Fund Research

Fund Management with Ken Baksh

 

January 2019 Market Report

During the month to December 31st, 2018, major equity markets registered sharp falls, dropping by 7.74% overall and the VIX index rose sharply to 25.42. Over 2018 as a whole, global stocks experienced their worst year in a decade, falling 11.95% (FTSE ALL Wold Index).

The European Central Bank confirmed the end of net purchases under the APP scheme and seems likely to delay any interest rate increase until at least the summer of 2019. Economic news seems to have been weaker than forecast in recent months, particularly in Germany and Italy, and PMI figures point to a very slow fourth quarter. Political events were not in short supply as Italian bonds oscillated with the tension between the two-party Government and the ECB, Spanish politics took a more extreme right turn, street rioting Continued in France and Merkel's CDU successor was confirmed in Germany. US market watchers continued to grapple with ongoing tariff discussions, Federal Budget deadlines (partially closed at the time of writing), NAFTA follow up, Syrian troop withdrawal, North Korean meeting uncertainty as well as mixed mid-term election results and key personnel changes. US economic data and corporate results so far have generally been above expectation and the official interest rate was increased again in December to a range of 2.25%-2.50%. In the Far East, China flexed its muscles in response to Trump's trade and other demands while relaxing some bank reserve requirements and contemplating other measures to help the slowing economy. Japanese economic data reflected a recent bout of natural disasters while Shinzo Abe consolidated his political position. At the October BoJ meeting, the current easier fiscal stance was reconfirmed although, more recently, there have been rumours of an end to QE. The UK reported mixed economic data with satisfactory developments on the government borrowing side, inflation as expected, but poor relative GDP figures and deteriorating property sentiment, both residential and commercial. Recent retail data shows mixed month to month trends, some "weather related", but anecdotal evidence from both physical retail centres and online companies e.g.Asos show a distinctly weaker trend over the period overall, the trend worsening towards the end of the year. There will undoubtedly be more retail casualties to follow HMV,just announced. Market attention, both domestic and international is clearly focussed on ongoing BREXIT developments and their strong influence on politics. Although the Budget presented on October 29th, showed a slightly higher GDP forecast and a more expansionary fiscal approach, the Chancellor made frequent references to the unsettling effects of any unsatisfactory Brexit outcome, and the end of the month saw both government and the Bank of England painting weak post-Brexit economic scenarios under all scenarios.

Aggregate world hard economic data continues to show expansion of around 3.0%-3.5%, although forecasts of future growth have been trimmed in recent months by the leading independent international organization. Fluctuating currencies continued to play an important part in asset allocation decisions, volatile sterling being a recent example, while some emerging market currencies enjoyed a bounce from very weak levels. Government Bond holders saw some gains over the month-some more inspired by equity market moves rather than changed fundamentals.

Equities

Global Equities fell sharply over the month of December the FTSE ALL World Index losing 7.74% and finishing 11.95% down over the full year. The UK broad and narrow market indices, both fell by between 3.5% and 4% over the month, underperforming world equities in sterling adjusted values from the end of 2017 by about 7% The S&P Index and Japan showed large losses over the month but remained the leading major indices over the full year in sterling adjusted terms. The VIX index rose strongly 33.6 % over the month, and 148% over the full year. The current level of 25.42 still indicates a high degree of nervousness, though off the extreme levels of the 2008/09 crash.

UK Sectors

Sector volatility remained very high during December, influenced by both global factors e.g. commodity prices, tariffs, as well as corporate activity. Oil and mining stocks rose significantly while the life assurance sector and telecoms suffered large falls. Over the year, pharmaceuticals, the leading UK sector, outpaced the worst performing major sector, telecommunications, by around 40%. Preliminary figures show that, amongst UK All company unit trusts, passive funds outperformed active managers by over 2% over the year.

Fixed Interest

Gilt prices rose over the month but finished the year down 2.21% over the full year in capital terms, the 10-year UK yield standing at 1.26% currently. Other ten-year yields closed the month at US 2.72%, Japan 0.02%, and Germany 0.17% respectively. UK corporate bonds rose 0.72% in price terms ending December on a yield of approximately 2.71%. Amongst the more speculative grades by contrast, emerging market debt, in local currency, rose slightly rose slightly over the month. Floating rate bonds showed little change over the month, finishing the year up about 4% in total return terms (Alcentra fund), and are still recommended. See my recommendations in preference shares, convertibles, corporate bonds, floating rate bonds etc. A list of my top thirty income ideas (many yielding around 6%) from over 10 different asset classes is available.

Foreign Exchange

A busy month for the major currencies with sharp gains for the Japanese yen largely on safe-haven grounds, and sterling oscillating with BREXIT news, ending the month down on major crosses. Currency adjusted, the FTSE World Equity Index ended the year outperforming the FTSE 100 by around 6% since the end of 2017. The American and Japanese equity markets outperformed the world average by 5.5%and 2.5% respectively, in sterling adjusted terms.

Commodities

A generally mixed month for commodities with gains by gold, softs, uranium and, iron ore and palladium, and falls by copper, platinum and oil. Over the full year some of the agricultural names, palladium and uranium were amongst the few commodities to show absolute price gains.

Looking Forward

Over the coming months, geo-political events and Central Bank actions/statements will be accompanied by the first quarter reporting season, where forward looking statements will be scrutinised even more than the historic figures, at this advanced stage in the cycle. A gradual global withdrawal from quantitative easing and rising interest rates will provide headwinds.

US watchers will continue to speculate on the timing and number of interest rate hikes during the 2019/2020 period while longer term Federal debt dynamics and trade "war" winners/losers will affect sentiment. Corporate earnings growth will be subject to even greater analysis after a buoyant nine-month period, amidst a growing list of obstacles. Additional discussions pertaining to Saudi Arabia, North Korea, Russia, Ukraine, Iran, and Trump's own position could precipitate volatility in equities, commodities and currencies. In Japan market sentiment may be calmer after recent political and economic events although international events e.g. exchange rates and tariff developments, will affect equity direction. There is increasing speculation that China may announce more stimulative measures. European investment mood will be tested by economic figures, EU Budget discussions, Italian bond spreads, German, French and Spanish politics, and reaction to the migrant discussions. It should also be remembered that EU elections and change of ECB Chairman are expected this year.

Hard economic data and various sentiment/residential property are expected to show that UK economic growth slowed during the last quarter of 2018, and any economic upgrade over current quarters appear extremely unlikely. The UK Treasury and the MPC have both produced rather negative economic medium-term projections, whatever the Brexit outcome! It is highly likely that near term quarterly figures will be distorted, and general asset price moves will be confused, in my view, by a mixture of currency development, political machinations, international perception, interest rate expectations.

On a valuation basis, most, but not all, conventional government fixed interest products continue to appear expensive against current economic forecasts and supply factors and renewed selective bond price declines and further flat performance should be expected in the medium term, in my view. See my recent 'iceberg' illustration for an estimate of bond sensitivity, particularly acute for longer maturities. Price declines are eroding any small income returns leading to negative total returns in many cases. On the supply point there are increasing estimates of US bond issuance against a background of diminished QE and overseas buying. European bond purchases are also winding down. Apart from debt implications, corporate earnings growth and discounting purposes, remember that higher bond yields also are starting to play into the alternative asset argument. In the US for example the ten-year bond yield at 2.72 is over 40 basis points higher than that on equities (2.3%), although the reverse applies to the UK. The current FTSE 100 yield is 4.7% (historic) compared with the ten year gilt yielding just 1.26%. Equities appear more reasonably valued after recent price falls, but there are wide variations. Equity investors will be looking to see if superior earnings growth can compensate for higher interest rates in several areas. Helped in no small part by tax cuts, US companies have been showing earnings growth more than 20% so far this year, although the last quarter of 2018 was widely expected to be the peak comparison period, and 'misses' are being severely punished e.g. Caterpillar,3M Facebook, General Electric, Kellogs, and Twitter. Accompanying corporate outlook statements are being carefully scrutinised.

Outside pure valuation measures, sentiment indicators and the VIX index are showing significant day to day variation, after the complacency of last year. The current level of 25.42, though off the recent extended level, reflects the uncertain market mood, as does the relatively high put/call ratio.

In terms of current recommendations

Depending on benchmark, and risk attitude, first considerations should be appropriate cash/hedging stance and the degree of asset diversification. An increased weighting in absolute return, alternative income and other vehicles may be warranted as equity returns will become increasingly lower and more volatile and holding greater than usual cash balances may also be appropriate, including some outside sterling. Among major equity markets, the USA is one of the few areas where the ten-year bond yields more than the benchmark equity index. The equity selection should be very focussed. Certain equity valuations are still rather high, especially on a PE basis (see quarterly), and a combination of tighter monetary policy alongside any corporate earnings shocks would not be conducive to strong equity returns. Ongoing and fluid tariff discussions, as well as growing regulation could additionally unsettle selected countries, sectors and individual stocks Harley Davidson, German car producers, American and Brazilian soy producers, Chinese exporters, selected tech shares etc etc.

  • I have moved UK to an overweight position for the first time in over two years. Further detail will be available in the quarterly. However, ongoing Brexit debate, political stalemate and economic uncertainty could cause more sterling wobbles, which in turn could affect sector/size choices. I would expect to see more profits warnings. Extra due diligence in stock/fund selection is strongly advised.
  • Within UK sectors, some of the higher yielding defensive plays e.g. Pharma, telco's and utilities have attractions relative to certain cyclicals, though watch regulatory concerns, and many financials are showing confidence by dividend hikes and buy-backs etc. Over recent months, value stocks have been staging a long overdue recovery compared to growth stocks. Oil and gas majors may be worth holding despite the outperformance to date. Remember that the larger cap names such as Royal Dutch and BP will be better placed than some of the purer exploration plays in the event of a softer oil price. Mining stocks remain a strong hold, in my view (see my recent note for favoured large cap pooled play). Corporate activity, already apparent in the engineering (GKN), property (Hammerson,Intu), pharmaceutical (Glaxo, Shire?), packaging (Smurfit), retail (Sainsbury/Asda), leisure (Whitbread), media (Sky), mining (Randgold) is likely to increase in my view, although the Government has recently been expressing concern about overseas take-overs in certain strategic areas.
  • Continental European equities continue to be preferred to those of USA, for reasons of valuation, and Central bank policy, although political developments and slowing economic growth need to be monitored closely. I suggest moving the European exposure to "neutral". European investors may be advised to focus more on domestic, rather than export related themes. Look at underlying exposure of your funds carefully and remember that certain European and Japanese companies provide US exposure, without paying US prices. I have recently written on Japan, and I would continue to overweight this market, despite the 2017 and 2018 outperformance relative to world equities. Smaller cap/ domestic focussed funds may outperform broader index averages e.g. JP Morgan Japanese Smaller Companies and Legg Mason.FX will play an increasing role in the Japanese equity decision.
  • Alternative fixed interest vehicles, which continue to perform relatively well, in total return terms, against conventional government bonds, have attractions e.g. floating rate funds, preference shares, convertibles, for balanced, cautious accounts and energy/ emerging/speculative grade for higher risk e.g EnQuest. These remain my favoured plays within the fixed interest space. See recent note
  • UK bank preference shares still look particularly attractive and could be considered as alternatives to the ordinary shares in some cases. Bank balance sheets are in much better shape and yields of 6%-7% are currently available.
  • Alternative income and private equity names have exhibited their defensive characteristics during 2018 and are still favoured as part of a balanced portfolio. Reference could also be made to the renewable funds (see my recent solar and wind power recommendations). Both stocks registered positive capital returns over 2018 on top of income payments of approx. 5%. And are still strongly recommended. Selected infrastructure funds are also recommended for purchase but be aware of the political risk. The take-over of JLIF during the month highlights the value in the sector!
  • Any new commitments to the commercial property sector should be more focussed on direct equities and investment trusts than unit trusts (see my recent note comparing open ended and closed ended funds), thus exploiting the discount and double discount features respectively as well as having liquidity and trading advantages. However, in general I would not overweight the sector, as along with residential property, I expect further price stagnation especially in London offices and retail developments e.g. (Hammerson, Intu). The outlook for some specialist sub sectors e.g. health, logistics, student, multi-let etc and property outside London/South-East, however, is currently more favourable. Investors should also consider some continental European property plays.
  • I suggest a very selective approach to emerging equities and would continue to avoid bonds. Although the overall valuation for emerging market equities is relatively modest, there are large differences between individual countries. A mixture of high growth/high valuation e.g. India, Vietnam and value e.g. Russia could yield rewards and there are signs of funds moving back to South Africa on political change. Turkish assets seem likely to remain highly volatile in the short term and much of South America is either in a crisis mode e.g. Venezuela or embarking on new political era e.g. Mexico and Brazil. As highlighted in the quarterly, Chinese index weightings are expected to increase quite significantly over coming years and Saudi Arabia, is just being allowed into certain indices. One additional factor to consider when benchmarking emerging markets is the large percentage now attributable to technology.

Full quarter report available to clients/subscribers and suggested portfolio strategy/individual recommendations are available. Ideas for a ten stock FTSE portfolio, model pooled fund portfolios (cautious, balanced adventurous, income), 30 stock income lists, defensive list, hedging ideas, and a list of shorter-term low risk/ high risk ideas can also be purchased, as well as bespoke portfolio construction/restructuring. Feel free to contact regarding any investment project.

Good luck with performance! Ken Baksh 02 /01/2019