability of monetary policy to further stimulate growth is now pretty much exhausted after 10 years. When even the Central Banks themselves are calling for fiscal policy, as Draghi recently did, then you know that they consider they have done all they can. Commercial Banks are becoming increasingly cautious, consumers are already heavily leveraged and political risk overrides just about everything. An end to the trade war is far more important to global growth than cheaper credit, as indeed on a more parochial view is some sort of deal on Brexit.

As always, thank you to Schroders Asset Management for the consensus economic forecasts with pretty much all GDP numbers being downgraded over the last few months.

2018 GDP 2019GDP 2020 GDP 2019 CPI 2020 CPI
World 3.3 2.6 2.5 2.6 2.6
US 2.9 2.3 1.8 1.8 2.1
Eurozone 2.0 1.1 1.1 1.3 1.3
UK 1.4 1.2 1.1 2.0 2.1
Japan 0.7 1.0 0.2 0.6 0.8
Emerging Markets 4.8 4.1 4.3 4.3 4.0
China 6.6 6.2 5.9 2.4 2.3

Markets….The Bubble of Fear

When I worked at a large asset management house in the 1980s and 1990s we equity mangers dined out on our annual double digit gains, swaggered around, lunched profusely and in some cases unwisely, and best of all made fun of the geeks on the Fixed Income desk. Blimey guys, I think the bond market moved by 1/64th this morning, can you cope with the stress? How we laughed, but those who laugh last laugh longest. Investor attention tends to focus on the stock market but it is bond markets where the biggest beasts roam and who call the shots these days. The collapse in yields this summer to levels not dreamt about even a few months ago has driven price moves across all asset classes. The US 10 year yields tumbled from 3% to 1.5%, the entire German bond market now yields less than zero and 10 year Gilts yield touched a miserly 0.4%. In this environment any investment strategies based on improving economic growth have been punished. As we feared last quarter, Goldilocks did turn out to be a pretty Grimm tale after all.

This has yet again raised the question of whether we are in a bond bubble. The answer is probably yes, but one into which more air can still be blown and one that has been inflated by fear not greed, unlike the classic bubbles of the past. The markets are desperate for ‘safe haven’ assets and the huge, liquid Government bond market fits the bill. Yields are likely to remain at super low levels for a fair old time given the current market and economic environment but we do not think bond yields are following Japan where deflation has been embedded for three decades. Ten years of deflation and austerity have led to a vast political outcry and a momentum for change in the western world that isn’t part of the consensual and deeply conservative Japanese culture. Over the longer term we expect global yields to slowly grind back upwards but a sustained increase in yields is unlikely without a resolution to the trade war, an improved economic outlook and a major commitment to fiscal stimulus from developed world governments.

The collapse in bond yields has had a significant effect not so much on the direction of the equity markets but on their ‘shape’. Markets have been volatile but held on to the double-digit gains racked up in the first half of the year. It is the divergence in performance between different styles of stock that has been eye-watering. ‘Long duration’ growth stocks continue to make huge gains (lower bond yields means lower discount rates in equity valuation models) but value plays continue to struggle, especially banks and ‘low quality’ cyclicals. Market valuations in aggregate are not excessive but growth stocks are priced for perfection, value stocks for destruction. Value stocks rallied in September when bond yields backed up a tad, though it is way too early to say whether this is a turning point in the style wars or just another dead cat bounce. Our concern over the growth stocks is not their quality but their valuation as multiple compression is a terrible, terrible thing. A super high quality multinational consumer staple company could continue to churn out pristine and consistent earnings numbers but still fall by a third if bond yields spike up and its multiple contracts. The business as a whole won’t notice it but shareholders will. Don’t believe me? Google ‘Nifty Fifty’!

Times they are a changin…

We’ve got a new buzzword this year, de-globalisation. The last three decades have by and large been a time of stable growth, falling inflation, prudent fiscal policy, liberal/democratic government, technological change and above all globalisation. The last few years though have been times of political upheaval and unrest. Brexit, the US/China trade war, the belligerence of the Trump administration, and increased conflict in the Middle East which have all contributed to a slowdown in global growth as well as being very negative for investor sentiment.

World trade rose from 39% to 61% of GDP between 1990 and 2008, lifting a billion people out of poverty in the emerging world, kept living costs low in the developed world through cheap imports and presented huge new markets for global multinational firms. The nationalism and political extremism unleashed by the backlash to the financial crisis have though created a new ‘anti-globalisation’ narrative which is beginning to drive financial markets as political commitment to open markets begins to disintegrate.

With their domestic economies slowing it defies economic logic that either the US or China should wish to embroil themselves in a damaging trade war. Yet economic logic has little to do with it; this is a game of politics as attitudes harden in the US with both sides of the House agreeing that China represents an increasing threat to US hegemony. Events are being driven on the one hand by a Trump administration that wants an outcome to sell to the electorate in the run-in to a 2020 Presidential race (“Trade wars are good; easy to win”) and, on the other hand, a Chinese administration who are playing a much longer term game for control of a technological battleground that will play out over years, even decades. No matter the end result from this trade war, the longer the dispute goes on and the more it escalates the worse it will be for the global economy. A world divided between authoritarian China, a tired and sclerotic Europe and a partisan, nationalistic US is an increasing headwind for global growth and financial market returns.

The Market of Extremes

I have alluded in previous newsletters to the difficulty of managing portfolios in such unusual markets, marked by extremes of valuation and a huge divergence between winners and losers. The key challenges have been

  • Long or short duration bond positioning.
  • The balance between ‘winning’ but very expensive growth stocks and ‘losing’ but very cheap value stocks.
  • The balance between the UK and Overseas equity weighting.

The extreme economic and market conditions post 2008 have led to the ideal portfolio composition (in retrospect!) being a long duration position in Fixed Income to gain maximum benefit from falling bond yields, owning predominantly growth stocks and having a high overseas/low UK equity weighting post the Brexit referendum, exacerbated by the weakness in sterling. We always strive for a well-diversified rather than too binary a positioning so have had both winners and losers on portfolios. In particular, our safety-first low duration bond positioning has lost us ‘opportunity cost’ and some of our value funds have done the same, making money this year but not enough to keep up with equity indices. The challenges of the markets have disappointingly proved beyond the compass of most Absolute Return fund managers and we have been selling these funds over the last two years.

Apart from trying to second guess politics, the bond market, the global economy and growth versus value, the final challenge is finding safe havens other than cash, which pays such minimal interest. The great safe haven and portfolio diversifier of the last decade has been long duration Government bonds but yields are now so low that it is questionable whether this get out of jail free card will still work. Should bonds and equities become positively rather than negatively correlated a tricky job would get getting trickier still.

Avoiding the unavoidable

I don’t want to write about it anymore than you want to read about it and you know what, let’s not. I have written exhaustively about what may happen in markets post Brexit and under a Corbyn regime so I don’t want to repeat myself. Something concrete should actually happen by or on October 31st which will lead to new problems to debate but at least (surely) we will have moved forward. For those missing their Brexit/Jezza fix my colleague David Andrews has written an excellent article about financial planning in a Marxist Britain in our sister HFMC publication The Wire.

Scores on the Doors

Figures from Financial Express Analytics

These are excellent numbers but in the case of equity markets bear in mind that they are to an extent a ‘bounce back’ from the big falls in the final quarter of last year. Nevertheless, given the wringing of hands and gnashing of teeth in January, this year has been a surprisingly good year for investment returns, with the US equity market the standout and Brexit benighted UK somewhat of a laggard. It is the returns from bond markets that have been the most unexpected with prices soaring/yields collapsing from May onwards with the Fed volte-face, slowing global growth and increasing political tensions driving investors into a desperate search for ‘safe haven’ assets. Growth sectors, notably tech, continue to outperform the value sectors like energy and materials whilst financials are struggling in the super-low interest rate environment. Absolute Return funds continue to disappoint, and we have reduced our exposure significantly over the last 18 months. UK bricks and mortar commercial property funds have started to show small losses this year whereas gold, another classic safe haven asset, has risen nearly 20% this year, its highest level for 6 years.

Conclusion… Waving through the Window

Musical references a-plenty this newsletter with something in the paragraph headings for the heavy metal head-bangers, the grunge crowd and even for you old hippies out there. I’m a show tune boy at heart though and my conclusion heading refers to a standout song from the brilliant new musical Being Evan Hansen, a smash on Broadway which deals sensitively and touchingly with the problem of anxiety, a theme I’m trying to convey throughout this newsletter.


So with anxiety the driving force of the markets just what should we be worried about most? The closely followed Bank of America Merrill Lynch monthly fund management survey shows that only 9% expect to see higher bond yields in the next 12 months (the most bullish since 2008) and most expect value stocks to continue to underperform. They see the biggest risk to markets being the trade war with the most consensual or ‘crowded trade’ is long US Treasuries. More of the same then. If you are a contrarian you sell long duration bonds and buy value stocks. It’s a tough call to go against such an overwhelming majority and ‘don’t fight the tape ’and ‘don’t fight the Fed’ are tried and tested market saws. Nevertheless, such extremes of opinion and valuation have (in retrospect!) marked significant market turning points. A very tough call to which I wish I had the answer.

Our sense is that both bond and equity markets this year have produced pretty much all the returns they are going to make, with the capacity for a pull back. While we expect bond yields to remain ‘lower for longer’ it does concern us that the market is pricing in no inflation risk at all. Global equity markets with the glaring exception of the UK, are flirting with all-time highs and if bonds seems too pessimistic about the global economic outlook then maybe equities seem too sanguine, especially given the rather gloomy outlook for earnings.

Our mantra this year has been that whist we are not bearish we have entered the later stages of the bull market cycle where equity markets can still produce gains, but with a far greater volatility and sense of uncertainty so capital preservation remains increasingly important for more risk averse portfolios. We will stick with that.

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