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December 2019 Market commentary

“People often talk about the value of thinking outside of the box, but they seldom mention the greater value of thinking as if there is no box!”  From the book Novacene: The coming age of hyperintelligence by James Love

Simon Martin


“People often talk about the value of thinking outside of the box, but they seldom mention the greater value of thinking as if there is no box!” 

From the book Novacene: The coming age of hyperintelligence by James Lovelock

Life is full of certainties: your train will always run late when you have an urgent appointment, you’ll never choose the right queue in the supermarket, a broken clock is right twice a day and toast will always land butter side down.

We’re led to believe that there are also ‘certainties’ in investing too, but in the current changing financial landscape, these assumptions are looking less certain every day.  For example cash deposits have long been the safe choice for cautious investors.  However, since the Bank of England cut the base rate to 0.5% cent in March 2009, savers have seen the real value of their money steadily eroded when inflation and tax are taken into account.  If you only pay basic rate tax there are no accounts that match the 2.5% you would need to get a positive return after deduction of tax and inflation at the government’s target figure of 2% (it is 1.5% at the moment).  You would need 3.33% to beat inflation and higher-rate tax.

Therefore, we have to look at issues from a different perspective.  If we accept that, using current economic forecasts, it is unlikely that interest rates will increase in the foreseeable future we need to manage lower risk investments from a different perspective and accept that we may not be able to replicate the returns we have received on investments in the past!  Perhaps we live in a new world where Central Banks can never repay their QE or the huge debt governments have borrowed.   If we have to think differently about our low risk investments, which traditionally we use to assess the risk free rate of return, we have to also think again about our allocation within equity markets.

We certainly cannot change what has previously happened such as the good old days before President Trump started to stir up trouble with China and implement his tax reforms which caused the US dollar to increase relative to other currencies.  Each and everyone one of us has a different reference point about what we consider are ‘the good old days’, so in this new world we have to probably accept that from now on market conditions are simply different and we have to just get on with it. 

We have heard a number of our competitors have recently started re-allocating money to the UK.  You may remember that we increased our weighting in the UK earlier in the year ahead of this trend and many of the portfolios have benefitted from this strong performance and it is reassuring to see that people are following our lead.  At this moment we are not advocating reducing the UK weighting because the funds we have chosen all have very strong track records of producing an above average compounding yield and in many cases have a dividend reserve which will help us through any adverse markets. 

However, if we accept that the future will be different what do we have to do differently?  Nobody wants to be called an unthinking optimist especially as the global economy faces numerous threats and at times being even mildly bullish can seem a bit unnerving.  We still feel this flow driven market has the potential to unwind and if it were to do so, the pace would be remarkable.  But for the time being events are still working in favour of equity markets and momentum is still positive.  We just have to be mindful that sentiment could change and it is for this reason we have positioned portfolios in a cautious manner and focussed on our core philosophy of initially protecting, and then growing our client’s wealth


Why the dollar’s ascendancy is looking tired

Since the start of October, global equity prices are up by around 7% and there has been a move away from the safe or defensive assets that hold up in bad economic times, towards those that do well in an upswing.  We have also seen the dollar weaken relative to most currencies apart from sterling (as I mentioned in my recent commentary about the election the pound has reacted positively to shifts in the opinion polls and we still anticipate that it could weaken in the New Year.)

A weaker dollar will be beneficial for the continuation of the economic recovery and whilst the currencies fortunes have not yet shifted decisively, conditions for it to weaken are starting to fall into place.

If the US dollar weakens, we believe we will see a huge flow of US funds to Asia/Emerging Markets (EM).  The appeal of EM is their very lack of superficial appeal.  So, if liquidity risk has fallen in EM, it has probably risen in developed ones.  EM’s look cheap and we appreciate that there is no law saying they cannot become even cheaper especially as the dollar’s continued strength is ‘kryptonite’ to emerging markets. 

Central banks are once again printing money and this money is creating a short term blip but at some point we believe that sentiment will force markets to re-direct money to where there is value rather than buying things just because it has risen over the past few weeks. 

The constant worry is that investors are chasing the same assets: be it government bonds; investment-grade corporate bonds; technology stocks; and dollar assets in general.  The more investors cram into these markets, the greater the risk of a rush to the exit.  In these situations you would naturally expect out-of-favour markets to be cheap and appeal less to investors obsessed with short term goals.  But from our perspective, as longer term investors, out of favour markets tend to be uncrowded, and so less at risk of a sudden sell off.  Liquidity is everything in a flow market and we need to get our asset allocation correct.


What we are increasingly seeing in the current market

We are certainly living in a world of low interest rates and where interest rates are likely to remain low for many years to come.  The recent flow of monies moving around markets has meant that fundamental analysis is no longer as relevant as it was and the inflow into low volatility assets simply because they have not fallen is creating misrepresentation in certain assets and is misdirecting more flows of money.  As a consequence the pricing theory is completely wrong and is creating an opportunity for those prepared to think differently

Despite the fact that generating a meaningful income is important, we need to look elsewhere for an attractive return and we have to ignore the supposed attraction of large yields, simply because they are high, especially if it could result in significant fall in capital.  False yields, which are financially engineered, are creating irresponsible investing especially as these assets don’t have the ability to reinvest into the business models and hence the companies have to issue shares when they need to raise money.  This business model is unsustainable when you look at the potential of total return investing.  In our opinion slightly lower yielding companies with a compounding dividend will become increasingly important. 

What are the risks to the American economy and Equity Markets?

Despite being 11 years into their recovery the US Federal Reserve (Fed) has not managed to ‘normalise’ fiscal policy.  Unlike all other Central Banks it did attempt to take advantage of a stronger economy and increase interest rates and reverse Quantative Easing (QE).  But this led to the dollar strengthening even more and this encourages American asset allocators to repatriate more assets back to America, which has compounded the overvalued nature of their markets.  As risks have increased, and to sustain a flagging US economy, the Fed has reversed attempts to raise interest rates and shrink a balance sheet inflated by QE.   This policy reversal shows that inflation targeting is effectively dead, which financial-system stability and growth becoming the dominant policy objectives.  This implies that economies will be allowed to run hot, potentially setting the scene for the last phase of this elongated cycle.

With Government bond issuance also rising, which could put further upward pressure on real interest rates, bonds are likely to offer poor defensive properties — and perhaps even compound losses in the risk asset classes they are supposed to counterbalance — investors must seek other ways to diversify their portfolios.

The potential for a weakening US economy — combined with the upcoming presidential election — is fast eroding Donald Trump’s negotiating position with China, making a truce increasingly desirable.  We also have to be mindful of a 50% chance of either a Trump victory and a 50% of an Elizabeth Warren victory in next year’s American elections.   According to JP Morgan even if it appears that she has a chance of winning we need to be moving sooner rather than later because a flow market will move on the probability of something happening not waiting for the eventuality to occur.

Equity market returns in 2019 have belied the widely diverging performance within the asset class, this has largely been driven by a rotation out of cyclical stocks into defensive stocks.  If this trend continues, and political risks increase  2020 may therefore be the year that US equity dominance — which has persisted since the 2008 financial crisis primarily driven by relative US economic strength and healthier margins — finally falters.

If American asset allocators decide to shift money away from America where will it go? 

It goes without saying that we must deliver on performance rather than try to be too contrarian, we therefore have to think out of the box and more like an American asset manager and not just from a UK perspective.  We have to try to understand how they will react.  After all their markets have done so well and they will certainly want to protect these long term returns and not see capital fall if markets roll over. 

We therefore need to try to work out how they will invest when they start to move their monies away from American assets.  We don’t believe that they will move into ‘deep’ value assets, such as Europe or Japan, because, from their perspective, these can be perceived as being as equally risky as remaining in pure long term growth investments.  One thing we do know is that everyone will try to react to these pressures at the same time and as a result the sheer weight of money that will move from US trackers into overseas trackers will cause significant shifts in sentiment.  We still think that it will be safer to move earlier rather than later to get to avoid being left behind but the dilemma is how soon do we move? 

Hence why we think in this new world no-one will revert back to historic patterns.  US investors are more likely to switch into Asia and EM because a large number of Asian companies are listed in America via Depository Receipts and passive/ mutual tracker funds provide American investors with the ability to buy very cheap liquid funds.  Obviously we need to be aware that certain US investors will find it very difficult to change directions.  From their perspective diverting capital from America’s stock market to other less-blessed places seems like an invitation to career suicide.  Their markets have done so well for a long period and many investors have never witnessed a major correction or needed to consider moving money away from America!!  In addition with 56.38% of the World All World Index still exposed to America any shift in the capital allocation will be relatively small from a US perspective.  But from everyone else’s perspective it will be a serious amount of money which would move prices sharply.  The percentage of the All World Index exposed to Asia (excluding Japan), EM and Pacific Rim economies is 14.12%, hence why they will need to hold assets that can cope with the size of money moving towards the Pacific Rim, which is why we believe that passives will be used. 

This is another reason why we need to be avoiding investments in illiquid asset classes because we need to be invested in liquid assets in these types of markets.  The news flow surrounding M&G Property and Neil Woodfords crash has highlighted the risks of holding illiquid investments and why we feel that certain asset classes such as alternative assets are higher risk that many people believe. 

So why Asia/ Emerging Markets

Generally, equity markets outside the US offer risk premia that look attractive on both an absolute and relative basis.  A moderate weakening in the US dollar will assist financial conditions in EM which should ensure higher growth in 2020.  The difference in valuations between (relatively cheap) Asia equities and (extremely expensive) US equities is at a level that has historically been associated with protracted periods of outperformance for more moderately valued stocks. 

As you are probably aware we have been using market weakness in 2018 and 2019 to build strategic equity exposure to Asia as they represent a great hunting ground for active investors.  Asia’s superior growth rate is not, of itself, a sufficient reason to tilt allocations eastwards.  But the growing power of the Asian consumer is set to remain one of the dominant investment themes for many years and even decades to come. 

But why are EM out of favour?  The perennial fear is that they are crisis-prone.  Take for example Argentina. It has moved with breathtaking speed from default to emerging-market darling and then—unhindered by a $57bn IMF support package—back to the brink of default.  Hence why we have chosen to focus on South East Asian Developing economies.

These economies tend to have freely floating currencies which mitigates against the build-up of external debts and internal pressures.  Their independent central banks aim for low inflation and most of the 25 EM’s listed on the indicators page of The Economist have inflation below 4%.  It is in the double digits in only two—Argentina and Pakistan.  Low and stable inflation has allowed the market for local government bonds to deepen and this long-term debt makes them more stable.  According to the IMF, the average emerging market has public debt of 54% of GDP, around half the so called developed economy norm.  

All this has made EM much less brittle.  The price-to-earnings ratio for the MSCI index of emerging-market stocks is below its average since the mid-1990s.  It looks even better value when compared to that in the rich world.  The S&P 500 share-price index has only rarely been dearer relative to EM stocks than it is now.

Having said that we accept that EM has underperformed over the past decade but this is solely due to the exceptional performance within North America.  Today EM and frontier markets make up 50% of the world’s GDP verses 37% for developed markets.  EM and frontier markets are home to 59% of the planets population compared with just 13% for developed markets (The remaining 28% of the world’s population live in countries with no or small under-developed equity markets.) 


How are we positioned to reflect our views?

Whilst we are very aware of the potential problems in markets, we are also aware that it would be an almost impossible task to identify when and how these problems may start to unwind.  At the moment the flow in markets is too powerful to completely position against it.  It is for this reason that we aim to participate in markets whilst also positioning ourselves more towards the periphery so that if we see signs of unravelling, we are better equipped to exit and protect portfolios.

With the global population set to grow by another billion people a demographic change is also another key theme we plan to exploit.  Also as populations continue to age, over the next decade the developed world will experience a scenario whereby the number of people aged 65 plus will outnumber children under 5.  This trend is completely reversed in EM and hence why this will make them an attractive area to invest in for many decades to come!  In addition the rise of middle classes in EM is also likely to have a profound effect on markets in the next decade as households spend more money on consumer durables and services.

Over the past year or so we have steadily reduced the duration in both the fixed income and equity components of portfolios, by this we mean we have reduced risk and reduced the sensitivity of portfolios to bonds and stocks that rely heavily of growth to deliver shareholder returns.  We have nudged positions in order to remain in control of the risks within portfolios.

We accept that we may be wrong or have moved a little early and hence why we may have to “remain nimble”.  But as we have mentioned before, we are not trying to be bold, we just need to focus on the core themes of protecting capital, generating a rising dividend that moves ahead of the underlying rate of inflation and being able to sleep at night!.  We believe we have delivered strong risk adjusted returns and as a result of the changes we have been making we believe our portfolios are differentiated when compared to a large number of our peers, the benefits of which are numerous but the most important of which will be shown during periods of market stress. 

We are confident in our thesis we just do not know the timing.  As we have pointed out before we believe it is better to move early in a calm and considered manner, than to panic when they close the escape doors to the burning theatre. 

I hope that this report is useful, however if you would like to discuss anything further please do let me know.


Simon Martin
Branch Manager/ Senior Investment Manager
Leeds Office




Nothing in this article should be construed as personal advice based on your circumstances.  No news or research item is a personal recommendation to deal.
The value of investments can fall as well as rise. Investors may get back less than invested

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