Notz Stucki Investment Meeting – Pierre Gave

Is the worst of the global slowdown behind us?

In 2018 there was no place to hide in financial markets, but in the first quarter of this year a much better environment took hold. The turnaround is surprising in some ways. The fundamentals of most economies have not changed much. Growth has been slowing everywhere, but this was not unexpected. Given the length of the expansion, now a record 37 quarters in the US, a slowdown was inevitable. But for financial markets liquidity was the critical factor. After 10 years of central banks adding liquidity to the system, this reversed last year led by the US and China. Markets foundered, but when the Fed made a complete reversal of policy in January, and China announced a new stimulus package, the market rallied hard. The market reaction suggests they have repriced growth, but that growth has not come through yet. If there is one message that investors should take away it is that when the world’s monetary base contracts trouble follows.

While liquidity conditions remain benign it will still require fundamentals to do well for asset prices to rise from here. The outlook for the US economy is still positive, but the growth is more moderate than before. Two areas look likely to do well are the consumer and housing. Mortgage activity and construction should pick up, as affordability is good. A further positive is inflation is not a problem. There is some wage inflation, but it is modest. Globalisation and automation/robotics remain powerful forces on labour’s ability to bargain. A boost to the stock market could come from the dollar falling. On a PPP basis the dollar is expensive, but it enjoys a yield premium and the relative strength of the US economy. The principal concern in the US is debt. The US government deficit is projected to reach $1.4 trillion this year. Corporate debt has ballooned and much of it has been deployed in financial engineering, not invested in productive assets. For example in Q4 2018 there was a record $225 billion of share buy backs. But total US leverage is not so bad because household leverage has declined.

Europe is much more vulnerable to world trade and global growth declining. If President Trump introduces tariffs on the auto sector this would be significant. For Germany in particular the auto sector is an important part of the economy. Car production already faces a weak environment as it is in the middle of a big technological shift, and sales in China slow as capacity has been reached, and demand there now enters a replacement cycle phase. Europe’s domestic demand remains sluggish, and this is being worsened by the recent rise in oil prices. The ECB are at the limits of what they can do with monetary policy. In theory Europe should undertake a fiscal stimulus, but it is constrained by fiscal rules on this. Indeed the German Finance minister has just said that weak growth limits the ability to make fiscal packages. If Germany slips into recession then this thinking may start to change. To reinvigorate Europe probably requires massive fiscal stimulus by a tax cut and infrastructure packages. For now there is little appetite for this.

China has also slowed, but it should pick up in the second half. China’s slowdown is different from its previous ones which centred on its industrial economy. This time the slow down relates more to the consumer credit. The export numbers have also fallen, but this may be due to buyers building inventory ahead of US tariff imposition. Nonetheless China is ramping up stimulus and the results should be seen in the second half. It will mean that leverage will rise again in China, which may become a problem in the future, but is not a concern for now. A recovery in China will help the emerging markets where investors are massively underweight, but they are unlikely to rebalance until the dollar weakens.

There is a calmer mood in the market compared to the end of last year. It has been created by the Fed stepping back from raising rates, China’s stimulus, and a brighter outlook on the US-China trade talks. Against that must be weighed the fact that global growth is slowing, Europe is on the brink of recession and US government borrowing is far too high for this stage of the cycle. A big unknown swing factor is the oil price which has been rising recently. If this continues it could upset the better sentiment. But the combination of the world’s two major economies looking set for steady growth this year, and no sign of inflation, provides a good background for equities.

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Notz Stucki Investment Meeting – Anatole Kaletsky

“Bull Market Will Continue – despite all the risks”

2018 has been a difficult year in financial markets with almost every equity and bond market suffering, with the notable exception of the US stock market. A further complication for investors has been that this has not been caused by a serious deterioration in economic fundamentals. Instead markets have been driven by political risks and uncertainties. Ultimately the question for investors is whether this is just a painful correction, and therefore a buying opportunity, or is this the start of a reversal in markets, signalling the end of the US bull market. The presentation considered three causes of the setback in markets since April/May, and then how far these issues might develop or revert. Anatole made a case that the bull market would resume, but cautioned that others in Gavekal were more cautious.

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Notz Stucki Investment Meeting – Charles Gave

The question the meeting considered was how do you manage money in an inflationary period. It is not certain that inflation is returning but investors need to be ready if it does. The question is all the more pertinent because after 30 plus years of disinflation almost no one active in the market today has needed the skill set to invest when inflation is rising. Several generations of managers have not needed to think about this, so it would be a profound test if the inflationary winds change.

Charles Gave giving his speech during our last investment meeting

In the past 30 years when inflation was declining the best portfolio was one composed half each of bonds and equities. When equities tumbled bonds rose, and when bonds fell equities rose. This gave a portfolio an inherent balance and stability. However when inflation rises, bonds and equities have a positive correlation – they both fall together, so you no longer get the benefits of diversification. An inflationary world is far more unstable. Looking at past periods of inflation the asset that suddenly becomes the star performer is gold. So one conclusion is that if inflation is coming back then the one asset to avoid is bonds which will be murdered. Instead of being reliable yield giving assets they will become volatile and wealth destroying. Similarly as bonds come down you need to reduce the duration of equities. Instead of growth stocks on high PEs portfolios will need to be shifted to short duration cyclicals. Again, this begs questions of finding the required skills. Growth strategies in equities have so outperformed value that value managers have become an endangered species. The gold price also becomes critical from here. First if gold outperforms it is an indicator of inflation. Second gold outperforming US bonds would indicate that the market is losing confidence in the USD, because gold has no yield. The greater the extent of this the greater the likelihood that the environment should favour value over growth strategies.

What should bond investors do? One solution is to invest in the bonds of a non-inflationary country. In the 1970s this was the German bond market which kept its diversifying power due to the respect in which the Bundesbank was held. From 1965 to 1988, the German bond market did much better than the US stock market, dividends reinvested. Today the Bundesbank has been emasculated by the ECB. Meanwhile China has been trying to emulate the Bundesbank in Asia, and to turn the Renminbi into the Deutschmark. Since 2006 the best bond market has been the Chinese one. China is also becoming more integrated with many markets around the world, not only its neighbours in Asia, but also places like Russia and Brazil. One can see a convergence of yields in these countries’ bonds to that of the Chinese bond, along the same lines as occurred in the 1990s as European countries bond yields fell towards Germany’s yield. Therefore over the next 5 years an attractive trade could be to buy the bonds of Brazil, Russia and Indonesia which have high single digit yields and enjoy their convergence to China’s yield, currently under 4%. Emerging market bond yields can be a strong asset class, and Asia growth stocks should be part of a similar theme.

The next bear market will be a bear market of indexation. Indices are constructed with companies that have worked in the disinflationary period of the last 30 years. The momentum buying of big companies, which has accelerated recently, is starting to look a dangerous strategy. The indices are composed of the wrong assets for an inflationary world. In fact most portfolios look as though they are invested in the wrong place. The worst asset of all is European government bonds, but most European savings have been herded into these. Together with a relatively narrow group of large cap growth stocks which have extended valuations global portfolios look in a perilous position if inflation does return.

Only when the tide goes out do you discover who’s been swimming naked. Warren Buffet

The financial world appears as though it is approaching a generational inflection point as the long disinflation of the past 30 plus years starts to turn round. If this is the case then investors will be forced to reposition their portfolios. Warren Buffet’s famous dictum that when the tide goes out you discover who is swimming naked will come into play. As the inflation tide turns portfolio managers may be embarrassed. Bonds and growth stocks will underperform value and cyclicals. A much more active approach will be required. In industries like semi-conductors and energy an understanding of their cycles will be necessary as there will be times of shortages that will lead to dramatic spikes in these sectors, and equally dramatic busts. On a more structural basis, places like Japan and Asia should do well as that is where most of the value is. So much manufacturing has been outsourced to Asia that they now control the production and prices of many goods. Asia can thrive in this new world. Elsewhere special situations can flourish. One example of this is the UK. The Brexit vote was a vote for freedom and democracy over technocracy and tyranny. Charles Gave has never seen a market decline where democracy is winning.

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