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September 2019 Market commentary

The one thing we are certain about at this moment in time is we have no ability to try and second guess what is happening in Westminster and therefore we have to continue with the agreed strategies and persevere going forward.

by
Simon Martin

17.09.2019

Just before going on holiday I read a report which highlighted that since the middle of the decade most of the increase in markets around the world, had been led by just 77 shares!  In addition, apart from the period when President Trump introduced his tax reforms, since 2002 company earnings have not really grown in real terms.  Consequently we can argue that the main reason why markets are up is because of the flow of money driven by bond investors seeking to improve returns in this low income era. 

As we mentioned in the last market commentary we expect interest rates will fall again as we witness an increase fears of a global recession.  Nicola and I recently attended a presentation by JP Morgan and it was interesting to hear that of all of their models are now starting to confirm that the global economy is slowing down and that recession risks are rising.  We are not necessarily saying that a recession will happen shortly but we should be conscious that one will occur at some point.  We are already seeing signs that bond markets appear to be pricing in the risk of a global recession but equity markets are ignoring these trends and assuming that Fed interest rate cuts will bail them out.

Another of the central messages to come out of the JP Morgan presentation was that this era of low interest rates is going to continue for a long time and that we should not be overweight risk assets or over exposed to low quality investments i.e. those that don’t generate profits.  They also believe that it may take a recession for the ‘growth’ trade to be reversed and complete the regression into ‘value’.  We have to be mindful that at some point we will see this trend evolve which is exactly the strategy that we have been preparing for over the past few years.

We also need to be aware of the other risks associated with markets.  Brexit and political risks continue to weigh heavily here in the UK and the bookies are now predicting a 100% chance of an election before the year end.

The biggest threat to the global economy continues to be the trade war between China and Trump.  At the moment these tariffs are not really being applied to things that will hurt the pockets of most Americans and as a consequence this tough stance with China is boosting President Trump’s polling numbers.  However, if tariffs start to hit American wage packets this may change sentiment quite dramatically amongst wavering American voters.  At this moment this policy is not negatively viewed in America. 

Although the tariff war has reduced global growth from 5% to 0% and the tax cuts Trump have worked their way through the system, we are now getting to the stage where companies are having to cut costs and if this starts to effect capital expenditure a recession becomes increasingly inevitable.  At the moment the US economy and jobs are expanding however the number of hours being worked is being cut and this is another indication of a slowdown.  Wages are currently rising despite the fact that American companies experiencing slowing growth and in turn a squeeze on margins.  This is another indicator of where recessionary risk could occur.  The Federal Reserve (Fed) is starting to move to help protect the economy but will interest rate cuts be enough to offset a recession or offset an increase in the cost of living caused by tariffs rises?  

Unfortunately changes in monetary policy cannot do everything needed to minimise the potential downside.  Government lending rates are already very low and whilst this is helping to keep borrowing costs lower and encouraging governments to keep spending it is not necessarily the panacea that many investors delude themselves will be the ultimate salvation to reckless government spending and investors maintaining a ‘higher’ risk strategy. 

Having said that, fiscal stimulus should help us here in the UK.  The recent CBI survey indicated that the UK economy is at its weakest level since 2008 and without stimulus will ultimately be heading for recession.  Recession threats are worrying for us as investors and tax payers.  The annual impact on the average household from the past five recessions in Britain has been £2,500.  The hit from the 2008-9 recession would have been much larger — estimated at over £8,000 for each household, with a much bigger rise in unemployment — were it not for Quantative Easing (QE) and the cut in interest rates.  During that period UK interest rate were cut from 5.5% to 0.5%, and an initial £200bn of quantitative easing (later extended to £435bn) was launched, VAT was cut from 17.5% to 15% and other measures were introduced.  Unfortunately, at this moment in time the Bank of England’s armoury to defend against a recession, if not bare, is a lot emptier than it was.  Interest rates at just 0.75% equates to much reduced head room for manoeuvre.  On the fiscal side, there is the perceived constraint that comes with a debt-to-GDP ratio that is more than double the one prevailing ahead of the crisis (at about 85%). There are still policy choices available, but a new approach will almost certainly be required.  It is a dilemma and like many investors we question whether the Bank of England and other Central Banks have the tools to fight the next downturn, which do not involve magic money trees? 

The levels of spending and tax cuts being talked about by Boris may be enough to minimise the effects of a recession threat especially if we start to see further election promises over the next few weeks.  I believe that both the remaining and leaving factions will happily engage in “reckless electioneering”.  (I don’t think we can think in terms of left and right wing politics for the foreseeable future)  However, having said that, it is possible that given other European countries have negative interest rates we could see our interest rates move into negative territory. 

In addition the UK market is and remains one of the most unloved sectors of global markets.  For over 41 months it has been the most unloved sector.  However with assets at these levels and standing at a massive discount, any further weakness could be the catalyst that encourages investors to consider buying into the UK.  Private equity funds have huge amounts of money to invest and global companies could also look to purchase good quality assets at a discount.

 

What else is affecting markets?

Michael Burry , one of the central characters in the film The Big Short has plenty to say about everything from central banks fuelling distortions in credit markets to the ‘bubble’ in passive investing.  He believes that the recent flood of money into index funds has parallels with the pre-2008 bubble in collateralized debt obligations (CDOs), the complex securities that almost destroyed the global financial system.  Burry, who made a fortune betting against CDOs before the crisis, said “index fund inflows are now distorting prices for stocks and bonds to the same extent that CDO purchases did for subprime mortgages more than a decade ago and the flows will reverse at some point and it will be ugly when they do”. He believes it is not inconceivable that equity benchmark levels will fall sharply and the assets of those investors who have stuck to benchmark tracking asset will fall further.  We have also seen a huge increase in derivative positions to help many of these funds pseudo-match flows and prices each and every day.  This fundamental concept is the same one that resulted in the market meltdowns in 2008.  However, like most bubbles, the longer it goes on, the worse the crash will be.

Here’s what else Burry had to say about index investing in fixed income markets, “Central banks and regulation have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism anymore.  In the past there was a direct correlation with interest rates, but more recently with the increase of negative interest rates and the sheer momentum of buying investors have started to ignore interest rate and security of the underlying assets as they have just chased returns at any cost”.  In addition he believes that these simplistic theses and the models encourage people to invest into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies do not require the analysis that is required for true price discovery.  He maintains that price-setting in that market is not done by fundamental security-level analysis, but by massive capital flows.

The current global economic cycle is now the longest in recent history, however, just because an investment has done well for the past 5 years does not necessarily mean that it always will or just because it is held up in the last crash does not necessarily mean that it would do so in any future market correction.  For example in 2007/2008 we could buy government security with a yield of 5% standing below par which produced a very attractive rate of returns.  As we point out below many government bonds now have negative yields and therefore we have lost many of our safe haven investments.  The 10-year US Treasury yield is currently 1.71%, whilst 10-year German bund yields moved below -0.6%.  The spread between 3-month T-bills and 10-year US Treasury bills has been a key focus with the yield on 3-month paper higher than the yield on the longer dated 10-year bonds, sending an ominous warning over the outlook, with a negative spread almost always preceding a recession ahead.

Any future movement in the market will be completely different to the previous cycle so we have to be prepared to think differently. 

Many investors are naturally worried about the state of global growth and the US economy, at the moment this is public knowledge and we worry when it evolves into common knowledge.  The current concerns are not secret and almost every fund presentation we attend focuses almost all of the time on this issue.  However most of the media and commentators are focusing their attention elsewhere.  So if this scrutiny does revert away from politics to markets and recession then volatility will increase.  It’s when we start to hear comments like “the fed is behind the curve” that we will really know that the market is taking over and will start to dictate policy and we will see a sharp change in the mood surrounding markets.

This may not happen for a while but when it does the movement in prices will be sharp!  Investors have started to move funds, but we believe that most have moved to the wrong sectors all together!  Investors have surged into the fixed income markets believing that they will provide low risk alternatives.  But whereas the yield on a UK government stock in 2007 was 5.5% the corresponding yields on a gilt is now 0.4%.  So in order to improve returns investors have moved into higher risk assets to replicate the income believing that they will all benefit from the capital protection!  In our minds this is sheer folly and why we have moved further away from any investments with credit and default risk.

We have also heard the dreaded phrase “cash proxy” mentioned on more than one occasion.  Where mangers are trying to promote higher yielding investments as a cash alternative.  This is not the case and there is a distinct possibility that investors could lose money in the event of a breakdown in fixed income markets.

In 2008 there were $118 trillion of bonds in issue. There are now $178 trillion — a rise of 50 per cent.  In addition $17 Trillion of those bonds now have a negative yield or 10% of world borrowing.  It is no wonder that investors have been happy to buy anything with a positive yield at any price!  Huge amounts of money has been pumped into high yield bonds, emerging market debt and corporate bond markets as these all offer higher yields but not necessarily capital protections.  Corporate bonds in particular are much less liquid than shares, because, unlike shares, there are no dealers or middlemen.  Before the crash of 2008 investment banks played a key role as market makers, but that changed after Lehman Brothers went bust and the banks withdrew from that role. We came very close to a meltdown in corporate bonds in 2008.  Next time around I really don’t see how we can avoid one.

 

Conclusion

In a world where benchmarks are becoming increasingly relied on by regulators and time horizons are diminishing many investors are being rewarded for chasing risks not necessarily for the long term returns that they are meant to be achieving.  With current low levels of volatility many investors feel that they don’t need to change the way they position portfolios even though this is illogical.  When the factors we have mentioned earlier change, investors will have to react and make significant changes to their portfolio.

To protect capital from volatility and inflation we have been actively moving away from growth orientated investments.  We believe that once passives starts selling the stampede to reposition will be significant and we don’t wish to get caught up in that highly volatile trade.  We prefer to be in our of favour sectors away from the market noise that will provide us with a good rate of return, minimise downside but more importantly maintain capital which we can then use to buy good quality long term assets at more attractive prices.  If markets do fall we will have to work quickly and there will be occasions where you will see buying contract notes when the market appears to be in complete turmoil.  We have to take advantage of market fears and overcome the emotional issues of buying at difficult times.  We could be entering a situation where the UK might be the right thing to be buying whereas global markets look completely out of favour.  We feel that it is vital that we fully understanding why we are holding something in a portfolio and we believe that by being more cautious and positioning ourselves ahead of these curves we are in a better position to weather these market conditions.  For example holding onto good quality UK based assets because we believe the UK market is undervalued.  We have to accept that if we see a selloff we could see prices fall, however securing a 5% plus compounding yield on an asset already priced at 4% will over time generate positive returns and help to protect any downside.

The one thing we are certain about at this moment in time is we have no ability to try and second guess what is happening in Westminster and therefore we have to continue with the agreed strategies and persevere going forward.

 

Simon Martin

Senior Investment Manager

6th September 2019

 

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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