Market Update - December 2016

Andrew Clifford, Platinum’s CIO, provides an update on global markets and how Platinum is positioned for the present environment. He also addresses Platinum’s recent investment performance.

On our last market update in August we talked about a coiled spring. We highlighted that investors were continuing to crowd into apparently safe assets, such as fixed interest and within equities, sectors such as consumer staples, utilities, and telecoms. On the other hand, they were avoiding at all costs any hint of uncertainty, areas such as financials, cyclicals, and emerging markets. We noted that when the coiled spring was released there would be significant implications for investors’ portfolios.

We expressed the view that we could well be at the cusp of a major change in market trends. Global economies were continuing to pick up momentum and coupled with political pressures which have delivered Brexit, President Trump and a failed Italian referendum, governments were moving toward greater fiscal spending. And indeed since our last call we’ve seen a significant sell-off in bond markets, and consumer staples and other predictables have started to lose investor’s money.

The response to Trump’s election has seen an extreme rotation in the US market from long duration stocks to financials and cyclicals. This may in the short-term be overplayed but the positioning of long-term investors has not changed much. If we are at the start of such a big shift, the implications are significant. As we have seen in the past, once major changes start to take hold in markets, asset prices can make very large moves.

So let’s take a look at what is happening in the world today, focused particularly on the US, Europe, China and Australia. As I do, please think about the picture that I am painting, and ask yourself, how does this align with your view of the world? Certainly what I am going to describe is broadly at odds to the understanding of the world held by most investors and certainly different from what is reflected in the financial headlines.

Firstly, the US economy continues to build momentum. Unemployment is at 4.6%, approaching lows of the last 20 years; wages are starting to accelerate driving median household incomes up 5.3%, the fastest rate since 1995; and housing starts continue to grow strongly. The US is clearly entering the latter stages of its business cycle, with the Fed ready to lift rates and banks already tightening credit conditions. The US economy is growing strongly. Trump’s ascendancy undoubtedly has many reasons, but the general economic performance of the US is not one of them. For all you heard on the campaign, as we wrote in October, America does not need Trump to be great again. It is doing fine, though unintended consequences of his policies may moderate this – more on that later.

Europe’s major economies continue to recover steadily from the combined effects of the GFC and the sovereign debt crisis. The process of labour market reforms has started in France and Spain. In Spain, the last two years have seen approximately 1.5 million jobs created, bringing unemployment down from 26% to 19%. European banking systems are in good shape with large provisions having been taken against loan portfolios that have been well and truly tested over the last eight years. There remain outliers such as the investment banks (think Deutsche Bank) who face increasing regulatory burdens and individual institutions where problems remain unresolved for the moment, but by and large the banking systems are in good shape. More broadly we see improvement in both auto sales and property across Europe.

In China, ongoing consumption growth and increased government spending are driving a cyclical recovery. Residential property inventories are down in key markets from as much as two years to less than six months. Heavy truck and construction equipment sales are up as much as 50%, admittedly from a low base, but up strongly nonetheless. Electricity consumption is running at high single digit growth levels and rail volumes are also on the rise. To those who are sceptics, these are real indicators of economic activity.

We have also seen significant increases in coal, iron ore and other commodity prices. While these are partly driven by supply side issues, a function of a reforming State Owned Enterprise (SOE) sector in China, it is also a sign that inventories have been worked down, and of firmer demand. Consumers continue to spend, auto sales remain strong, luxury goods companies are reporting better China sales, and e-commerce companies continue to report growth rates of 40% and more. Meanwhile, private investment spending looks poised to recover as capacity utilisation continues to tighten and this will give greater breadth to the story in 2017.

A strong US economy, recovering European and Chinese economies… how well does this picture tally with your view of the world? Most investors we come across, the focus is on other side of the ledger. Concerns remain about political instability in Europe and the future of the EU and the Euro. Post the Italian referendum, the focus is now about what to expect in French elections to be held next year. While the US market has reacted well to Trump’s election, there remain many concerns, particularly with regard to what he might do on the trade front. In China the concerns focus on the sustainability of a recovery sparked by government spending and funded by debt, not to mention ongoing questions around the recognition of non-performing loans (NPLs) by the banking system.

And it is not to say these concerns are not valid. However, to invest on the basis that the world is a troubled place, when there are many signs of improvement, and everyone else is investing on the same basis as yourself, is a risky strategy. In recent weeks the market has provided investors with two clear lessons on just this. Prior to the US election, many commentators predicted significant falls of up to 15% for the US market if Trump was elected. Indeed, when we surveyed financial planners and unitholders during our roadshow back in May, a Trump presidency was one of their significant concerns for the investment outlook. More recently the failure of the Italian referendum was predicted to spell doom for the Italian banking system and yet the Italian market and the good Italian banks rallied strongly after the result! Of course in both cases these are very short-term moves and may not be sustained, but they do illustrate once again the danger of investing with the crowd.

Onto the question of Trump, and what his presidency will mean for markets, all we can offer this far are a few observations. We would stress that for all the reams of material written on the topic, few probably really know what is intended or appreciate what is possible. We suggest investors remain open to a wide range of possibilities and unexpected outcomes. However, there are some clear themes that one can probably broadly expect:

- There will be tax cuts for corporations and individuals.

- There will spending on infrastructure. There are various views on how this might be funded but however it is done, together with tax cuts, the US fiscal deficit is expected to rise with some estimates typically suggesting as high as 7% to 8% of GDP.

- There will be protectionist trade policies, though the degree and nature of these is far from clear.

- Putting aside the politics of the Republican Party in the US and the capability of his administration, there are probably some real world and financial market limitations on what can be achieved and that investors need to factor into their considerations.

- As previously mentioned, the US labour market is already reasonably tight. Unemployment is near lows and we are seeing labour costs rise strongly, particularly for lower and middle income workers. Potentially this may attract more individuals back to the workforce and while undoubtedly good for individual workers, it may start to impinge on the profitability of companies.

- The US Federal Reserve is expected to raise interest rates at tomorrow’s FOMC meeting and US banks are already tightening credit standards. While perhaps early in the upward cycle in rates, the US treasury market has already seen yields move higher by 100 basis points anticipating the coming supply from a higher fiscal deficit. There is the potential for the increased fiscal deficit to crowd out the private sector as a result of higher interest rates.

- There are potentially a number of unintended consequences from his policies. For example, Trump’s protectionist stance, together with the rise in bond yields caused by his fiscal policies, has resulted in a strong US dollar, particularly against the Mexican and Chinese currencies. Of course the outcome is lower not greater competitiveness for the US.

- It is possible that tax cuts may not find their way into investment and consumption as hoped for. Prior amnesties on tax on repatriated cash by US corporations saw them channelled to buybacks and dividends. And for individuals there is the possibility that tax cuts are used to repair household balance sheets rather than spent, the risk of which seems greater as tax cuts are likely to be aimed at middle and high income households.

- It will take time for there to be clarity on exactly what policy will be and to understand any limitations that may apply. In the meantime, US equities have driven higher by a shift towards more cyclical and financial stocks, and buoyed by the hope of a broad corporate tax cut. Given data on sentiment and positioning in US stocks, we suspect that the market has already enthusiastically priced in much of the upside, at least in the short-term. Not something to chase the crowd into, for now.

Elsewhere, we have become more optimistic on the prospects for the Australian dollar and moved our position up to 23% in the Platinum International Fund. You will all have noted the improvement in iron ore and coal prices that have been driven in the first instance by supply closures and restrictions in China. While current prices are unlikely to be maintained we do not expect them to return to recent lows as some of the capacity loss is likely to be permanent. Besides an improving terms of trade, government spending on infrastructure and the apartment building boom are underwriting domestic activity for the moment. Longer term risks remain around household indebtedness and property prices, however, the divergence of the Australian dollar from the terms of trade is extreme and with domestic activity supporting interest rates, we expect short to medium term strength in the Australian dollar. Our partial hedge will provide some protection for your clients from such a move.

In summary, we see the global economic environment continuing to improve. The US is growing strongly even before any Trump policy; Europe and China are recovering. And while the last few months have been better for our performance as some investors have started to move away from extremes of risk aversion, most are still in perceived low risk assets rather than being positioned for the stronger world we are in.

We think it is more critical than ever at this juncture that investors reconsider their portfolios and how they will perform in a world where interest rates are moving slowly higher (or at a minimum, bond yields are no longer falling). It is in this type of environment where assets that are perceived to be low risk may prove to be quite the opposite.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.