Volatility is not dead – merely sleeping

As uncertainties now stand alongside opportunities, Artemis review the markets over the past six months …

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Market matters…

After a remarkably steady run (on the whole) through 2017 and into the beginning of 2018, markets reminded investors that volatility was not dead – but merely sleeping.

Uncertainties now stand alongside opportunities, and in what follows we will give you our views. We are, as you know, stock-pickers – or even profit-hunters. We believe that our approach will, as it has in the past, deliver the returns – though past performance is no guide to the future. However judiciously we try to choose them, of course companies are never complete masters of their own destiny. These days they and the rest of us, whether we like it or not, live with – or under – greater powers, such as the four (of many) that follow:

1. Trump and trade…

The most recent volatility in markets has come from Trump’s tariffs. They are thought to be inimical (at best) to the received wisdom of ‘free trade’ and, of course, to the General Agreement on Trade and Tariffs that is supposed to govern global trade. Most economists hold to the Ricardian principles: if I am good at producing potatoes and you are good at producing carrots, we are both better off if we specialise where we have advantages and trade with one another. The balance of that trade may affect the potato/carrot ratio over time (i.e. the exchange rate) – but it shouldn’t get in the way of meals.

That is not to say that current arrangements are beyond criticism. The Chinese government does tend to ask exporters to share intellectual property (IP) when they operate in China – though many, such as the Japanese automation companies, seem to be able to keep critical IP private. To the problems of tariffs and IP can be added dubious restrictions. The US, for example, has banned the import of haggis for 47 years. So, yes, the need for reform is obvious; but the opportunities for revenge are legion when reform goes awry.

Tariffs, whether “negotiable” or not, mean among other things that one must understand stocks fully. For example, Tenaris, which makes steel pipes for oil companies. It is listed in Italy and sells tubing globally – but almost 50% of its sales go stateside. On the face of it, then, Trump’s 25% on steel is hardly helpful. But on closer inspection? Tenaris has plants in the US, and so can be considered a domestic manufacturer helping to ‘Make America Great Again’. Equally, some of the steel it uses is imported from outside the US. Will that be affected by the tariffs? Unclear. Will Tenaris be able to pass on the tariffs to its customers? As the US isn’t self-sufficient in steel tubing, there is a strong argument that it will. So while tariffs are troublesome, they can create opportunities for stockpickers (or even profit hunters) – who know their holdings in the round.

2. Issues of interest and inflation…

Whether quickly or slowly, interest rates are going up (at last.) Financial theory does say that equity valuations, i.e. the price you pay for a pound of earnings, should drop as the interest rate used to discount that earning rises. Empirical evidence agrees. A simple linear regression of stock multiples vs interest rates shows that, over the long term, rates and market multiples are negatively correlated. Since 1954, for every one percentage point increase in 10-year US Treasury yields the price/earnings ratio on the S&P 500 has fallen by c. 0.70 points.

Trump’s lower taxes could add a further 0.8% to the GDP of an economy that is already doing well. US unemployment is down to 4%, lower than it was in 2007, and the cognoscenti see that falling to 3.5% over the coming year. It was last that low in the 1960s – when inflation was 6%. Meanwhile, when it hit $70 per barrel, oil had rebounded by 147% from its low of $27.88 (on 20 January 2016). That has to be inflationary.

3. In the business of bonds…

A big worry for the stockmarket, we think, ought to be the bond market. At the end of 2017, just under $10 trillion worth of bonds globally traded with negative yields. And while that’s still stranger than fiction, it’s more than $3 trillion below the peak. The direction of travel is clear …

As conditions (slowly) ‘normalise’, both in the US and around the world, the US bond yield is likely to be moved higher by three or four hikes from the Fed this year. And then there is the vital context of buyers and sellers. Last October, the Fed started to taper its (bloated) balance sheet. It will cut its holdings of US Treasuries and mortgage-backed securities by $300 billion over the current fiscal year and then by $600 billion during the following fiscal years. Meanwhile, under Trump, the US federal deficit is set to widen again back to over $1 trillion this fiscal year and next. So issuance of US Treasuries will balloon. And if Trump’s tax cuts boost growth and inflation, bond yields could run.

US Treasuries have returned 6.7% annually since 1987.  But to repeat this over the next three decades, yields would need to fall to -18%. In our view, July 2016, when the yield on the 10-year US Treasury touched a low of 1.45% will be cited, one day, as the end of a bull market in government bonds which began in 1981.

As for the UK? An admittedly extreme example is the 2065 index-linked UK Gilt, currently yielding -1.543% and priced at £218.64. If that yield rises to -0.543%, its price must fall to £136.53 – a drop of some 40%.

4. The demands of debt…

The Vietnam and Korean wars aside, never before has the US expanded its deficit substantially when unemployment’s been low and debt’s been high. But Congress has voted to do just that. The consequences can only be made worse when the cost of interest reverts, as it will, to long-term averages. The cost of the US servicing its debt is forecast to reach 3.5% of GDP by 2027 – more than it was in the 1980s or even the 1940s. And when the US even sneezes …

In November, consumer debt in the US rose by $28 billion, or the most since November 2001, to $3.827 trillion, an annualised increase of 8.8% – some three times faster than growth in GDP. Higher interest rates will, er, hurt. Then there are such signs as the boom in corporate PIK (payment in kind) bonds, which pay their interest with more debt, rather than cash.

Via the alchemy of money-printing, the assets of the European Central Bank (ECB) rose to a record €4.44 trillion in October last year, up by €853 billion year-on-year and by €2.45 trillion since late 2014. Of course the Bank of Japan (BoJ) is still at it too. The total assets of the US Fed, ECB, BoJ and People’s Bank of China reached a record $19.6 trillion in October 2017, up 10% y/y. Of those assets, it’s emerged that in July the ECB bought, among others, bonds in a South African retailer called Steinhoff (which are now trading at 59 cents on the euro.) This was because, apparently, “the company maintained an investment grade rating from Moodys.” And thus do markets remain the vassal of central banks – as credit card debt in the US goes back to being well over a trillion dollars ($1.011 trillion, to be precise) and fast approaching the all-time high of $1.02 trillion in the summer of 2008.

In theory, the central banks should be able to wean the world off QE. But of course there is theory – and practice. In theory, communism should work – but only 26 years after the demise of the USSR, there are only five states which call themselves communist – China, Cuba, Vietnam, Laos and North Korea – and only one of those has a centrally planned economy. When chairman of the US Federal Reserve, Ben Bernanke’s only witticism was: “The problem with quantitative easing is that it works in practice, but it doesn’t work in theory.”

‘I now pronouns you him and her.’ Matters remain no less malapropic; and it remains to be seen how and whether central banks can achieve what they must.

On the other hand, some positives…

The bears used to say that the bull market was driven mostly by the Fed’s QE. The popular and prime witness was a chart of the S&P 500 vs the balance sheet of the Fed. The two were highly correlated – until the Fed quit QE at the end of October 2014. Since then, the Fed’s assets have been flat at $4.3 trillion. But the S&P 500 is up by some 41.8%. The Fed has started to let its balance sheet shrink as the bonds it owns mature. Yet there’s been no ‘taper tantrum’ in the stockmarket or bond market.

An Artemisian accord is that, ultimately, valuation does matter. So where an investment thesis hasn’t changed but valuations have, we go on taking profits in stocks that have done better than we expected and putting the proceeds into underperforming stocks we like. This means, across our funds, a (pronounced) tilt towards value. Over the past 118 years, value stocks have outperformed growth stocks two-thirds of the time. But since the financial crisis, value investing has been out of vogue – until recently.

And stock-picking? On, say, a 10-year view, our fund managers believe they are better by thinking about ‘creative disruption’ more than inflation or ‘trade wars’. The latter just is (very) deflationary; and the ‘internet of things’ is inherently transnational. Take 5G. Present 4G networks download at one gigabit per second. With 5G networks, which will start to be ‘rolled out’ this year, the speed increases to 10 gigabits. In 4G, latency – the time it takes the network to recognize your request for data and to start sending you that data – is around 50 milliseconds. With 5G, that falls to one millisecond. Such studies are usually fatuous. But for what it’s worth, the ‘roll-out’ of 5G in the US alone is estimated to cost $300 billion – but to generate $600 billion in new revenues.

And so on balance…

At times like these, it’s always comforting to turn to the Barclays Equity Gilt Study. Since 1899, UK equities have given annualised average total returns in excess of inflation of 5%. Nine-tenths of this real return has come from dividends, rather than from gains in capital. On the whole, do you see dividends as sustainable? (We do.)

Secondly, and admittedly with the spectre of ‘trade wars’ all too present, for just now at least the global economy is growing and, with it, so are corporate earnings. With QE ending and rates rising, the way forward was never going to be smooth. Yet for the foreseeable, in our view, such a way is very feasible. The last big correction lasted 100 days and took the S&P 500 down by 13.3%. Beginning on 3 November 2015 and lasting until 11 February 2016, it begat many ‘buying opportunities’. Though the proposition is far from new, the fact is that for stock-pickers like us, volatility means opportunity.

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Data: As at 5th April 2018, sourced by Artemis, unless otherwise stated.

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