Investment update, Q4 2017
The power of increments: small changes over a long time.
Don’t be distracted by what seems potent now, try to look forward to what will really make a difference to the landscape. A fierce wind whipping around you today will have died away in a year’s time. But a glacier will have crept forward a third of a mile.
North Korea has stepped up testing its missiles and nuclear warheads, boosting tensions with the US. America, harried by unrelenting hurricanes, has been racked with protests about its President, its past and its future. Congress has failed to pass any of the new administration’s cornerstone policies. Meanwhile, more terrorism has blighted Europe and the UK.
Despite a volatile political and security background, we haven’t much changed our view on your investments. We still believe the world’s economy is growing steadily with few visible signals of substantial deterioration. In this environment, we think that equities should continue to deliver better returns than bonds. However, we are aware that prices are high, making us cautious about what we buy. In some cases, the amount of cash in portfolios may be heightened because of this.
For us to change our minds and back bonds over shares, we would have to see one or more of the following:
- Signs of imminent recession in the US or Europe
- Risks of a policy mistake by a major
- Unanchored inflation expectations, leading to rising bond yields.
Watching paint dry
Investors will need to digest a number of significant events over this next quarter. ‘Small changes over a long period of time,’ is a phrase that we believe investors will do well to keep in mind.
The US Federal Reserve will start to unwind its quantitative easing (QE) programme in October. It won’t sell any assets, but will instead not reinvest the cash it gets from maturing bonds and mortgage-backed securities. This ‘passive’ reduction will start at a pace of just $10 billion a month, rising to $50bn a month in a year’s time for thereafter. Although these numbers may sound large, this is a very gradual reduction of its current stockpile of $4.25 trillion of assets.
Investors should be clear, however: the Fed will not get rid of all of its bonds. This is because the Fed needs to run a balance sheet just like any other company. At its simplest, a central bank’s liabilities are the currency notes in circulation and commercial bank reserves, while its balancing assets are government bonds. Indeed, before the financial crisis the Fed’s balance sheet was pretty much that simple.
Since embarking on QE, however, this situation has become a bit more complicated. Suffice to say that the amount of US dollars in the US economy – the Fed’s liabilities – has grown and will continue to grow, and the Fed can’t reduce its assets below the value of the currency it has to back. Therefore, the quantitative tightening (QT) will stop when the Fed’s stock of bonds and the currency in circulation converge. We estimate that to be in a little over four years (as long as nothing happens to throw this out of kilter) meaning the Fed would only need to offload around 65% of the purchases made under QE. This is wholly untested, however. No central bank has unwound a QE programme before. But based on academic assessments of the effect QE had on US government bond yields, our uppermost estimate has QT raising the yield of 10-year US treasuries by between 0.68% and 1.54%. So that’s 0.17% to 0.38% a year. And our analysis suggests that the Fed may need to sell less than 65% of the bonds it has accumulated, making for a an even smaller effect on yields. Small changes over a long period of time.
Deleveraging the Dragon
China’s five-yearly National Congress will take place in October. This is where the party appoints or reappoints its leadership for the next term and codifies its legislative priorities. Will China pursue an agenda focused more on growth than risk management? Will it prioritise debt reduction at the expense of growth?
Sceptics say that President Xi Jinping entered office five years ago promising to decrease debt and increase reform, but instead paid lip-service to the notion. This is an ahistorical position. New Chinese leaders tend to spend their first five years of control unpicking the tentacles of the previous leadership, consolidating power in order to carry out their agenda in their second term. We believe the political attitude to debt has undergone a profound change: a year ago, no official spoke about the danger of debt, now it is considered a matter of national security. If Mr Xi consolidates his leadership even further in October, we believe he is more likely to cut borrowing and reform China.
If this comes to pass, it will inevitably lower the outlook for global growth (remember, China has accounted for 29% of global GDP growth since 2010). We would very much welcome the development. Total nonfinancial debt in China has increased at an alarming pace for over a decade, while economic efficiency has deteriorated chronically. Although China’s state-controlled economy has so far avoided any systemic crisis (most of the debt has been issued by state-owned banks to state-owned enterprises), the side effects – from financial asset bubbles to capital outflows – make the balance between growth and stability increasingly precarious. We would prefer smaller, but more sustainable, growth over a longer period of time.
Ballot box ballet
Chancellor Angela Merkel lost a significant number of seats in the German election, punishment for her welcoming refugees from Syria and Iraq. It was the worst electoral result of her 12-year leadership; right-wing anti-immigration party Alternative für Deutschland entered the Bundestag for the first time with 13% of the seats. Mrs Merkel has only one option to form a coalition government, after the SPD, her party’s nearest rival and current coalition partner, ruled out any new arrangement. With a three-way compromise needed on policy, it will take at least three months to iron out a deal. There may even need to be a fourth party brought into the government. All this will weaken Mrs Merkel’s leadership. Expect fewer gambits from Germany in the next few years.
Meanwhile, Japan goes to the polls on 22 October. Prime Minister Shinzo Abe ordered a snap election to take advantage of a resurgence in his approval ratings partly driven by rising tensions with North Korea. If he secures a longer term for his programme of reform and reflation, we would view this positively. Certainly, it is too early to say that Mr Abe has successfully revived Japan’s economy. Companies are still reluctant to raise wages, while companies and households are unwilling to borrow and invest in the future. Yet we believe it is wrong to write off ‘Abenomics’ as a failure. We believe that he has passed many important reforms that should start to improve growth from this year on. For example, loosening immigration rules and helping more women to join the workforce should ameliorate the nation’s declining labour force. Deregulation and greater investment in the tourism industry allows Japan to benefit from an explosion of Chinese demand. Cuts in corporate taxes alongside efforts to broaden the tax base and corporate governance reforms have caused companies to become considerably more focused on delivering shareholder returns. Since Mr Abe came to power, total dividend payouts from companies in the MSCI Japan index have increased 72% versus just 30% for the MSCI World. We believe these small changes add up, and will make a difference in the years to come.
Trickle-down tax reform
At quarter’s end, the US President’s short-term debt ceiling deal will need revisiting. The absolute limit on US borrowing has been lifted 46 times since 1980, and it rarely makes a dent in American equity or treasury prices. In recent years, fiscally conservative Republicans have used the issue to protest what they consider profligate US budgets – most famously in 2011 when S&P downgraded the US’s credit rating for the first time in history.
Increasing the debt ceiling should be a moot point this time round if Republicans are united around the White House’s new tax plan. Released in late September, the simplification of tax bands and deductions, along with incentives for investment, are forecast to reduce revenue by $2.2tn over a decade.
That would need to be funded with more borrowing – awkward for Republicans who have made careers out of damning debt. Their defence? Reforming the tax code and lowering rates will lead to a boom in economic growth that will increase the tax base so much that it will lead to greater revenue. ‘Trickle-down’ theory has a rather dubious history. Expect an interesting fight in Congress before next year’s Budget is passed.
Meanwhile, the Brexit dance continues. Prime Minister Theresa May conceded that the UK would aim to seal a transitional two-year agreement ensuring uninterrupted trade in return for open borders with the Continent, continued payments to the EU and submission to the European Courts of Justice. This was always the most likely result. It will ease the negotiations, but how will it weigh on investment spending over the next few years? Politics remains extremely fraught in the UK, with the Conservatives divided over Brexit and the Labour party growing louder in opposition. Consumers are encumbered with high debts, house prices have wobbled recently and real wages continue to decline. We are watching carefully.
Earlier this year, stock markets were whipped up by the promises of a new American President. Shares in cyclical companies roared higher on the chance that greater government spending would boost economic growth and their earnings. These shares have since retreated, with investors focusing instead on those businesses that are expanding on their own terms. In many cases, these are technology companies, such as Alphabet, Amazon and Facebook, which dominate our digitised world. These companies, and others like them, have redefined the way we live. These changes will continue over the coming years. Each day, automated trains roll through the Docklands, which used to be clustered with sails and rigging. One day, automated cars running solely on battery power will zip between the two cities of London.