Market Commentary – 23rd August 2017

Does the UK’s current position threaten the chances of a successful Brexit Deal?

It has been a busy week for the UK government this week as they have been inching forward with the negotiations surrounding Brexit. The new position papers appear to have two main aims: (i) to move the talks towards areas that the UK is most interested in; (ii) to emphasize to the domestic audience that the cabinet has agreed on a common approach and that the Government will try to make good on its previous promises for how Brexit could work.

In trying to alter the sequencing of the talks – sequencing to which the UK had previously agreed – the UK is playing a risky game. While it is true that customs arrangements are a necessary part of discussions on Ireland, the new papers offer nothing new on the other two issues the UK had agreed to progress first, namely the ‘divorce bill’ and rights of citizens. This increases the likelihood that progress will be slow, which would put further pressure on what is already a very tight timetable. The recent joint article by Liam Fox and Philip Hammond suggested that plans for transition now involve the UK being outside of the single market and customs union. This would require a new, temporary, set of trading arrangements to be negotiated, adding to timetable pressures. It also risks undermining the main benefit of transitional arrangements, namely stability for businesses. The more bespoke the transition deal, the greater both risks would be, so something close to the status quo remains likely.

With the next round of talks with the European Commission (EC) due to take place next week, the UK Government has put forward more of its ideas on life after Brexit. Commentary from cabinet ministers through early summer had offered encouragement that the Government was moving towards a pragmatic approach, which would promote a smooth transition. But the publication of a series of UK position papers and two newspaper articles, written by prominent cabinet ministers have dented our confidence that talks on separation and transition will reach a successful conclusion.

Global Economic News

In the UK, Britain’s current account deficit was even bigger in 2015 than previously thought. On Monday, the Office of National Statistics announced that the current account deficit was £98bn which is equivalent to 5.2% of GDP. July is usually the second biggest month for tax receipts during the year, with many large companies paying one of their corporation tax instalments, and an important one for self-assessment receipts. Indeed, the strength of receipts from some tax streams was reflected in a fiscal surplus of £0.2bn. This compared to a deficit of £0.3bn in July 2015 and was the first July to record a surplus in 15 years. Total current receipts grew by 3.4%. With strong contributions from VAT, up 4.9%, and revenues from self-assessment (a rise of 10.6% compared to a fall of 4.6% in July 2016). However, July’s data was not all good news. Debt interest payments surged by 18% YoY, as higher inflation pushed up interest payments on index-linked gilts. As for the fiscal year to date, borrowing from April to July stands at £22.8bn, 9% up on the £20.9bn recorded in the same period in 2016-17. With rising debt interest payments, a backloading of contributions to the EU budget and the depressing effect on self-assessment payments as income shifting ahead of the April 2016 dividend tax rise is unwound, the remainder of the fiscal year is unlikely to repeat July’s good news. So how resilient is the UK economy? Well, retail sales volumes rose by 0.3% MoM in July including fuel basis. The first half of the year had seen an unusual degree of volatility in the data, with a series of alternating, large, rises and falls in sales. Such a large degree of noise had raised question marks over the degree to which the monthly data was providing reliable information, so the greater stability over the past couple of months is welcome. The underlying trend appears to be one of fairly solid growth in volumes at a pace which, though well down on the past couple of years, is pretty impressive given the strength of the headwinds buffeting consumers. We are probably now at peak pain for households as far as the impact of high inflation is concerned. However, the situation is likely to improve only very slowly, with wages unlikely to begin rising in real terms (adjusted for inflation) before the early part of next year and the freeze on most working age benefits continuing. Also, strong growth in unsecured lending, which has been a key factor underpinning retail demand, appears to be cooling. So, while retail sales should continue to grow, a strong pickup looks unlikely.

In Europe, this morning, strong PMI data came out which reflects the current strength in the European Markets. Eurozone Manufacturing PMI rose to 57.4 in August from 56.6 in the previous month. The pace of expansion in the manufacturing sector was the strongest in two months, as both output and new orders grew at sharper rates, with the latter being boosted by the fastest rise in exports for six-and-a-half years. Also, manufacturing backlogs increased the most in 11 years, while employment rose at a softer pace. With this in mind, with the Services sector PMI, this fell to 54.9 in August from 55.4 in July based on activity growth easing to a seven month low. Finally, with the Euro Composite PMI, this came in at 55.8 in August, which was up fractionally from July’s 55.7. The reading remained around the best seen over the past six years, supported by a strong rise in manufacturing production, while services business activity increased at a weaker pace. Still business optimism was the lowest since last November. Among the bloc’s economies, Germany and France continued to register strong output growth in August, while the rest of the Eurozone saw a slightly weaker increase in output during the month, due to a slower rise in services activity. More specifically, German and French PMI remained strong which has boosted the Euro today. Overall, it is becoming increasingly evident that the Eurozone’s cyclical upturn still has more time to run. While the GDP growth rate of Q2 is unlikely to be matched, a mild moderation would still be impressive given the consecutive quarters of such solid GDP growth. As such, it appears that the decline in sentiment witnessed thus far in Q3 is a mere convergence back down to less extreme hard data, and that momentum in the Eurozone economy is still relatively strong, supporting our outlook of stable growth in Q3.

In the US, the July FOMC minutes showed that Fed officials discussed a wide-range of important issues confronting them, as they try to assess the economic and inflation market outlook. Most prominently a significant amount of the policy discussion involved a detailed examination of inflation dynamics and evolving inflation expectations. Most FOMC members still believe the recent decline in inflation had probably reflected idiosyncratic factors. The Personal Consumption Expenditure (PCE) deflator is a measure of inflation based on changes in personal consumption and is published when GDP data is published. The FOMC members expected the PCE deflator to continue to be held down over the second half of the year due to inflation expectations, and monthly readings might be depressed by possible residual seasonality in measured PCE inflation. There is a significant and growing minority of Fed officials that are becoming increasingly less confident that inflation will rebound back to 2% over the medium-term. Similarly, several officials indicated that the risks to the inflation outlook could be tilted to the downside. About inflation expectations, there was some concern that inflation expectations are becoming unanchored, and that low inflation expectations were exerting downward inflation pressures. Moreover, some suggested that maybe inflation expectations needed to be lifted. While there was a lack of consensus that inflation expectations were becoming unmoored, there was broad agreement that a decline in long-term inflation expectations would be undesirable. A compromise between the inflation hawks versus the doves could be the that FOMC soon starts to reduce the size of its balance sheet, which would very gradually remove some monetary stimulus, whilst holding off on raising interest rates until next year.

Barometers

 The Barometers below look at some of the data we review on a day by day basis and by having these detailed, it gives you some insight into what is happening.

 US Earnings are important because if the US starts to slow down, then so does the rest of the world.

As it stands from last week, 91% of the companies in the S&P 500 reporting actual results for Q2 2017, 73% have reported positive EPS surprises and 69% have reported positive sales surprises. For Q2 2017, the blended earnings growth rate for the S&P 500 is 10.2%. Ten sectors are reporting or have reported earnings growth for the quarter, led by the Energy sector.

UK & Non-UK Gilt Yields;

 UK and Non-UK Government Debt are a good measure, as they indicate whether we expect the economy to improve or worsen, with rising yields reflecting positive environment and reflecting positive interest rate movements as we look out. The opposite with lowering yields as the expectation is worsening economic conditions.

Over the last week, we have seen bond yields drop with corresponding valuations increasing. Volatility remains high in these assets which should not be functioning like this. This is a further example of why we are still not directionally investing into these assets.

 GBP to USD/Euro/JPY;

 We monitor the GBP rate to see how much of the returns are coming from underlying equity valuation increases and movements in the currency, to see if we should be locking in the gains and hedging the risks. We have changed our 12-month expected range for sterling across the US Dollar, Euro and Japanese Yen. This is to reflect a stronger pound, following Brexit, and less negative risk due to the UK economic data stabilising, and therefore uncertainty risk is dropping off. As Brexit matures, we expect Sterling to weaken over the coming months as negotiations set off and both sides prevaricate, then reappreciate towards year end to roughly where we are now or slightly higher.

Since the Brexit vote last year, Sterling has been down and now it is very sensitive to any changes in the political and economic landscape. Following Sterling weakness, imports have been dearer and exports have been cheaper which reflects the current landscape. So why has the pound continued to drop today? After an incredibly flat start the pound took a dive today, infected by Brexit bearishness. There’s not really been much to force sterling lower against the dollar and the euro. The former has admittedly seen something of a comeback this week following a fortnight of macro-economic losses; the latter, meanwhile, received a bit of a boost from a better than expected Eurozone manufacturing PMI (even if the services reading was worse than forecast). With little else going on in the UK, it seems investors have been left to speculate about the state of the Brexit negotiations, rarely a good thing for the health of the pound.

GBP / USD – Range 1.32 – 1.20 – Today at 1.28
GBP / EUR – Range 1.14 – 1.05 – Today at 1.08
GBP / JPY – Range 150 – 130 – Today at 140

Oil Price;

 We monitor the oil price as it is a strong indicator of global consumption when balancing the output and storage data. Strong supply and usage denotes a strong global economy. Opposite reflects underlying weaknesses.

The price of oil over the past week has been volatile and relatively flat. WTI Crude is currently trading at $47.66 and $51.74 for Brent, down approx. 0.3% for WTI and up approx. 1.2% for Brent. A report from the American Petroleum Institute (API), stated that oil reserves in the US fell by 9.2 million barrels. US inventory data has lost a degree of its value in recent months as trader’s express concern about data that show near-record reserve levels elsewhere and reports that global supplies are rising ahead of demand. Traders are especially anxious about the rising output from US shale oil fields and excess supply from the OPEC cartel that’s ahead of its pledged production cap. But such a wide overshoot will undoubtedly inject some optimism into the market. Oil prices fell again today due to oversupply fears again. Investors are unnerved about oil supply from Libya with mixed reports on whether its Sharara oilfield is open or closed. The flood of news reports makes it clear that the situation in Libya is still chaotic and that conditions in the country are still far from normal.

Gold Price;

Gold is a safe haven and a spike in price can be an indicator of increasing underlying economic concerns and as always, the opposite.

Over the past week, we have seen the price of gold futures remain slightly volatile, gaining approx. $16 an ounce to $1,286 a troy ounce. Gold last week reacted to the terrorist attacks in Spain and the mounting political turmoil in the US, when it almost reached $1,300. As investors move away from riskier assets, there is a corresponding rise in the “haven buying” of assets perceived as safer, such as gold and government bonds. Ultimately the effects of the terror attacks on markets will not be long lasting, but trader sentiment is also weak because of longer-standing concerns over the waning prospects of Trump’s pro-business agenda in the US. Further investors’ fears were prompted by the disbanding of the President’s business committees following a spate of resignations over his response to the violent clashes at a far-right rally in Charlottesville, Virginia. Gold fell earlier this year as a consensus emerged that a promised $1trn of infrastructure spending and a raft of tax cuts would boost growth and prompt interest rate rises. Increasing rates tends to boost income-generating assets and increase the opportunity cost of holding non-yielding gold, thereby putting downward pressure on the metal’s price.

Model Portfolios & Indices

Over the last week we have seen most of the indices that we track drop slightly after hitting record highs. Markets inched up slightly yesterday after a week’s losses following commodity prices increasing, which benefitted most of the manufacturing and mining firms held in the indices. Hong Kong markets were closed on Wednesday following powerful Typhoon Hato hitting the area. Trading was mixed elsewhere in Asia, with losses in South Korea and Australia, whilst Japan’s Nikkei 225 index edged lower.

 

Even though markets haven’t been very strong over the past week, our portfolios remained resilient and beating their respective benchmarks.

 

Investment Committee Meeting Outcome

 

Yesterday the Investment Committee convened and we analysed our current positions and the macro- outlook. Following this meeting, we decided to make small changes to the portfolios which will benefit our clients towards the end of this economic cycle. The nature of Outcome Based Investing (OBI) captures this trait of our investment strategy, as it allows us to cyclically adjust our portfolios to take into consideration areas we hold strong investment conviction in and vice versa during the end of the cycle.

 

As part of our meeting, we decided to fully sell the Artemis Pan European Absolute Return Fund as this fund is a GBP hedged position fund and when Sterling improves, this fund would improve. However, as highlighted above, Sterling is struggling to gain ground since the referendum results last year and is even more sensitive at this juncture based on various political and economic factors. For this reason, we will be selling the fund and adding the proceeds over to cash whilst we complete our research for an alternative fund. For OBI 3, OBI 4 and OBI 5 (which are the lower risk portfolios) we will add the proceeds to the Sterling Strategic sector, which will give the lower risk profiles exposure to areas we have high conviction in with low capital risk. For OBI 6, OBI 7 and OBI 8 (which are the higher risk portfolios), we will add the proceeds to the Equity space giving these portfolios higher returns on areas we believe will do well in the current economic cycle, such as Emerging Market Equities.

 

Since we believe that we are nearing the end of this cycle, we will start to review our positions from a 12-month horizon to a 3 – 6 month horizon. This way, we are able to actively keep an eye on the fundamentals and make changes to the portfolios as things start to slow down. By adapting this strategy, we will be able to change our asset allocation and review any high risk assets on a shorter time scale.

 

 This Day in History

 

On this day in 1993, the New York DOW Jones Index reached a record high of 3,638.96 points. Today, the average is at 21,899.89 and hit 22,000 not so long ago.

 

As always have a wonderful week and stay safe.

 

VBW

 

 

 

Jason Stather-Lodge  CFP, MCSI, APFS
CEO & Founder
Chartered & Certified Financial Planner
Chartered Wealth Manager