Fourth Quarter Report

Transcription

1 Fourth Quarter Report

2 General Commentary For the first time since the financial crisis, growth is decent across the world. In Europe, over EUR 2 trillion of printed money has galvanized the whole Eurozone, with Germany on the verge of overheating. Yet printing continues, with the ECB giving weight to the slowest ship in the convoy, Italy. In the US, fiscal stimulus has been applied to an economy with unemployment at 17 year lows. In the past, such synchronized growth has led to inflationary pressures, but recent history has led the market to discount such fears. The forces for deflation have been strong over the last 25 years including: globalization; technology changes; weak trade unions; the gig economy and the disruptive effect of the internet. Crucial to inflation is the development of wages. In the US it is clear that the Phillips Curve is not dead, but it is substantially less steep than before the crisis, largely reflecting those deflationary forces. Nevertheless, with unemployment likely to fall below 4% on consensus forecasts of growth, earnings on the Atlanta Fed model (which measures same job year-on-year changes) should rise by over 4% in Further support will come from increases in the minimum wage 14 states mandated increases this January and widespread reports of skills shortages. With additional tailwinds from energy and commodity prices, themselves reflecting the general growth in the world economy, service inflation can be expected to accelerate modestly but relentlessly. Furthermore, the offset from globalization, that is the fall in goods prices that has reflected largely China s increased market share in global trade and ever lower prices, may be over. China s corporate inflation rate is over 6% and US import prices are rising at 3% (1.3% excluding petroleum), very different from the negative numbers that have prevailed for large parts of the last 20 years, -0.7% on average in the last five years. There may be a parallel here with the 19th century when changes in transport by rail and ship allowed grain from the prairies to be sold around the world, lowering prices, causing a rural depression in the UK and leading to stable prices overall. But in the mid-1890s there was no more virgin land, while populations continued to grow rapidly. The subsequent rise

3 in food prices set off a trend to higher general inflation that lasted for 25 years. In a similar way, the changes from goods deflation to modest inflation as the benefits of globalization are largely captured could represent an important change in trend. Rising service inflation will no longer be offset by goods deflation, so that the overall rate may increase. That s important because the shape of the yield curve suggests that the market believes that any increase in inflation in 2018 will be temporary, whereas the underlying forces of increasing earnings look sustainable, in the absence of recession. And recession looks unlikely given the restraint on raising rates that is imposed by excessive debt. Indeed, particularly in the UK, pushing up rates in response to rising inflation seems to be limited to perhaps 2-2.5% nominal because of the impact on mortgages. The US is less sensitive to short term rates, but the Federal Reserve is also constrained by debt levels. Nor is there much sign of any central bank willingness to risk recession by robust tightening. Any indications of a slowing economy will elicit further monetary accommodation. No-one wants to repeat the mistake of But if short rates remain at historically low levels, rising inflation could lead to a steepening yield curve and if the view that such an increase is not a blip but part of a persistent trend then that steepening could be quite dramatic. The consequences for asset prices, distorted as they are by QE, will be interesting. Peter Spiller

4 Fund Information as at: Share price: 31st Dec Investment objective The Company s dual objectives are to preserve shareholders real wealth and to achieve absolute total return over the medium to longer term Fund information NAV return history (total returns) Largest fund/equity holdings Market Cap. 214m 1 month 0.8% % Vanguard FTSE Japan ETF 3.0% Yield < 1% 3 month 1.4% % Vonovia 2.8% Ongoing charge 0.89% 6 month 1.4% % North Atlantic Smaller Co.s 2.7% Benchmark RPI Year to date 5.1% % Deutsche Wohnen 1.8% 1 year 5.1% % Residential Secured Income 1.8% NAV performance since January 2000 (total return) Largest bond holding UK I/L 0.125% 22/11/19 US I/L 2.00% 15/01/26 US I/L 0.25% 15/01/25 US I/L /01/25 Sweden I/L 0.25% 01/06/22 7.6% 4.2% 3.8% 2.5% 2.0% 200 Currency exposure 100 GBP 53% USD 30% 0 EUR 8% SEK 5% Capital Gearing NAV MSCI UK All Cap UK RPI JPY Other 3% 1% Asset allocation Fund/equity breakdown Index Linked Gov t Bonds 37% Property 18% Conventional Gov t Bonds 0% Equities 13% Pref Shares / Corp Debt 16% Private Equity/Hedge Fund 3% Funds / Equities 40% Loans 4% Cash 6% Infrastructure 2% Gold 1%

5 All active investors are value investors, given they employ strategies that attempt to identify securities worth more than the prevailing market price. However value investing, of the Benjamin Graham school, has traditionally been associated with stock selection by attractive fundamental measures such as high dividend yields, low price to tangible assets or low price to revenue ratios. Over the long term these valuation measures have proven themselves and given the increasingly rich data sets available today these principles are increasingly used to assess the valuations of entire market indices such as the S&P 500. The most closely watched indicators followed by value sensitive global asset allocators (like us) are the cyclically adjusted price earnings ratio, market price to asset replacement costs (Tobin s Q) and price to revenue multiples. All these measures suggest that the US stock market is trading close to the most expensive level in its history. Notwithstanding the long term success of value investing many other styles have been more profitable over the last five years. This has led to an increasing number of market observers asking whether some combination of digital business models, lower levels of competition in the US economy, changing accounting standards and/or the record low levels of interest rates mean that value measures have lost their relevance. Or to put it another way, this time is different. In considering these arguments it is important to remember what stretched valuations could mean. They do not mean that the US market is on the cusp of a bear market, over the short term market direction is random with a slight upwards bias. They do not even mean current market levels are unsustainably high, although that is certainly our belief. What it does mean is that the medium term return prospects are significantly lower than the historical norm. If a new breed of globalised digital business models mean that the FANGs* are fair value today, then there are a significant number of more traditional companies that are significantly overvalued, as implicitly their customers are shortly to leave them for the digital disruptors. If low interests rates are the justification for high valuations, or to put it another way equity discount rates have reduced, that is the same thing as saying medium term returns will be lower than the historic norm. Lower levels of competition in the US economy may explain why current profit margins are so high. However price earning ratios today are at high multiples of those peak profit margins. To generate historically normal returns it is not sufficient for these high profit margins to remain stable, they need to go even higher. We do not consider that this time is different. Arguments that are deployed to justify the sustainability of current US stock market valuations may or may not be valid. However, even if they are valid they would still imply that the medium term return prospects are moderate, and that the opportunity cost of not being invested in the US market is at historic lows. This view is not widely shared, indeed market sentiment indicators suggest investors are fairly excited about prospective equity returns. In the short term this excitement maybe warranted but over the medium and longer term we believe that the fundamentals will assert themselves. *FANGs is stock market shorthand for Facebook, Amazon, Netflicks and Google.

6 There are two key processes in the creation of a multi asset portfolio. Firstly deciding what proportion of the overall portfolio each asset class should make up. Secondly selecting the individual securities to populate those allocations. These processes of top down asset allocation and bottom up stock selection influence each other in a constant iterative cycle. Capital Gearing Trust holds risk assets collectively that make up just less than 40% of the portfolio. These risk assets are made up of listed funds that hold a wide range of underlying assets. The largest grouping within risk assets is property, mostly real estate investment trusts, which have been a major driver of fund performance over the last 12 months. In the last quarterly report we commented on the attractions of the European property markets relative to the European bond markets. The second largest risk category is global equities, largely held through investment trusts and exchange traded funds, which make up around 13% of the portfolio. This equity weighting is extremely low, probably as low a weighting as the fund will ever have given its multi asset mandate. When considering the appropriate top down equity weighting by far the most important factor we consider is the valuation of the US equity market, as measured against long term fundamental indicators. Even if the equity allocation is largely made up of non-us equities, the US market is the weathervane for all developed stock markets. If the US sneezes the world catches a cold; if US equity valuations are unsupportable, then there is elevated risk in European or Japanese equities even if valuations in those markets are supportable. 100 years ago different national or regional stock markets were uncorrelated, today they are highly correlated. On a relative basis there are international stock markets that, whilst not cheap, are significantly better value than US. The most notable of these is Japan which has performed extremely well over the last 5 years and still remains the best value of the global developed markets. European markets also look reasonable value relative to the US, although undoubtedly part of this apparent cheapness reflects sectoral differences. The US market has more than its fair share of extremely profitable digital monopolies e.g. Facebook and Google, that naturally command higher valuations than, for example, southern European banks. However even adjusting for these sectoral differences both Japan and Europe appear 25%+ cheaper than the US. Furthermore corporate earnings in Europe, after a long period of stagnation, have started to rise strongly and given the early stage of the cyclical upswing could have significantly further to go. The fund also has a modest home market bias to the UK stock market, and within that weighting has reasonably high weighting to small capitalisations stocks. The elevated valuations of US stocks means that our overall allocation to equities is very low. Within that allocation the UK, European and Japanese equities are all significcantly overweight relative to the US. This allocation has helped the fund s equity portfolio to outperform global indices over the last 12 months, and we hope makes it relatively defensive. That said when the next US bear market does arrive relative valuation arguments will not protect equity investors from losses, and a 13% weighting to global equities may quickly change from seeming uncomfortably low to uncomfortably high.

7 Thoughtful Investing CG Asset Management 25 Moorgate London EC2R 6AY +(44)