Peter Elston: Investment Letter Issue 39: August 2018

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1 Peter Elston: Investment Letter Issue 39: August 2018 This document is intended for professional investors only Inflation Macro and markets monthly Current fund targets Inflation Am I right to worry about higher inflation? Followers of our funds and my writing will know that we have been reducing risk in anticipation of inflation becoming a problem over the next 1-2 years. There is a sound basis for this stance, but it is one we keep under constant review. There are two aspects to this question about inflation. First, should one in general worry about high inflation? If yes, should one be worrying about it right now? Seneca Investment Managers Limited Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. T E info@senecaim.co.uk W senecaim.co.uk Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority FRN Registered in England. Registered Office: Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. Company Number VAT No

2 As to the former, a Mr Bill Bengen has the answer. Bengen was an MIT-trained aeronautical engineer turned financial planner who in 1994 wrote a paper titled Determining withdrawal rates using historical data. His approach was empirical not theoretical, looking at how balanced funds performed during 20 year periods since 1926 given a certain equity/bond proportion and a certain withdrawal rate. Part of the analysis involved looking at the effect on portfolios of the three major financial events during the period under review, which Bengen called Little Dipper ( ), Big Dipper ( ), and Big Bang ( ). The results of the analysis are shown in Table 1 below. Table 1: Characteristics of 3 Major Financial Events Total return common stocks Total return int-term bonds Total return 50/50 stocks/ bonds Inflation Total return 50/50 stocks/ bonds (real) Little Dipper ( ) Big Dipper ( ) Big Bang ( ) -61.0% +10.5% -25.3% -15.8% -9.5% -33.3% +16.7% -8.3% +10.5% -18.8% -37.2% +10.6% -13.3% +22.1% -35.4% Source: Bengen 1994 The Wall Street crash of 29 may have been the worst equity market decline of the three, but a 50/50 bond-equity fund only fell 9.5% in real terms from 1929 to The period that was the worst for balanced funds on an inflation adjusted basis was Big Bang ( ). The reason for this was that consumer prices rose by 22.1% during the 1973 to 1974 period, compared with just 10.5% from 1937 to 1941 and deflation of -15.8% from 1929 to While deflation can be nasty, the real killer is high inflation. This is obvious in relation to bonds, where principal and coupons are fixed in nominal terms so get impacted by high inflation in real terms (the opposite occurs in a deflationary environment though it is possible default rates will be higher). With equities, the relationship is indirect. During a recession or otherwise, companies, unlike bonds, are able to adapt to high rates of inflation. They can raise prices, adjust capex, mothball capacity, cut workforces etc. This is borne out by the performance of equities and bonds during the two prolonged periods of rising inflation in the last 150 years, 1901 to 1920 and 1940 to During the first of these, annualised real returns from bonds and equities were -4.3% and -0.3% respectively. During the second, they averaged -2.7% and 5.9%. On this basis, it could be argued that bonds are more risky than equities! Furthermore, it is also possible that many have forgotten just how badly bonds can perform given the 70s are now a distant memory. One way however in which there is a more direct impact of higher inflation on equities is via real interest rates. Monetary policy will naturally be tighter when inflation is high; the higher the inflation the higher the real interest rates required to bring it down. Since equities compete with bonds, rising real interest rates associated with rising inflation will tend to mean higher equity yields. This, of course, means lower equity prices, all else being equal. 2

3 In summary, therefore, high inflation is more damaging to portfolios than low or negative inflation. As to whether we should be worrying today about high inflation, there are again two angles. One pertains to cyclical inflation, the other to longer term or structural inflation. From a cyclical perspective, wages across the developed world are accelerating and this will likely feed through to higher inflation pressures in the months ahead. Respected economists like Larry Summers have been arguing that the Phillips Curve is now redundant given that, as The Economist noted, since 2010, as the unemployment rate has fallen steadily from 10% to 4.4%, inflation has hovered between 1% and 2%. I wonder however if the relationship is still intact and that what has in fact changed is central banks ability to prevent higher wage inflation resulting from tighter labour markets feeding through to inflation. This suggestion is supported by the below chart from US investment strategist Ed Yardeni s excellent new book, Predicting the Markets. Chart 1: Reports of the demise of The Phillips Curve may be greatly exaggerated. Production & nonsupervisory workers. Note: shaded areas denote recessions according to the National Bureau of Economic Research. Source: Bureau of Labor Statistics. 3

4 While it maybe correct that there has been some change in recent years in the relationship between unemployment and consumer price inflation, the above chart shows that the relationship between unemployment and wage inflation has if anything got stronger over the last 30 years. It also shows that wage growth hitting 4% triggered the last three recessions in the US, which thus would have been a good leading indicator for the equity bear markets that preceded them. The recessions themselves likely were the result of the tight monetary policy aimed at preventing the rising wage inflation from feeding through to consumer price inflation. As can be seen in the chart above, the unemployment rate is now lower than it was on the last three occasions wage inflation hit 4%. Also, the only time in the last 55 years that unemployment was lower than it is today, wage inflation was around 6%. I m not an economist, but my simple brain tells me that on the basis of the above chart wages are likely to continue to accelerate and wage inflation could well hit 4% (currently 2.7%) fairly quickly. Of course, this analysis pertains only to the US but it is likely that the same relationships apply elsewhere. Furthermore, given global interconnectedness, other countries economic cycles are probably somewhat coincident or at worst lagging with that of the US. What about inflation over the longer term? This is perhaps a trickier question. While it is logical that there is a link during an economic cycle between unemployment and inflation pressure, it is less clear what has caused the longer periods of rising and falling inflation. As mentioned, there have been two prolonged periods of rising inflation over the last 150 years or so, from 1901 to 1920 and from 1940 to These appear to have coincided with periods of falling income inequality, as indicated by Chart 2 below. Chart 2: Inflation versus income inequality in the US Source: measuringworth.com 4

5 Not only was rising inflation associated with falling inequality, but falling inflation appeared to coincide with rising inequality the last 40 or so years being a case in point. There may well be economic theories as to why this is the case, or indeed ones that suggest the opposite holds true. For me, it makes sense that rising inequality is associated with a shift of income from labour to capital. It also makes sense that a shift from labour to capital would mean falling or stagnating real incomes for the majority of workers, which should be and indeed has been disinflationary. There is growing discontentment among workers across the developed world about stagnating incomes and falling economic mobility. This discontentment anger even is manifesting itself in a backlash against the mainstream political establishment, for example in the election of Donald Trump or the vote to leave the EU, among others. Given that wealth and income inequality in many countries has reached extreme levels, and that a backlash seems to have started, it is possible that the decades ahead could well see structurally higher inflation. The one thing I haven t mentioned is QE, which many see as inherently inflationary. I do not ascribe to that view, as I believe QE was the necessary response to interest rates hitting the zero bound, but I suspect my suggestion that the years ahead could see materially higher inflation will make those that do happy! Review and Outlook Equity markets were generally strong in July, as investors appeared to shrug off fears of a global trade war. US and Eurozone equities were particularly strong, Asia and EM in the middle of the pack, and the UK bringing up the rear. Although sterling has not been that much weaker against the dollar than the euro in recent weeks, it may be that Brexit concerns are starting to impact the UK equity market. As for bond markets, yields across the developed world rose during July. This was more about higher real interest rates than higher inflation expectations, suggesting that the rise related to investors anticipating tighter monetary policy ahead. That said, although longer term inflation expectations in general have been stable for the last few months, they appear to be in an uptrend that began in Furthermore, the University of Michigan monthly survey now has 1 year and 5-10 year inflation expectations at 2.9% and 2.4% compared with 2.2% and 2.3% at the end of Expectations of interest rate hikes in the coming two months in the US and the UK increased in July. The implied probability of a rise in the Fed Fund Rate at the September meeting rose from below 80% at the end of June to 92% at the end of July. A similar pattern was seen in the UK, with the chances of the Bank of England increasing the Base Rate at the 2 August meeting rising from 70% to 90%. The respective central banks had guided these expectations higher over the month but so too did the macro data. In the US, second quarter GDP came in at 4.1% QoQ annualised, with the first quarter revised up from 2.0% to 2.2%. In the UK, employment change, construction output, unit labour costs and the composite purchasing manager index were all higher than expected or the previously announced figure. Late in the month, consumer credit data was announced, showing that credit card growth reached 9.5% YoY in June. This compares with mid-single digit growth back in 2014 and

6 It is a somewhat different story in the Eurozone and in Japan where the possibility of interest rate hikes this year remains remote. That said, there is now evidence of inflation pressures building in both jurisdictions. Monthly cash earnings in Japan are now rising by 2.1% YoY compared with zero for much of 2016 and In Europe, wages and salaries are rising by 1.8%, showing a clear acceleration in the last five or so years. Another potential source of inflation down the road is the oil price, which has been rising sharply this year. In the emerging world, perhaps the most important development relates to the Chinese currency, which has depreciated significantly in the last two months both against the dollar and on a trade weighted basis. This is clearly a response to the US trade tariffs imposed on Chinese goods thus far as well as fears of further tariff hikes. An even cheaper Chinese currency is certainly not what US president Trump intended so this issue still has the potential to spiral out of control. Indeed, Trump is attempting to rewrite rulebooks on so many fronts, whether internationally with respect to North Korea, trade, Iran, or domestically in relation to such issues as immigration and taxation, and it is unclear what the longer term implications of such an approach will be. Of course, trade tariffs themselves are inflationary in that they feed straight through to consumer prices. They may also hurt growth so the prospect of some sort of stagflationary environment looms large. As for fund activity, we reduced equity targets in July across all funds under our management. This was a scheduled reduction, as per the road map we have laid out for asset allocation changes as we move ever closer to the end of the cycle. The reduction came out of the UK, where we think inflation is becoming more pronounced and thus where we expect more hawkish language from the central bank. Specifically, we took the opportunity to exit one of our UK holdings that has become very expensive as a result of strong share price performance. Sales are ongoing so it would not be appropriate to broadcast the name at this stage. In terms of use of proceeds, we added to holdings in our two short duration high yield funds. Spreads had risen in recent weeks so on a short-term basis the timing seemed reasonable. The asset class allows us to avoid duration risk (the risk relating both to rising inflation and rising real interest rates) while maintaining exposure to credit risk which we think can continue to generate decent returns for the foreseeable future. Looking ahead, there has been no reason to change our expectations, namely that the global economy is now in expansion phase and will continue to move in a forward direction towards peak phase. In the expansion phase, we expect equity returns to fall but remain positive and bond returns to be negative. Commodity prices in this phase tend to be good, as evidenced by the rising oil price in recent months, but they can also be impacted by events such as the recent rise in trade tensions (note the poor performance of late of some industrial metals). 6

7 Table 1: Current fund tactical asset allocation (TAA) target weights as of (prior month s targets in brackets) OEICs Investment Trust TAA target Weights (%) (prior month s targets in brackets) LF Seneca Diversified Income Fund LF Seneca Diversified Growth Fund Seneca Global Income & Growth Trust plc Equities Fixed income Specialist assets* UK 19.0 (19.5) 15.5 (16.0) 29.5 (30.0) North America 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) Europe ex UK 5.0 (5.0) 8.0 (8.0) 7.0 (7.0) Japan 1.0 (1.0) 8.0 (8.0) 3.0 (3.0) Asia Pacific ex Japan 5.5 (5.5) 10.5 (10.5) 9.5 (9.5) Emerging Markets 1.0 (1.0) 4.5 (4.5) 3.0 (3.0) Global Funds 2.0 (2.0) 2.0 (2.0) 1.5 (1.5) Equities Subtotal 33.5 (34.0) 48.5 (49.0) 53.5 (54.0) DM Government 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) EM Debt 5.0 (5.0) 2.0 (2.0) 1.9 (1.9) Corporate 27.7 (27.2) 10.5 (10.0) 7.8 (7.3) Fixed income Subtotal 32.7 (32.2) 12.5 (12.0) 9.7 (9.2) Property 6.5 (6.5) 6.6 (6.6) 7.0 (7.0) Private equity 3.8 (3.8) 4.0 (4.0) 3.8 (3.8) Specialist financial 8.6 (8.6) 7.9 (7.9) 8.7 (8.7) Infrastructure 10.5 (10.5) 10.7 (10.7) 11.3 (11.3) Specialist Subtotal 29.4 (29.4) 29.2 (29.2) 30.8 (30.8) Cash 4.4 (4.4) 9.8 (9.8) 6.0 (6.0) Total Source: Seneca Investment Managers, 31 July 2018 * Target weights for the specialist assets subsectors are the aggregate of holding level targets as top down driven asset allocation targets are not applied to this sector. Increased Decreased 7

8 July Commentary SIGT, SDIF and SDGF Equity markets were generally strong in July, shrugging off concerns about trade tariffs. June inflation rose in the US and the Eurozone and was flat in the UK and Japan, supporting our view that generally we are in a rising inflation environment. Custodian Real Estate was exited in order to facilitate additions to AEW UK REIT and Ediston Property which stood on a lower valuation and have delivered solid updates on their strategy. We participated in the successful IPO of Hipgnosis Songs Fund which has commenced trading on the London market. SIGT and SDIF Insight UK Equity Income Booster was increased, in order to ensure a high level of income was still being generated from UK equities, post the TAA reduction. SIGT and SDGF Royal London Short Duration Global High Yield Bond Fund was increased, following increase in tactical asset allocation weight to fixed income. SDIF and SDGF Added to HMG Global Emerging Markets Equity Fund which brought the position to target weight. SDIF We lowered the fund s total equity target by 0.5%pts to 33.5%, with the money coming out of the UK. Muzinich Short Duration High Yield Fund was increased, following increase in tactical asset allocation weight to fixed income. Additions to Templeton Emerging Markets Bond Fund and Royal London Short Duration Global High Yield Bond Fund. SDGF We lowered the fund s total equity target by 0.5%pts to 15.5%, with the money coming out of the UK. Positive trading update by Britvic which has benefited from the hot weather this summer. Addition to Templeton Emerging Markets Bond Fund on weakness year-to-date. SIGT We lowered the fund s total equity target by 0.5%pts to 29.5%, with the money coming out of the UK. Initiated investment in CIM Dividend Income Fund which was funded by the exits of Schroder Asian Income Maximiser Fund and Aberdeen Asian Income Fund. 8

9 Important Information Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. LF Seneca Funds This document is provided for the purpose of information only and if you are unsure of the suitability of this investment you should take independent advice. Before investing you must read the key investor information document (KIID) as it contains important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available in English from Link Fund Solutions, the Authorised Corporate Director of the Fund ( ). Seneca Global Income & Growth Trust plc Before investing you should refer to the Key Information Document (KID) for details of the principle risks and information on the trust s fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital. The KID, Investor Disclosure Document and latest Annual Report are available at senecaim.com Seneca Investment Managers Limited is the Investment Manager of the Funds ( ) and is authorised and regulated by the Financial Conduct Authority and is registered in England No with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP