Quarterly Market Update – April 2017

“Wilders, Le Pen, Sturgeon, Schulz, May….”

It would be unusual not to have some market uncertainty; recent research in the US showed that 37.9% of investors and 63.1% of market professionals were bullish about stock market prices. This is comforting because there is such a divergence of opinion; we would be more concerned if everyone thought the same.

Some of the key themes this year seem to be European elections, UK / Article 50 / Scotland and the US. Each of these can and will create volatility within the markets, and we will expand further in this update.

We saw the first of the European Elections in March; it became clear that many of the predictions in the UK press about a Wilders victory, the Netherlands calling a referendum to the leave the EU and the implosion of the EU were unfounded. Eyes now turn to France in May (and June) and then Germany in September. Italy’s election is set for the first quarter of 2018.

It is possible that whatever happens in France, and with the UK evoking Article 50, the EU will take a look at what they stand for and whether changes are needed. Behind the headlines, we are seeing positive signs from Europe; we think the political risks are being overstated, valuations are cheap on a relative basis, earnings are coming through and the macro picture is pretty good.

I learnt a new parliamentary term called “ping pong”, which is the passing of legislation between the two houses in the UK. The Lords’ actions frustrated May but didn’t derail her plans. However, we think there is considerable uncertainty for the UK.

Article 50 has been triggered and now we are embarking on a path that no-one has gone down before. The outcome will be long lasting, and like any divorce it could well be messy. To add to the mix Scotland has announced its intentions to call a second referendum. The timing of the announcement was not a surprise and its aim was to cause maximum disruption! Whatever our views on this May is unlikely to want this distraction whilst looking to leave the EU, so Scotland may have to wait two or three years before they get a chance to vote.

Sturgeon seems to think the process will be simple but we have already seen the likes of Spain saying they will veto Scottish entry to the EU, and the EU themselves saying Scotland would have to start outside and then go through the process of joining which would include the adoption of the Euro.

The uncertainty of Article 50 and Scotland’s actions doesn’t help the UK.

In the US, it is easy to focus on “Trump Tweets” as these make the headlines! The more we look at the idea of protectionism, the more it becomes clear that it is a little more complicated than even Trump seems to appreciate; we are in a world where much of what happens is global, and both economic and financial ties are interlinked. In Mexico, one auto part manufacturer provides springs for almost all US trucks; Americans love their trucks, a tariff on Mexican imports will just increase the cost! At the same time the US exports food to Mexico, to cut the supply will hurt US farmers. We could go on….

Valuations in the US are expensive but there is still earnings growth and potential momentum from a Trump stimulus. Although many fear emerging markets will suffer from ‘Trump tariffs’ it is worth considering that any tariffs will equally hit US profits as much as the countries that have the tariffs imposed on them. We can expect a lot of noise which in the short term might cause market volatility, but long term sense should prevail. If Trump introduces tax reforms, people will spend, and if companies continue to grow earnings then the US should be okay and this will feed out globally.

In summary uncertainty is a good thing; there is no set view. We know that the returns in 2016 were supercharged but they came on the back of two benign years. If Trump gets the US moving, then globally that will benefit many economies; if the markets are overstating political risk in Europe and focus on fundamentals, that will be positive. If the UK manages to get even a slightly better deal than most fear, then that will be positive.

DEVELOPED MARKETS

Five year returns 1 April 2012 – 31 March 2017

Special note to graph: You should note that past performance is not a reliable indicator of future returns and the value of your investments can fall as well as rise. The total return reflects performance without sales charges or the effects of taxation, but is adjusted to reflect all on-going fund expenses and assumes reinvestment of dividends and capital gains. If adjusted for sales charges and the effects of taxation, the performance quoted would be reduced.

There seems to be more happening now than ever before; over the past few years any of these events would cause massive market uncertainty. However, for some reason the markets appear to shrug them off. Perhaps it is a reflection that it is becoming increasingly more difficult to sift through fact and fiction.

In Europe, all eyes are on the elections and if we read some of the UK press we would think that the EU was on the brink of implosion. However, the big difference when we compare to something like BREXIT is that the voting system is such that it makes it hard for an outsider to win.

In the Netherlands, (despite the support for Wilders) the idea that he would win a majority government, call a referendum and for the Dutch to vote to leave was unfounded and very much unlikely to happen. As the results filtered through, the markets reacted positively with the FTSE hitting an all-time high.

There are risks with France; Le Pen will likely win the first round and does have the potential to win the Presidency especially if there are negative musings about her opposition candidate in the second round, or there is a terrorist attack. If that happened, then most would assume that opens things up for a referendum.

However, to do this Le Pen needs the support of parliament and her party is the 9th largest party in France. She would need to win the elections in June as a majority; to put this in context it would be like UKIP winning the UK elections!

If she did achieve this seemingly impossible feat then it is a grand assumption to think France would vote to leave the EU. The risk does become greater at this point as we know, but the odds are very much against it. We do however think that with the UK evoking Article 50 and populism in the Netherlands and France, the EU may have a look at themselves moving forward, and we are likely to see changes.

In Germany, we may see Martin Schulz win the election to be the next Chancellor in Germany; this might not be such good news for the UK as the press reports that he wants the ‘hardest Brexit possible’. We will watch this carefully over the coming months, and how it might impact the UK.

There is evidence that investors are holding back investing in Europe until certainly the outcome from the French elections is known. Our view is that the markets are over-estimating the political risk and ignoring positive fundamentals which are coming through; valuations are relatively cheap (especially vs the US), growth in earnings figures is continuing and the macro picture is positive. It is also worth adding that like the UK, many continental European companies are global, therefore they would benefit from any global uplift.

Turning to the UK; we see inflation is rising but there is evidence this is not ‘true’ inflation. Effectively with the fall in the value of the pound, this has pushed up prices of items like food which drives increases in inflation. It is possible that inflation could drop back. Interest rates are unlikely to rise until we see ‘true’ inflation, and it is highly likely that Bank of England will wait until after BREXIT (that’s 2019 at the earliest).

It was unlikely that parliament would stop Article 50 happening and even though the Lords tried to delay things they had no choice but to pass the bill without any changes. We have now triggered Article 50 and are heading down a path with no known outcomes.

There are things on the ground that we know; for example, on the downside prices are going up as the pound weakens so we can expect things to be more expensive especially food, but on the upside the UK is attractive for investors because it is cheaper to invest (deals with Toyota etc).

Interesting discussions I have had include how Poland may benefit from the UK leaving the EU. Many skilled workers are returning home as their UK earnings are less attractive. In turn Poland is becoming a hub for European outsourcing companies, and so it seems our loss is their gain!

There are many discussions regarding the impact on the City of London; we spoke to one investment house and they confirmed they were looking at what they may need to do, there appears to be two options. Firstly, they will need to set up a European operation which reduces their base in London, or secondly, they set up a base in Europe but continue with the bulk of the operations in London. At the moment, they don’t know which will happen and will only know as the deals are agreed.

There are also concerns that up to 200,000 construction jobs could be lost, but whether the thoughts on Poland, banks and jobs come true, only time will tell.

I do fear for Vauxhall jobs after having been taken over by Peugeot; which has nothing to do with BREXIT. Logic dictates that you can’t run a loss-making factory where you import 60% of parts from Europe and export 80% of the goods produced. The only option seems to be to move the manufacturing to Europe to keep costs down and operate in the market you serve.

One thing I have learnt is that much will be written in the press, but how much of it turns out to be true is another story! Much of it will be smoke and mirrors, and as we speak to fund managers we will share their thoughts.

Just to make things more complex is the demand from Scotland for another referendum. We are sure that this will be pushed out until after the Brexit negotiations are completed. Taking away the emotional side it is very hard to see how this would work, economically oil prices will remain low and this is big source of revenue. Scotland would be a new country with its own share of debt and no help from the UK, effectively an emerging market economy (or even a frontier market).

The assumption is that they would be welcomed into Europe with open arms but this doesn’t seem to be the case. They have been told that they would have to apply and pass the various requirements to entry, as well as adopt the euro. On top of all of this Spain is likely to veto any request. Scotland could go it alone with their own currency, but that would defeat the point of calling a referendum. Like everything, nothing is impossible and many Scots are passionate about having an independent country but it is hard to see the economic benefits this choice. If we get to the stage of a referendum I could not guess what the outcome might be and what it will actually mean!

Away from Europe and the UK we have “Trump Tweets” or TT. I looked at all his tweets and many are as boring as mine, but one or two hit the headlines and it becomes difficult to work out what is happening. Job figures in March were considerably better than many expected, and this has led to the first rate rise this year (which the markets liked). We expect more to follow with rates touching 2% by the end of 2018. It is worth adding that the US has real inflation coming through, and this will support rate rises combined with a buoyant economy.

US crude oil inventories surged to a record high in 2017 showing that not only is the US becoming self-sufficient for oil but it could also become a major exporter. This benefits the global economy especially non-oil producing economies as it reduces prices (not such good news for other oil producing economies).

Turning to markets; the S&P 500 bull run has been in effect since its low on 9 March 2009 and the total return to date is 320%. There are two primary sources of equity performance; valuation expansion and earnings growth. It is hard to see any valuation expansion but earnings growth forecast is at 10% for 2017. Added to this would be any benefits from Trump’s agenda, particularly tax cuts and pro-growth measures; it seems there is still some juice left in the tank.

For all the talk of protectionism there are some serious considerations. The manufacturer of iPhones in China considered moving the factory to the US; it was estimated that in doing this the cost of the iPhone would increase threefold. Mexico supplies car parts to the US and in some cases exclusively, any tariffs or means to block this only impacts the US consumer and / or corporates. There is also the “tit for tat” actions; Mexico imports food from the US, what would happen if this was disrupted? It is clear that it is not simply about slapping massive tariffs on imports, bringing everything in-house and assuming you will have a better country. The world is too interlinked in terms of trade and skilled people, and we think much of the noise will come from “Trump Twitter”, but what we are looking for is actual concrete action.

Just briefly touching on Japan not a lot has changed, they have moved on to the third arrow of reform. New corporate governance rules are making companies more pro-active with cash, meaning more money coming back to investors as well as re-investing into companies. Japan was never going to change overnight, and everything will be slow and steady but it is still moving in the right direction.

In summary, all eyes are on Europe and we think if elections go the way we believe, then the focus will switch to the fundamentals which seem positive, meaning good news for investors. The UK faces many challenges and no-one knows the outcome, it is unlikely interest rates will go up any time soon and only time will tell which headlines ring true. “Trump Twitter” will hold the US front page but what we want to see is firm action, although the S&P is riding high there is the potential for more growth albeit slower.

EMERGING, ASIA AND FRONTIER MARKETS

Five year returns 1 April 2012 – 31 March 2017

Special note to graph: You should note that past performance is not a reliable indicator of future returns and the value of your investments can fall as well as rise. The total return reflects performance without sales charges or the effects of taxation, but is adjusted to reflect all on-going fund expenses and assumes reinvestment of dividends and capital gains. If adjusted for sales charges and the effects of taxation, the performance quoted would be reduced.

The fundamentals surrounding Emerging, Asia and Frontier markets remain sound. Although there have been strong returns over the last 12 months, these have come on the back of a near five years of underperformance. It is worth adding there are around 60 countries across these regions so this is far from one homogenous group, there are big differences between countries and regions.

In Korea, we have seen President Park impeached over a corruption scandal sweeping the country. All of this involves her close friend Ms Choi, who used her connections with the President to pressure companies to give millions of dollars in donations to non-profit foundations run by her. The scandal has dragged in the de-facto head of Samsung; Lee Jae Yong, who has been arrested for a string of corruption charges. It’s unclear how this will play out but it seems certain that the relationship between politicians and large family businesses (who seem to be the powerhouse of Korea) needs to change. It is worth adding that this is at a time when there are growing tensions with North Korea.

Turning to Africa, much has been spoken about South Africa and yet despite high hopes in 1994 that change would come, the economic situation for many has got worse (rather than better). Unemployment is at a 13 year high at 27.6% and, 45.5% of households are receiving at least one social grant. Consumers are also under pressure with higher food and fuel costs, and lower wage growth. You also have in place an administration plagued with scandal, but is unlikely to alter until 2019. Change is needed but it doesn’t seem to be happening fast.

The two powerhouses which many talk about are China and India. China is making the transition to being domestically focused. This is a natural move for any economy, and again it’s worth understanding this when the news focuses on how bad Trump is for this country. China has accounted for a quarter of world GDP over the last twenty years, and yet its share of GDP is smaller than it was over two centuries ago! E-commerce revenues in China make up nearly 50% of the world’s total, with mobile payments 50 times the level of those in the US, at $5.5 trillion.

China is on the road to moving towards a service driven economy with greater urbanisation. Its aim is to have 70% of its population living in urban areas; in 2010, this figure was 52%. There are significant changes associated with this, including revamping the household registration scheme, improving land rights, offering more government pensions, health care benefits and adopting more green initiatives.

Of course, a trade war will have some impact but China trades with the US particularly in aerospace and many US global companies would not want this to be damaged. Trade with the US is a small percentage of the trade that China does, so any war is likely to impact other nations more.

On the other side is India, which is going through a multi-year reform programme under Modi. Some of the big initiatives include increasing investment in rail and roads, as well as moves to improve rural growth, develop affordable housing and a digital economy. Demonetisation is part of these reforms and today, coconut traders accept digital payments via customer mobile phones (something that was unheard of two years ago). There is an expectation that change will happen immediately, but it needs strong government and patience. Indian reform will take time but it is heading in the right direction.

We have highlighted four countries at different stages of their economic cycle, and there are other countries we could look at including Poland, Mexico, Pakistan, Argentina etc. Emerging, Frontier and Asian Markets are a diverse mix of economies with opportunities as well as risks. There are concerns that protectionism impacts some of these economies, but it must be considered that in a world where we are so interlinked how can this happen in reality? You can move manufacturing back to your country but if that forces prices up then is that the right thing to do? You can restrict labour movement but this may not offer the best workers. Although some economies will clearly suffer from lower oil prices, others will benefit. Equally where Trump and others want infrastructure projects, these need raw materials.

In summary, as with any country across the globe there are those that are naturally in a better place than others. South Africa must think hard if it is to grow; Korea needs to reform but countries like China and India are making significant changes. Trump may have some impact on emerging markets but in reality where there is a need, he is a business man and he won’t want to disrupt that. So, we remain positive for the region and believe in the right places there are significant opportunities.

CASH

Five year returns 1 April 2012 – 31 March 2017

Special note to graph: You should note that past performance is not a reliable indicator of future returns and the value of your investments can fall as well as rise. The total return reflects performance without sales charges or the effects of taxation, but is adjusted to reflect all on-going fund expenses and assumes reinvestment of dividends and capital gains. If adjusted for sales charges and the effects of taxation, the performance quoted would be reduced.

This piece will always look like a scratched record.

We understand why investors hold cash in the short term because there are things that are short term goals. Cash should be held for a holiday, work on a house, a new car etc, but where cash is being held in the hope that rates will go up then it must be questioned.

Although inflation is going up this isn’t real inflation, as it is being driven by a weak sterling which forces up food and energy prices. Interest rates will not go up until we see real inflation. It also seems likely that the Bank of England will not want to raise rates until the BREXIT negotiations have been concluded. There would be very little point in raising rates and then suddenly having to pull back.

The N&SI issued a 5-year bond paying 2.30% gross in July 2016. If investments are being locked away for this period of time, surely there are better ways to achieve this level of return either as an income or growth on the investment? Investors are putting the money away and forgetting about it for five years. Ignoring the volatility in the markets, it is historically more likely that tucking the money away in a diversified portfolio would over 5 years deliver a better return, and if income was needed a higher level of income.

Journalists bemoan the death of cash savings but this has been the case for nearly 10 years and isn’t going to change anytime soon. There are alternatives but it requires taking some risk and being prepared to sit back and let the money do what it will do. Those who are prepared to do this are likely to be rewarded in the long term.

In summary, where money is needed in the short-term then cash is the sensible option and worrying about the rate of interest is irrelevant. Over the long-term (3 to 5 years plus), holding cash seems an illogical investment with low rates and inflation, but the reality is that if after ten years investors cannot change their mindset on this they are not going to do it now!

CONCLUSION

It is my job to worry; I worry when markets fall, I worry when markets go up! What I do believe is that over a period if you win more times than you lose then you will see positive returns.

Of course, we feel uncomfortable when markets go down and this quote from Buffett perfectly sums it up “The years ahead will occasionally deliver major market declines – even panics – that will affect all stocks. No one can tell you when these traumas will occur.”

Buffett adds that long-term investors should remember two key points for when the market crashes, or if there’s an all-out panic.

  1. Widespread fear is your friend. As an investor, you should love it when virtually all stocks are falling, as this is the time to look for bargains
  2. Personal fear, however, is your enemy. Not only that — it’s completely unnecessary

Effectively it’s about finding good globally diversified investments and sitting tight! There has been (and will be more) nervousness in the markets this year as we saw the markets rebound on the back of the Dutch election. I am sure there will be more volatility around the French elections but if our thesis is correct and the focus moves away from politics to fundamentals, then we could see a positive uplift in European equities.

There is a risk that Trump shuts down the US and turns inward facing, but logic says this is just not possible (fact vs fiction). There are plenty of opportunities in emerging, frontier and Asian markets and some may suffer from Trump policies; but also where lower oil prices benefit some, for others it will be a hindrance.

And then we have the UK; I want to be positive but it is hard to be! We have chosen the ship we want to sail and there is no going back. If we believed the lies without doing the research then more fool us, it is perhaps a lesson learnt! If things turn out better than we expect then happy days. All I would say is don’t believe everything the press writes because we have created a generation of lazy journalists with little integrity, no desire to find out the truth and a clear focus on their own personal gain and writing sensationalist headlines.

Roll on quarter 2!

Source: Charts have been sourced from Morningstar. Other data sourced from BBC, The Motely Fool, Standard Life, BlackRock, Schroders, Templeton, Hermes and JPMorgan. Any reference to a fund or share is not a recommendation to buy or sell that asset. Past performance is no guide to future performance and investments can fall as well as rise.

Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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