Category: Uncategorized

By Jolette Persson, Hottinger Capital Partners

There has been a clear spike in corporate profit warnings in the last three weeks. Apple was one the first of many US companies to publicly cut its revenue outlook driven by China’s slowing economy which in recent weeks has dampened further due to the spread of the coronavirus. The profit warning was narrowed down to an anticipated decline in iPhone sales in China and slowing pace in production. [i] Microsoft in parallel also issued a profit warning statement, particularly focused on its Windows and Surface businesses, due to supply chain disruption caused by the virus as the segment relies heavily on production operations in China. [ii] Similar to Apple and Microsoft, companies across geographies and industries are lowering their first-quarter forecasts, most notably in luxury goods, automobiles, leisure, airlines, technology and banks. Just in the UK, more than 100 UK-listed companies have now warned its investors about potential impacts of the coronavirus on their business. [iii]

Concerns over further escalation extends to global governments and central banks. Most recently in an attempt to soften the blow experienced in the US economy in the short-term, the Fed on the 3^rd of March decided to reduce rates by 50 basis points. [iv] Bank of England governor, Mark Carney, shortly after signalled that it was also prepared to cut interest rates in an attempt to keep current supply chain disruptions temporary as opposed to a permanent impairment in supply. [v] Economists are not ruling out the possibility of a global recession, especially if global growth in 2020 disappoints from what is already a relatively modest forecast. The recent decline in the oil price, which to a large extent reflects the deterioration in Chinese consumption, has aided our concerns about the global economy. Particularly, as we remain in a close to zero inflation environment. Though, it’s worth emphasising that there are yet clear signs of real economic damage, with unemployment rates left relatively unchanged since the beginning of the year, and consumption still in decent health outside that of mainland China. If a recession was to occur, it will likely hold little resemblance to our last seen financial crisis in 2008 (shockwave in demand) as banks went bankrupt, home prices plunged, and stock markets bottomed. This crisis would more likely evolve around a lack of supply, leading to a slowdown in economic activity.

So far corporate profit warnings have been concentrated around companies whose business is fed by a global supply chain. Companies without direct links to the disease have not experienced the same correction in revenue forecasts and/or share prices,  although, potentially, yet to be announced. We will continue to monitor this under the assumption that a global recession may not be as imminent a threat if this remains unchanged. In the meantime, there are some sectors with certain business models that might even stand to benefit from the current “quarantined” situation. With companies and governments encouraging people to avoid travel, work more from home, and self-isolate, companies catering to consumption through domestic internet services such as Amazon, Netflix, online education, online gaming and other home entertainment could be rewarded. These assets might serve as short-term stress reliefs in portfolios. What we as investors are more concerned with, however, is the long-term story.

There is a possibility that the market is overreacting, particularly in areas outside of Asia where the spread of the virus continues to remain relatively low and with stark measures in place for containment. Yet, major indices worldwide have lost trillions of dollars in value over the last few weeks. That said, however, we feel that perhaps markets may still be overvalued with some way to go before getting close to their intrinsic value.

When studying the effects of previous outbreaks of respiratory viruses like SARS and MERS (see figure 1), markets remained volatile in the short-term followed by a longer recovery period. With that in mind, although we do not think we have seen the bottom of the market yet, this could serve as an attractive inflection point, though it is still too early to tell. Markets will typically start to price risk correctly following a period of unchanged fundamentals. Potential positive catalysts  include the number of infected people outside of the mainly infected areas decreasing, suggesting that the virus is getting contained, workers returning to their regular schedule and production activity in China picking up. As we are yet to see any of this, the situation remains volatile and impossible to predict.

[i] https://www.ft.com/content/ab59aac6-51ce-11ea-8841-482eed0038b1

[ii] https://www.nytimes.com/2020/02/26/technology/microsoft-coronavirus-earnings.html

[iii] https://www.cityam.com/132-uk-companies-issue-coronavirus-warnings-as-ftse-100-spirals/

[iv] https://www.wsj.com/articles/federal-reserve-cuts-interest-rates-by-half-percentage-point-11583247606

[v] https://www.ft.com/content/2b0dfbc6-5d4d-11ea-b0ab-339c2307bcd4

 

By Kevin Miskin, Hottinger Investment Management

In last week’s blog, we noted that the global economy could enter recession within the next 12 months and urged caution as the risks to financial markets were weighted to the downside. At the time, however, we believed that markets would remain relatively benign until closer to Easter.  If, as Harold Wilson famously once said, “a week is a long time in politics” then it can seem an absolute eternity in investment markets.

During the first three weeks of February, the S&P 500 climbed to an all-time high and European stock markets reached levels not seen since the financial crisis as the broad consensus held that the global economy would avoid recession in 2020. Headline PMIs had troughed in October and PMI new orders were improving. US and European company earnings for Q4 2019 had exceeded expectations and high single-digit earnings growth was forecast for this year. There was a further assumption that as long as the coronavirus could be contained within China, the impact on global economic growth would not be too severe. However, with news of the virus spreading around the globe (notably in Japan, South Korea and Italy) towards the end of the month, this base case scenario was shattered.

The market reaction was both swift and severe as global equity indices fell into correction territory (a downward move of 10 per cent) in the shortest time period ever. For February as a whole, the MSCI World Equity index fell by 6.7%. The UK led the declines with the FTSE100 falling by 9.7%. Elsewhere, the major US, European and Japanese stock markets fell between 8% and 9%. Ironically, China became a port in a storm, with the Shanghai Composite index appreciating by almost 5% after markets returned from the Chinese New Year.

In the early stages of the coronavirus outbreak, Asian equity markets and cyclical sectors, such as transport, understandably bore the brunt of the selling. However, more recently it has been the ‘winners’ of last year that have come under pressure, including US Equities, technology, growth and quality.

The increasing chances of Bernie Sanders becoming the Democratic presidential candidate has also cast a pall over certain US sectors. His radical agenda includes breaking up banks by reinstating the Glass-Steagall Act, imposing a financial transaction tax, capping interest rates on consumer loans, increasing taxes for the super-rich and cancelling student debt.

In commodity markets, Brent Crude suffered a decline of 16.5% to $50, having traded at $70 in early January. Oil consumption in China has fallen by a quarter since the outbreak of the virus. Saudi Arabia is attempting to stem the price leakage by calling for a concerted cut in production of 1 million barrels per day, of which it has offered to bear the lion’s share. However, at the time of writing, Russia appears reluctant to fall in line. Gold initially fulfilled its role as a safe haven, rising to a 7-year high of $1,688, but ultimately gave up its gains to end the month in marginally negative territory.

The ultimate safe haven asset proved to be long-dated government bonds. Over the past two decades, the negative correlation between equities and bonds has hardly changed, despite ever-lower yields. The reason is that it is not the level of yield that provides the hedge, but the sensitivity to the change in yield, which comes from the length of duration. Therefore, even with today’s low/negative bond yields, having some duration in portfolios mitigated some of the losses from the equity market correction. The yield on the US 10-year Treasury closed the month at a record low of 1.15%, down from 1.51% at the end of January, representing a capital return of 3.3%. The UK 10-year gilt fell by 8 basis points to 0.44% and the German benchmark bund yield fell further into negative territory, ending the month at –0.61%.

At the short-end of the curve, the US 2-year Treasury yield has fallen below 1%, implying that the US Federal Reserve is expected to cut interest rates by 75 basis points by the end of the year. Meanwhile, the 30-year US Treasury has fallen to a record low of 1.7%, which suggests investors have become concerned about the sustainability of any longer-term recovery.

At the time of writing, the spread of the virus is accelerating outside of China and analysts are in the process of downgrading their predictions for global growth and company earnings. A Bloomberg poll of analysts has global growth predicted to fall to 2.8% this year, which would be the lowest rate since the financial crisis.

According to Absolute Strategy Research (ASR), we are at a crucial stage in the coronavirus narrative. During previous episodes when bond yields and equity markets have fallen to this extent, the relative valuation between the two asset classes has seen investors move back into equities. However, should risk assets fail to rebound during early March, ASR cautions that investors may start to focus on the potential for further supply chain disruptions with negative implications for global markets.

The disruption to global economic activity for Q1 may have now largely been discounted by markets. The question is whether the virus outbreak will be contained by the end of March or whether it will expand in terms of duration and geographic reach.

On the positive side, the slowdown in growth could yet prove to be short-term. In addition, recent political shifts towards anti-globalisation could ultimately prove to be beneficial; in Europe, companies have been stockpiling ahead of Brexit, while in the US companies have been forced to overhaul their supply chains as a result of the trade war with China. There is also hope that the spread of the virus could be curtailed as the weather turns warmer.

We believe a more likely scenario is that the disruption will continue into Q2 and result in a tightening in financial conditions. Central banks will likely respond with even easier monetary policy and governments may open the fiscal taps, which could provide short-term support for risk assets.

We were relatively cautious entering February and reduced equity allocations where appropriate as the virus spread beyond China. In the current environment, we will monitor developments while coronavirus fears continue to obscure the outlook for global markets until such a time as there is more clarity.

By Tim Sharp, Hottinger Investment Management

Global monetary conditions remain tight and the risks for financial markets are weighted to the downside. We continue to believe that there is a tangible risk of global recession within the next 12 months and will maintain our cautious stance in the near term.

The coronavirus has started to affect supply chains, underlining our prediction that the next likely inflection point will be around the beginning of the second quarter. This will coincide with first quarter reporting, the selection of the Democratic candidate for the US Presidency and the forward-looking tendencies of equity markets to be focusing current economic forecasting on Q420.

There is now evidence, as reported by Apple Inc, that the coronavirus is affecting global supply chains and is predicted to have a significant effect on Chinese Q1 growth and the wider prospects of the Asia Region. Japan is now predicted to enter a technical recession in the middle of 2020 – this is based on the slowdown in activity with China, South Korean President Moon Jae-in’s call for “emergency steps” to support the economy and Singapore’s unveiling of a $6.4bn virus-related stimulus package.

We recently highlighted in our China / India article that a 1% drop in China’s GDP will affect global growth by 0.2%, so the fact that the outbreak is having a magnified effect should not be surprising. However, it may only suppress spending in the short term – causing a spike in demand once the worst of the outbreak has been overcome, instead of causing longer-term damage to global growth prospects. It could be argued that equity markets in particular are discounting a v-shaped recovery in trade, growth and earnings, however, equity valuations are looking over-extended, the buy-on-dip mentality seems to be firmly in place, sentiment remains positive and few look as though they are positioned for recession[i].

We feel that current forecast earnings in developed markets over the coming year are too high and open to significant revisions, and we remain sceptical about whether the current levels of central bank stimulus will be enough to boost the global economy, so we believe a threat of significant equity drawdown remains. A squeeze in profit margins has been the reason for the fall in corporate profits over the past year, as wage growth has strengthened across developed markets. The consensus expects 9% EPS growth over 2020, which looks optimistic to us. Absolute Strategy Research (ASR) expects global EPS to decline 4%, with declines of 6% and 9% in the eurozone and US respectively[ii]. EPS growth remains underpinned to an extent by share buybacks that have seen company balance sheets change exponentially as debt is raised to buy back shares. According to Julius Baer, S&P 500 buyback peaked in 2019 at approximately $1trn but is likely to stay high while the cost of equity remains substantially above the cost of debt and the economy continues to expand[iii]. However, fundamentals cannot be ignored indefinitely and a sustained squeeze on profits should be reflected in stock prices eventually.

A strong dollar is a symptom of tight global monetary conditions. There remains a reluctance of international banks to lend US dollars due to the interest differential and it is unlikely, in our opinion, that the recent weakness will last. A weaker dollar would be necessary to support a recovery in global growth outside of the US, and the continuation of a strong risk appetite would be a prerequisite for this depreciation to persist.

The early results in the Democratic candidacy race have been upset by the entry of Michael Bloomberg, who immediately polled in second place behind Bernie Sanders. We continue to believe that the Democratic choice of presidential candidate could have a material effect on investors, due to the strong socialist ideals of some candidates that will frighten markets.

The final risk not being priced in by financial markets concerns the inflation that could result from the squeeze in corporate margins further sustained by the supply-side disruption due to shutdown in China. US Housing Starts and PPI in January both surprised on the upside, and while the FOMC meeting agreed that current policy was appropriate, minutes revealed an active discussion around inflation and financial stability concerns in light of elevated equity valuations and corporate debt.

In the UK, Consumer Price Index inflation rose above expectation in January, at +1.8% vs.+1.3% in December. This was seen to justify the BOE’s decision to leave rates unchanged, although many economists expect inflation to move back down as early as February on the back of lower utility prices. The next potential inflection point in the UK is the March budget, where investors will be looking for commitments to fiscal spending designed to boost productivity. We agree that UK equities are relatively cheap among developed markets, but also recognize that there remains uncertainty as to the final shape of the UK-EU trade deal that may continue to hold back capital expenditure.

Turning to Europe, the euro is the worst performing G10 currency vs. the dollar and fell below 1.08 this month for the first time since April 2017[iv].

 

The second estimate for eurozone Q419 GDP remained unchanged at +0.1% quarter-on-quarter.  There is a growing realisation that growth in the eurozone is weakening again on the back of waning external trade and softening domestic demand, so that the expected pick up in domestic growth over 2020 is unlikely to materialise in the medium term.

In terms of asset allocation, we retain our view that there remains a heightened risk of equity drawdown and we believe that investors will need to become more vigilant around Easter, particularly if the coronavirus outbreak starts to have a material effect on global economic activity in the medium term. The expected support from emerging market economic growth, particularly in Asia, will be tested significantly by the spread of the virus. Greater risk aversion by investors could cause capital flight, leading to pressure on low interest rates.

 

[i] Absolute Strategy Research – Investment Committee Briefing 7^th February 2020.

[ii] Absolute Strategy Research – Profits downturn to persist 18^th February 2020

[iii] Julius Baer – Asset Allocation Perspectives 5^th February 2020

[iv] Capital Economics – Global Markets Update 19^th February 2020

 

By Jolette Persson, Hottinger Capital Partners

Q419 Chinese GDP growth of +6% year-on-year was in line with expectations. Industrial output at 6.9% and retail sales at 8% both surprised on the upside as the US and China came closer to their ‘phase one’ trade deal. Although it is encouraging to see that demand for spending and consumption has somewhat picked up alongside a steadily growing CPI – currently at 105.4 (though some of this is directly attributed to pork prices rising as a result of the African swine fever)[i] – property and infrastructure investments continue to slow. The fact that these are both key drivers of growth challenges the perception that China’s deceleration is coming to an end. China has historically built its economic growth on low-cost manufacturing, machinery and equipment and built its cities around factories to attract labour. As a result, close to a quarter of China’s economy is in real estate [ii].

India, another key driver of Asian growth, is expanding at its slowest pace for the last six years, down from close to 7% to 5% during 2019, followed by what has been a period of the weakest industrial production output in the last 8 years, high unemployment rates and slowing consumption. A decline in manufacturing might suggest that India’s economic issues are deeper rooted than initially thought, particularly as recent tax and interest rate cuts do not seem to have had a material effect on the economy. More concerningly, economists predict that India must grow in excess of 10% per annum to support the 12 million young workers entering the labour market every year [iii].

So what?

China being the world’s largest exporter by value (~$2.5trn) means that the magnitude of the effect of China’s growth on global growth is enormous. To put that into perspective, a 1% drop in China’s GDP shaves off 0.2% of global growth. This should not come as a surprise considering that China’s GDP represents approximately 19.24% of world GDP [iv]. In Europe, there is a clear relationship between the Chinese purchasing managers index and exports. Germany, with China as its largest trading partner, is likely to take the biggest hit from slowing Chinese growth of the European countries. For decades, China has provided a steady stream of income and contributed to growth in sectors such as automobile, machinery and engineering tools. German carmakers such as Volkswagen, Daimler and BMW all generate at least a third of their revenue from China, which has slowed significantly as a direct result of trade war tensions and their effect on Chinese demand for consumption, particularity on big-ticket items [v].

In the rest of the world, China’s largest trading partners – the US, Hong Kong, Japan and South Korea – have all suffered as a result of its slowing growth. Hong Kong’s economy contracted by 1.2% during 2019, pushing it into its first annual recession since the financial crisis in 2009, driven by trade conflicts and anti-government protests. Mainland Chinese travellers have since stopped going to Hong Kong (where they used to account for 70% of tourists), causing hotels, restaurants and the retail sector to plunge. Hong Kong’s exports, which mostly come from re-exported goods from China, have also reached an all-time low. Similarly, Japan’s manufacturing and exports to China have declined and the consumption tax hike in October 19 has further dampened demand and put off Chinese tourists, who are usually a major source of retail spend on luxury goods (~$16.4bn/year).

In India, IMF economists commented at the beginning of the year that India was the primary party responsible for the downgrade in forecasted global growth in 2020. Although we do not necessarily agree that India alone, more so than China, is a determining factor in global growth considering that it is a merely domestically-driven economy, India remains the fastest growing trillion-dollar and fifth largest economy in the world. As such, its output is not to be dismissed. The trade fallout between China and the US has hurt, but the decline in domestic consumption is the bigger problem. This has led to poor business sentiment, most evident in sectors such as automotive and manufacturing, as companies are refraining from capital expenditure.

Who stands to benefit?

Factors leading to today’s picture allows other countries to fill the gap and represent opportunities for some investors. We have already observed a change in dynamics whereby companies that normally extend their supply chains to China are now considering other countries such as Indonesia and Vietnam. Vietnam has already seen a huge increase in production and exports of smartphones and consumer electronics over the last 18 months. However, debates over local Vietnamese expertise in comparison to that of China still represent a hurdle despite the appeal of lower labour costs. Other countries, such as India and Indonesia, could eventually get to the point where they are regarded as exporters, provided that they continue to invest in infrastructure and policy reforms. Other direct beneficiaries of the US-China conflict include Latin American exports. Mexico, in particular, has been an unexpected winner as it has built out its manufacturing capability. In contrast to many countries in the Southeast Asia region, Mexico’s free trade agreements offer guaranteed access to more than 50 countries and it benefits from its geographical location being in close proximity to the US. Taiwan is the exception to the rest of Southeast Asia, whose additional exports to the US rose a whole 12.46% over the year totalling $85.48bn in 2019. This is reflective of its mature local tech industry that in turn has allowed its factories to ramp up capability and speed, with companies such as Taiwan Semiconductor Manufacturing Co. taking world-leading positions in their application. Taiwan also benefits from its geographical positioning with close trade links to mainland China [vi].

Bearing this in mind, 70% of surveyed European companies said that their supply chains had been disrupted to some extent and that holding off further action until real clarity is provided on trade is no longer considered a viable option. As such, we are forecasting additional haste for those companies looking to relocate production as well as more emphasis on supply chain diversification to avoid large and concentrated negative impacts in the future. We will continue to monitor the situation closely [vii].

[i] https://tradingeconomics.com/china/consumer-price-index-cpi

[ii] https://tradingeconomics.com/china

[iii] http://www.oecd.org/economy/india-economic-snapshot/

[iv] https://www.statista.com/statistics/270439/chinas-share-of-global-gross-domestic-product-gdp/

[v] https://think.ing.com/articles/germany-what-role-does-chinas-automotive-market-play-in-the-current-economic-slowdown/

[vi] https://www.ustradenumbers.com/country/taiwan/

[vii] https://www.china-briefing.com/news/eu-businesses-china-look-mitigate-trade-war-impact-eucham-2019-survey/

By Tom Wickers, Hottinger Investment Management 

The Alternative Investment Market (AIM) is a sub-market on the London Stock Exchange (LSE) which was introduced in 1995. The shares are unquoted (not listed on a recognised exchange) and provide a channel for companies to list and raise capital under lower regulatory requirements than in other developed equity markets. As such, AIM is largely used by smaller companies that do not meet the capital requirements of the main market or those that would find stricter compliance too costly, making it a hub for businesses with growth prospects rather than stable cash cows. The AIM market has grown substantially since its inception and is touted as being the world’s leading growth market[1]. By year end 2019, there were 851 companies listed on AIM with a total value of £103.9bn, in contrast to 121 companies listed at the end of 1995 with a value of just £2.4bn[2]. The companies listed on AIM are notably diverse, with the value in the AIM index relatively equally spread across the majority of sectors [Figure 1]. Investors can therefore allocate AIM portfolios according to forecast market trends as well as by individual stock-picking.

In 2013, AIM portfolios became more accessible to the general public as a law was passed making them permissible under an ISA wrapper. This allowed investors to mitigate capital gains and income tax via the ISA, as well as inheritance tax through the Business Property Relief (BPR) benefit of AIM investments (provided that certain criteria set by HMRC are met). The regulatory changes coincided with fundamental shifts in the characteristics of AIM stocks, leading to renewed interest from institutional investors in recent years.

Due to its venture capital slant, the AIM market holds higher intrinsic risk than more traditional indices such as the FTSE 100 Index. The companies have a lot of room for growth, but quick bankruptcies can also occur on the back of scandals or difficult market conditions. Financial news is littered with success and disaster stories; a prime example being Bidstack’s performance in 2019, climbing 526% in the first half of the year only to then lose 75% of its value in the second[3]. However, in aggregation, particularly in more recent years when the AIM market has become more established, AIM stocks have outperformed FTSE 100 stocks in returns with similar volatility levels[4] [Figure 2]. This is to be expected to compensate investors for the greater downside and liquidity risks involved. Drops in value are pronounced in the AIM market (as shown in Figure 2 at the end of 2018), the worst occurring following the financial crisis, where 65% losses were recorded[5]. Between 2015-20, the AIM All Share Index performed poorly, only marginally beating the FTSE 100 Index and underperforming the AIM 100 Index. In contrast, growth in the AIM 100 index was strong, outpacing the FTSE 100 by 31% over the time period shown. Should this trend continue, the opportunity would mostly lie in the largest AIM stocks, rather than the market as a whole.

Often nicknamed the ‘Wild West’ of markets, investors initially viewed the AIM market as a playing field for short-term, gung-ho punters because it had sparse research coverage and was prone to financial scandals and collapses[6]. Further, institutional investors did not need to get involved in the AIM market in order to access these successful companies as they were expected to move to a larger exchange once they had accumulated sufficient capital. Recently, however, larger companies have shown continued interest in staying on the AIM index, favouring the manoeuvrability that its softer regulation enables. Boohoo, currently the largest stock on AIM, has made no effort to move to the main market even though it is now large enough to list on the FTSE 100[7]. The result is that the AIM market has become more skewed towards relatively larger and more stable companies [Figure 3], providing a more investable environment for institutions.

The AIM market has materially shifted in the past ten years, still offering access to nascent companies but also to a plethora of established businesses that have thus far brought substantial returns at tolerable volatility levels. The shift from gamble to investment proposition means that institutional and individual investors alike should continue to watch this space. However, historical slumps provide ample warning of the palpable downside risks involved when investing both in individual companies and the index as a whole. Investors should take careful stock of their capacity to absorb losses before acquiring any significant holding in AIM shares.

[1] https://masterinvestor.co.uk/economics/aim-still-worlds-leading-growth-market/

https://www.londonstockexchange.com/companies-and-advisors/aim/for-companies/companies.htm

[2] https://www.londonstockexchange.com/statistics/markets/aim/aim.htm

[3] https://www.ii.co.uk/analysis-commentary/best-aim-stocks-2019-whos-1700-so-far-ii510030

[4] FTSE 100 weekly volatility was 1.79% in the time series, while AIM 100 volatility was 1.72%

[5] In reference to the AIM 100 Total Return Index (Gross Dividend) on Bloomberg from peak to trough.

[6] https://www.theguardian.com/business/2011/jun/24/langbar-international-fraud-history

[7] https://www.proactiveinvestors.co.uk/companies/news/278183/asos-seems-happy-to-be-aim-s-standard-bearer-28183.html

By Tim Sharp, Hottinger Investment Management 

Global monetary conditions remain tight and the risks for financial markets are that we may indeed be in late cycle, which could mean a global recession is likely within 12 months. This remains our base scenario and will be the reason we maintain our cautious stance in the near term, with the next likely inflection point around the beginning of the 2^nd quarter. This will coincide with 1^st quarter reporting, the selection of the Democratic candidate for the US presidency and also takes into account the fact that equity markets historically tend to try to predict economic outcomes 9 months ahead based on current economic forecasts.

Stock markets started the year strongly, buoyed by positive sentiment following agreement of a Phase 1 US-China trade deal and the strong majority of the Conservative party in the UK general election. US stock markets continue to lead the way, with technology stocks once more at the forefront of market movements. The S&P 500 is flat on the year while the tech-heavy NASDAQ was up 1.5% on the month despite anxiety at the outbreak and spread of the coronavirus in China, Asia and more widely, which has checked performance in other stock markets. European indices are down on average 2.5%, Japan 2.9% and the UK 3.0%.  The strength in UK equities seen towards the end of 2019 had largely played out by the start of the year, when the focus returned to the relatively short time period available for a new trade deal between the UK and Europe to be agreed. Our most recent investment strategy meeting took place on the last day of the UK’s membership of the EU, with withdrawal taking place at 11pm on January 31^st. This leaves the parties just 10 months in which to agree a deal within the existing timetable.

Government bonds have rallied since the outbreak of the coronavirus, which threatens to reduce Q1 GDP in China to 3.5% year-on-year from the 5.5% year-on-year predicted[i] with obvious knock-on effects to its largest trading partners including Asia Pacific, Japan and Europe. 10-year US Treasury yields have fallen from 1.92% to 1.51% and Gilt yields from 0.82% to 0.51%. The safe haven qualities of the US Dollar have also seen it strengthen 1.1%, once more painting a rather different scenario to that forecasted by many investment banks coming into 2020, albeit in the light of an unexpected epidemic. A strong dollar tends to reflect tight global monetary conditions and high funding costs will discourage foreign banks from lending dollars, meaning this position may persist.

The coronavirus is predicted to have a significant effect on Chinese Q1 growth, particularly due to the fact that it came to light just before the Lunar New Year celebrations. This will also affect the prospects of the Asia region as a whole, which many had predicted would be the catalyst for maintaining positive growth globally. However, this may only suppress spending in the short-term, with the possibility of a spike in demand once the worst of the outbreak has been overcome, rather than causing longer-term damage to global growth prospects, but which of these scenarios will materialise is currently an unknown. The reaction of financial markets indicates to us the vulnerability investors feel when faced with the potential of a worsening slowdown, leaving the risks firmly tilted to the downside.

The slowdown in corporate earnings over the last year has led to non-residential fixed investment falling in the US. Many forecasters predict that the 4^th quarter of 2019 will be a low point in earnings and economic momentum will turn positive this quarter. However, if earnings continue to fall then the capital expenditure recession will persist, putting further pressure on the benign economic scenario being painted. This is why we see 1^st quarter earnings as coming at an important time for markets.

European Q4 GDP came in weaker than expected, not just in Germany and Italy but also in France, which had been more robust in the past despite strikes and protests. The coronavirus is likely to weigh on January’s sentiment – surveys showed a small improvement in Eurozone activity, meaning that the expected economic recovery there will be slower than forecast and any sudden rebound is unlikely.

In the UK, November GDP was weaker than expected at -0.3% month-on-month, with both the services sector and industrial production faring poorly, resulting in many revising Q4 forecasts downwards. Furthermore, December inflation figures also came in below consensus and although January PMIs showed a bounce since the election, levels are still at or below long-term averages. The Bank of England’s Monetary Policy Committee will come under further pressure to cut rates over the coming months in order to support the economy.

At the FOMC meeting, the Fed left US rates unchanged and the statement following the meeting was much as before, suggesting that monetary policy remains appropriate despite the emergence of some new downside risks. Chair Powell did describe the coronavirus outbreak as a serious issue but it appears not to be serious enough to affect policy at this time. This reinforces our view that central bank reaction to a worsening economic scenario will be slow and too late to prevent recession.

In terms of asset allocation, we retain our view that a global economy in late cycle bears heightened risk of equity drawdown and we believe that investors will need to become more vigilant around Easter, particularly if the coronavirus outbreak starts to have a material effect on global economic activity in the medium term. The expected support from emerging market economic growth – particularly in Asia – will be significantly tested by the spread of the virus. Greater risk aversion by investors could cause capital flight, leading to pressure on low interest rates.

The remaining “known unknown” for investors is the US presidential race and reactions from the Trump administration to potential changes in economic performance that may affect chances of re-election. Furthermore, the Democratic choice of presidential candidate could have a material effect on investors as the current leading candidates have more socialist ideals that may frighten markets.

[i] Assessing the impact of coronavirus on the UK – Capital Economics 3 February 2020

 

By Jolette Persson, Hottinger Capital Partners

Going into 2020, industry leading dealmakers seem to disagree on the Mergers & Acquisitions outlook for this new year.

Some active participants paint a rosy picture, despite global geopolitical and trade-related uncertainty ahead. A common theme amongst practitioners is the belief that M&A transactions continue to be the most efficient way for companies to transform, particularly with regards to ongoing tech disruptions. Given the accelerating pace of technological change, there is a clear trend towards acquiring ready-made, tech-enabled solutions developed elsewhere rather than attempting to develop these internally, as falling behind the curve is a real threat and a rising one at that. Additionally, shareholder activism continues to prevail in M&A transactions as demand for breakups and corporate clarity remains at an all-time high[i].

More bearish dealmakers make a case for a repeat of last year’s modest increase in M&A activity, primarily driven by a balance between a dovish growth picture and the economic uncertainty of a possible recession. Global cross-border transaction volume in 2019 was down (-13% [ii]) compared to 2018, likely reflective of continued protectionist policymaking taking stronger precedence in dominant markets, particularly in the U.S and China. In Europe, factors impacting deal-making during the year included Brexit, a global slowdown in trade and concerningly low PMI readings in Germany. On top of these factors, several European governments strengthened their regulatory regime in 2019 (as did the US, after multiple waves of intense industry consolidation) which further pushed down appetite not only for M&A transactions but also for wider European equity markets, as European companies either cancelled or put their IPO plans on hold.

As UK-based investors, the question remains whether the Eurozone will regain its competitiveness as a turnaround market relative to that of the US and Asia, particularly as the UK has historically served as a gateway in European expansion strategies. Certainly, from a valuation point of view, UK-based assets continue to trade on wide discounts to global equities, both public and private. With Boris Johnson winning the general election and “sufficient” progress being made in Brexit talks, it is expected that M&A activity will pick up in the region in 2020. This is further supported by easy financing conditions. Early indications of a rebound became evident during the month of December 2019, with a clear spike in acquisitions of UK assets, predominantly in IT, where total deal value was £625m [iii].

Elsewhere in the UK market, 2019 saw the highest deal volume since 2007 in take-private transactions by private equity buyers; a focus that is likely to continue in 2020. Given the record high level of dry powder in private markets (+£1.45tn of private equity capital alone [iv]), the wider industry consensus envisions private equity investors being very active in both public and private market opportunities in 2020. Private equity fundraising in Europe, although not as strong as in North America, remained robust throughout 2019, supported by a continued benign interest rate environment.

Going forward, cross-border dealmaking in the UK and wider Europe is expected to be driven by flows between Europe and Asia rather than the usual Europe-North American route. European companies and Asian investors rightfully remain nervous around further regulatory challenges pending in the US. The expanded CFIUS jurisdiction* due to be implemented in 2020 represents a significant risk for acquisition targets involved in advanced technologies, infrastructure or consumer data. Simultaneously, European companies deprived of growth cannot ignore the far more favourable growth prospects and demographics prevailing in Asia going into 2020.

*“CFIUS is an interagency committee authorized to review certain transactions involving foreign investment in the United States (“covered transactions”), in order to determine the effect of such transactions on the national security of the United States.”

[i] JPMorgan, 2020 Global M&A Outlook Annual Report

[ii] Dealogic data as of 12/31/19

[iii] GlobalData’s deals database

[iv] CNBC, Private equity’s record $1.5 trillion cash pile comes with a new set of challenges 03/01/20

By Laura Catterson, Hottinger Investment Management 

A term of economic plight, ‘Japanification’ is characterised by a sustained period of anaemic growth, very low interest rates, negative inflation and high government indebtedness. This is a cycle Japan has found itself in for almost three decades, with its aging population making it difficult to escape[i]. Stymied by a lack of policy flexibility, Europe continues to experience similar economic conditions, prompting many market watchers to consider whether it will succumb to a similar fate or whether notable differences between the two economies will favour the Eurozone in the future.

Following WWII, reconstruction narrowed Japan’s focus onto industrialisation and by 1978 it became the second largest economy in the world. However, weak yen policy addressed at the 1985 Plaza Accord led to significant appreciation ‘bringing exports to a standstill and abruptly halting growth’[i]. A horde of stimuli followed. Financial deregulation and loose monetary policy led to a fall in bond yields and significant easing of credit conditions. Outstanding loans rose to more than 210% of nominal GDP in 1990, up from around 140% at the beginning of the 1980s[ii]. Additionally, the acquisition of financial market securities and real estate prompted a surge in prices and by the beginning of the 1990s the market capitalisation of listed companies in Japan had increased fourfold, reaching approximately 140% of GDP[ii]. This explosive growth, coupled with speculative hysteria, caused the economy to significantly overheat. In response, the Bank of Japan raised rates in the early 90s (and held them at this rate until the mid-90s), causing a spectacular asset bubble burst. An immediate – yet short lived – spike in inflation caused by the crash preceded deflation due to the withdrawal of credit supply, which led to further depressed economic conditions and an unprecedented amount of quantitative easing.

The Eurozone currently finds itself in a similarly feeble economic environment which, at first glance, bears a striking resemblance to Japan’s ‘lost decade’ of the 90s. However, there are notable distinctions to be made so as to avoid bold comparisons.

Over the last 10 years, GDP growth year-on-year for both regions is close to parallel, remaining in a narrow range between 2% and negative 1%, however, significant national differences are masked by aggregate figures with southern Europe, namely Italy and Spain, being hit harder by the 2012 debt crisis and two consecutive recessions than the rest of the bloc. Europe is still running ahead of Japan in terms of growth and there is hope that this will continue with additional stimulus from the ECB.

 

 

Inflation is another area where similarities, yet also notable distinctions, can be drawn. Figure 2 clearly shows  where policy rates have come into force(rates have been negative for both since the 2008 recession). Both regions have been   unable to generate any effective inflation, suggesting that their economies are still running very slowly. Nevertheless, whilst the Eurozone is yet to reach its target level of 2% inflation, it has avoided deflationary years. By contrast, negative inflation has occurred 12 times in Japan since 1991, with the first deflationary month occurring after just three years[iii].

 

The Eurozone has managed to get its banks lending again following the financial crisis faster than Japan did after its credit boom collapse. If central bankers can continue to deliver accommodative monetary policy, ‘money supply should continue to grow above the rate of inflation and lending should remain positive too’[iv]. Coupled with the appreciation of real assets, Figure 3 suggests the Eurozone’s current situation stands in stark contrast to Japan’s enduring deflationary bust of the 1990s [iii].

Another negative trend in Japan and a significant contributor to long-term stagnation has been the decline of its working age population. In a bid to tackle this issue, Japan has drawn a lot of women and young people into the labour force, pushing employment to 60.9%[v], however that rate is unsustainable if the size of the population does not increase. Adding to this challenge is Japan’s inadequate pension system, which results in an over-reliance on younger generations. The public pension, which serves as the main source of income in retirement, is limited and thus burdens the youth with taking on additional risk in order to have any hope of supporting their latter years[vi].  Although a concern for the Eurozone, breathing room comes in the form of its structural advantages over Japan, which it will need to capitalise on in order to accumulate capital. These advantages include a relatively liberal approach to immigration, the global exposure and reach of European companies and the expansion of industries with the potential for strong growth. One such industry is  renewables, where Europe currently leads the world. Additionally, Europe will have to make significant advancements in robotics and automation if it is to maintain its GDP per capita at the current high levels whilst the population continues to age.

Japan’s inability to recover completely from the asset bubble burst of the 90s can be attributed to a slow and timid response by the central bank, coupled with significant mismanagement. With a government bailout only forthcoming at the end of the 90s, zombie firms, propped up by banks to prevent mass unemployment, staggered on, draining growth and being ‘unable to service their debts’[i]. For the Eurozone to avoid a similar fate, boosting potential growth and maintaining resilience against significant economic headwinds is key. It is still debatable whether quantitative easing can provide meaningful short-term growth without supressing growth metrics in the long-term[vii]. The Eurozone may need to look to fiscal policy to fully escape its current lull. For this to manifest, swift – albeit likely unpopular – structural and stimulus decisions are vital.

[i] https://www.worldfinance.com/wealth-management/europes-growing-risk-of-japanification

[ii] https://economic-research.bnpparibas.com/Views/DisplayPublication.aspx?type=document&IdPdf=38519

[iii] According to Bloomberg Japan CPI Year on Year at -.3% July 1994

[iv] https://www.rathbones.com/sites/default/files/imce/22_rathbones_investment_insights_q4_2019_v8.pdf

[v] https://tradingeconomics.com/japan/employment-rate

[vi] https://www.japantimes.co.jp/news/2019/06/04/business/financial-markets/japans-pension-system-inadequate-aging-society-council-warns/#.Xib3Fsj7S70

[vii] https://www.ft.com/content/031b49ec-c415-11e4-9019-00144feab7de

By Tom Wickers, Hottinger Investment Management 

In October, the Financial Times published an article calling attention to the drab performance of big technology stocks[1]. FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) returns waned in the face of wavering economic confidence over the summer as investors cycled more defensive stocks into their portfolios. Since then, Big Tech returns have rocketed. An analysis of this year’s cumulative returns of FAAMG – which substitutes Microsoft for Netflix and represents the five largest technology companies in the world – demonstrates just how strong their performance has been.

To provide some idea of the size of the FAAMG stocks, they represent the five largest companies in the world[2] aside from the newcomer Aramco. As at the end of 2019, their combined equity values constituted 23.47% of estimated US GDP[3] which is also 5.70% of estimated global GDP[4]. Turn the clock back ten years and only Microsoft featured as a top five global company[5]. On New Year’s Eve, Apple’s market capitalisation reached heights no company has achieved before, breaking the $1.3T mark. Looking forward to 2020 and the decade ahead, can we realistically expect these mammoths to continue to grow or could we see them stall or even become extinct?

While the tech industry is notably cyclical, the outperformance of big tech stocks can largely be attributed to the surprising promise they have shown at being able to adapt and innovate this year. Apple’s 2019 iPhone sales dipped in line with expectations; few users took the plunge to upgrade to the new model. However, this disappointment was outweighed by the potential of their wearable products that grew by 50% in the year to June[6]. Apple’s ability to successfully innovate away from its legacy product led analysts to factor substantial sales growth for the next few years into their valuation. Meanwhile Microsoft’s cloud services enticed investors, demonstrating year-on-year sales growth of 59% in its latest quarter[7], mirroring Apple in recent innovation progress. Finally, Facebook has so far managed to negotiate regulatory difficulties, shrugging off its dampened share price last year following the Cambridge Analytica scandal and gaining another 254 million users in the process[8].

At the turn of this year, evaluating FAAMG using a basic value metric, Market Value/Free Cash Flow (FCF)[9], highlights how expensive these stocks have become. A high figure suggests that in relation to other companies, the ratio of expected future FCFs to current FCFs is sizable and/or that these cash flows are seen as less risky.

As technology is a cyclical and risky sector, a significant proportion of the high prices of these stocks can be accredited to cash flow growth prospects. When considering that the majority of these stocks already generate significant cash flow in comparison to their sales, markets are already pricing in weighty sales growth for FAAMG stocks in the 2020s.

Based on these numbers, it is difficult to imagine FAAMG prices climbing much higher this year. Positive investment research tends to point to the opportunities in the services sector[10], such as Apple’s foray into TV production and Microsoft’s success in cloud provision. Services are seen as a more stable sector than technology, less susceptible to revenue fluctuations due to subscriptions and contracts. Lower risk in revenues would lead to further bolstered valuations. However, it is worth noting that these services are highly contested areas at the moment. Disney, Amazon, HBO and Netflix are all battling for viewer subscriptions and there is a war ongoing between Amazon’s AWS and Microsoft’s Azure cloud services. Progress in different services sectors for these giants is not a given and a win for one can often mean a loss for another. The current stock prices therefore continue to look hopeful and on the steep side.

For an outlook on the decade, it is worth noting how FAAMG companies appear to be bucking technology trends. The average technology company quickly blossoms, matures and withers as innovation surpasses them and their products become redundant. However, big tech companies are generally succeeding in branching out and diversifying their revenue streams, slowly transforming from technology companies into quasi-conglomerates. Their size allows them to stay at the forefront of demand, through massive databanks (which are proving to be barriers to entry for newcomers[11]) and big buying power for acquisitions. Damaging regulation, which has been a major concern for investors, has so far been avoided as a result of the global reach of FAAMG companies as well as their spending power; demonstrated by Facebook and its self-regulating investments following the Cambridge Analytica scandal. Further, diversification will lessen the damage of any potential future regulation. These forays into new technology and new sectors should keep big tech alive but will ultimately lead to more melees and increased competition as giants venture into similar products. Over the coming years, FAAMG growth is unlikely to reach levels anywhere near that experienced in the 2010s – any large big tech growth would most likely come from Asia where technology is starting to diverge due to nationalism. Nonetheless, these companies are here to stay and offer substantial exposures to the American and global economies that still hold the prospect of competitive returns.

[1] https://www.ft.com/content/5a6a95e6-e67e-11e9-b112-9624ec9edc59

[2] In terms of their market capitalisation – data from Bloomberg as of 10/01/2020

[3] https://www.jpmorgan.com/global/research/global-market-outlook-2020

https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=US

[4] https://www.statista.com/statistics/268750/global-gross-domestic-product-gdp/

[5] http://media.ft.com/cms/419e021c-fecd-11de-91d7-00144feab49a.pdf

[6] https://www.cnbc.com/2019/10/31/apple-wearables-business-growing-at-a-50percent-and-impressing-wall-street.html

[7] https://www.barrons.com/articles/microsoft-stock-soared-in-2019-51578002778

[8] https://www.statista.com/statistics/264810/number-of-monthly-active-facebook-users-worldwide/

[9] Market Value/Free Cash Flow (FCF) is similar to a P/E ratio in its use but is more relevant to the factors that determine valuation and is less prone to manipulation. However, it can also be noted that current PE ratios make FAAMG stocks look expensive.

[10] J.P. Morgan, ‘Apple: Are Shares Expensive? Thoughts on What’s Priced in Already, and What Remains on the Table’, 06/01/2020

Deutsche Bank Research, ‘Microsoft: Pre-Quiet IR Catch-Up’, 16/12/2019

[11] https://www.economist.com/leaders/2017/05/06/the-worlds-most-valuable-resource-is-no-longer-oil-but-data

By Tim Sharp, Hottinger Investment Management 

Equity markets ended the year in an upbeat mood, buoyed by the UK Conservative Party gaining an unexpected majority of 80 seats and the announcement of the US ‘phase one’ trade agreements with China.

UK equities led the way during the month; the FTSE All-Share gained 3.2% on the back of the strong mandate given to PM Boris Johnson by the British voters and the boost this could give to the UK economy through the removal of much of the uncertainty. The more domestically-oriented FTSE250 index of mid-cap stocks rallied 5.2%, thereby comfortably outpacing the more internationally-exposed FTSE100 index, which was held back by a further strengthening of sterling. Many investors are relieved by this result and the expectation is for an almost immediate increase in inward investment into the UK economy from corporate, private and retail sources. Prime Minister Johnson’s desire to have the final deal date enshrined in law could affect long-term plans, as there is still a level of uncertainty as to the type of trade deal that can be agreed. Nevertheless, the log jam of short- and medium-term investment should be eased.

The detente between the US and China was reflected in their respective equity markets; the Shanghai Composite Index gained 6.2% while the S&P 500 returned 2.9%, having hit all-time high after all-time high during the month.  In other major regions, European shares gained 1.1% and Japan’s Nikkei 225 index gained 1.6%.

Given the more growth-friendly political environment, it was unsurprising that rates continued to back-up; the 10-year US Treasury yield rose 14bps to 1.92%, the 10-year gilt climbed 12bps to 0.82% and the negative yield on the benchmark German bund narrowed to -0.19% from -0.36%.

The US dollar – often viewed as a safe haven currency – reversed some of the year’s gains during December, depreciating by 1.9% to 1.1229 versus the euro and by 2.6% to 1.3263 versus the pound. Dollar weakness also contributed to gold ending the year at a two-month high of $1,517.

It was a relatively quiet month for economic releases. Flash Purchasing Manager’s Indices (PMIs) for December continued to show a loss of momentum in developed economies during the last quarter. PMIs were higher in the US, lower in the UK and flat in Japan and the Eurozone despite the manufacturing recession in Germany and Italy, which seems to be squared away by better numbers in France. Capital Economics reports that forward-looking measures also suggest export volumes will stagnate in Q1 2020, while G7 jobs growth will soon move sharply lower.

As many investment banks and market analysts start to publish their forecasts for 2020, it would seem that the majority see the inverted US yield curve of the third quarter and the resulting market trauma as the peak of potential recession fears. The combination of this swift action by the main central banks, the US-China trade agreement and the UK general election result has led most to believe that risk assets are once more underpinned, and to conclude that the global economy will most likely stave off recession. In fact, most investment banks advocate for further investment in equities – despite lower expected returns – largely based on expectations of even poorer returns from government bonds. However, we feel that forecast earnings in developed markets over the coming year are too high and open to significant revisions. Most of the scenarios being painted are still plausible within a late cycle environment, so the question then becomes: When will recession hit?

Anecdotally, an inverted yield curve tends to point towards a recession within 12-18 months, meaning that equity investors should start to become cautious around Easter 2020. Without a significant catalyst, as has been provided by China in the past, we remain sceptical about whether the current central bank stimulus will be enough to boost the global economy, so we believe a threat of significant equity drawdown remains.

In terms of asset allocation, we retain our conviction that late-cycle investing bears heightened risk of equity drawdown. We are looking at the correlation between equity markets to investigate the possibility of reducing drawdown through diversification. Our investigations suggest that China and Japan show low levels of correlation to US and European markets. Furthermore, in the light of the recent general election result, we would increase the allocation to UK assets, particularly for UK investors, in view of the expected increased optimism for the UK to start to close the valuation gap that has opened since the 2016 referendum.

By Tim Sharp, Hottinger Investment Management 

Our final investment strategy meeting of 2019 took place in the aftermath of the UK Conservative Party gaining an unexpected majority of 80 seats and announcement of the US ‘phase one’ trade agreements with China. So far this month the, S&P 500 has hit all-time high after all-time high and the UK FTSE 250 has bounced 4.16% on the back of the strong mandate given to PM Boris Johnson by the British voters and the boost this is expected to  give to the UK economy through the removal of much of the uncertainty.

The FTSE 100 may only have gained 2.76% since the election due to the strength of the pound, but many investors are relieved by this result and the expectation is for an almost immediate increase in inward investment into the UK economy from corporate, private and retail sources. We believe that Johnson’s desire to have the final deal date enshrined in law will potentially affect long-term plans as there is still a level of uncertainty as to the type of trade deal that can be agreed, but even so, the log jam of short- and medium-term investment should be eased.

Flash Purchasing Manager’s Indices (PMIs) for December continue to show a loss of momentum in developed economies during the last quarter. PMIs were higher in the US, lower in the UK and flat in Japan and the Eurozone despite the manufacturing recession in Germany and Italy, which seems to be squared away by better numbers in France. Capital Economics reports that forward-looking measures also suggest export volumes will stagnate in Q1 2020, while G7 jobs growth will soon move sharply lower.

As many investment banks and market analysts start to publish their forecasts for 2020, it would seem that the majority see the US inverted yield curve of the third quarter and the resulting market trauma as the peak of potential recession fears. Over half of the global central banks had cut rates by then; the Fed acted swiftly with 3 rate cuts of its own and the ECB resumed quantitative easing. The combination of this swift action by the main central banks, the US – China trade agreement and the UK general election result has led most to believe that risk assets are once more underpinned, and to conclude that the global economy will most likely stave off recession. Capital Economics has predicted that the global economy will bottom out in Q1 2020 and a slow recovery in growth will develop thereafter, although unevenly spread across regions[i]. UBS concedes that 2020 will see lower expected returns on equities, but the firm stills expect stocks to outperform other public assets[ii]. In fact, most investment banks advocate for further investment in equities despite lower expected returns, however we feel that forecast earnings in developed markets over the coming year are far too high and open to significant revisions. Most of the scenarios being painted are still plausible within a late cycle environment, so the question then becomes: When will recession hit?

Anecdotally, an inverted yield curve tends to point towards a recession within 12- 18 months, which still allows for a late 2020 / early 2021 period of negative growth, meaning that equity investors should start to become cautious around Easter 2020. As we have already published, the global economy has previously relied on China to add sizeable stimulus in order to prevent recessions, but a China that is currently in transition is unlikely to step in at this point in its own cycle. Without a significant catalyst, we remain sceptical about whether the current central bank stimulus will be enough to boost the global economy, so we believe a threat of significant equity drawdown remains.

Absolute Strategy Research (ASR) continues to have a 2020 US recession as its central economic view, due to monetary overtightening in 2018 that still leaves monetary policy too tight in 2019, rather than supply chain issues leading to a blip in trade – a characteristic of a mid-cycle slowdown. This aligns with our own late-cycle view. Corporate profits and margins are under pressure, balance sheets remain levered and the recent rally in equity markets leaves very few investors positioned for a recession, meaning that such a scenario will have a notable effect on risk assets should it materialise.

Our recent dollar article outlined a scenario for a stronger dollar again in 2020, which also looks like a contrarian argument with many forecasters using the Fed‘s decision to hold rates as a signal that a weaker dollar will boost emerging markets next year. ASR believes there is less room for dollar appreciation against developed currencies, but unless there are clear signs of recovery in global growth outside the US, a broad dollar decline is unlikely.

In terms of asset allocation, we retain our conviction that late-cycle investing bears heightened risk of equity drawdown. We are looking at the correlation between equity markets to investigate the possibility of reducing drawdown through diversification. Our investigations suggest that China and Japan show low levels of correlation to US and European markets, so we have been looking at potential medium- and long-term opportunities there. Furthermore, we have increased our allocation to UK assets, particularly for UK investors, in the light of the recent general election result and the expected increased optimism for the UK to start to close the valuation gap that has opened since the 2016 referendum.

 

[i] What to expect in 2020 – Capital Economics, The Chief Economist’s Note, 16 December 2019

[ii] UBS House View, Monthly Letter, Chief Investment Office GWM, 12 December 2019

By Harry Hill, Hottinger Investment Management 

1,130:

The number of people arrested in London during the protests in April 2019.

£7.5 million:

The additional cost to the police force over the same period.

2025:

The deadline for net zero greenhouse gas emissions demanded by Extinction Rebellion[i].

For many, 2019 will be considered as the year the world at large woke up to climate change. From Extinction Rebellion and Greta Thunberg to David Attenborough’s 2019 documentary ‘Seven Worlds, One Planet’, the theme has now become an all-too-dismal feature of the everyday.

The last four years have been the hottest four on record, with winter temperatures in the Arctic having climbed by 3°C since 1990, sea levels rising, coral reefs dying, and the number of natural disasters indisputably on the rise[ii]. Ten million people were displaced from their homes between January and July in 2019[iii] alone, according to a report by the International Displacement Monitoring Centre. Any efforts to curb the consequences of global warming will require change not just from governments and corporations but also from investors and consumers.

Unlike Extinction Rebellion, the concept of ESG investing (investing with environmental, social and governance issues in mind) has been around for more than a decade. In January 2004, UN Secretary General Kofi Annan asked 50 CEOs of major financial institutions to participate in a joint initiative under the auspices of the UN Global Compact. The aim of the initiative was to encourage the integration of ESG factors into capital markets. The year following, Ivo Knoepfel released a report entitled “Who Cares Wins”[iv] which outlined environmental, social and governance factors in capital markets and set a benchmark to encourage more sustainable markets and better societies. According to KPMG[v], over the course of 2015-2017, ESG integrated investments grew 25% to US$23 trillion, accounting for around a quarter of all professionally-managed investments globally. Whilst progress has been encouraging, there remain inefficiencies surrounding ethical investing, as well as broader misconceptions about the different strategies available and how best to bring about change within society to the benefit of future generations.

Investment strategies typically fall into three categories, with slight overlap between each. (1) ESG, which refers to environmental, social and governance practices. Although there is an overlay of social consciousness, the objective of ESG is to incorporate additional factors into the existing investment process. (2) Socially responsible investing (SRI) employs negative and positive screening to eliminate investments that don’t meet certain ethical guidelines. (3) Environmental impact investing, on the other hand, proactively seeks investments that have a positive impact. Each strategy should be considered as a variation on a broader theme to ensure a better future society, but each will result in different portfolios with potentially large discrepancies in their ability to combat climate change and address social issues. The CFA Institute has expressed[vi] its concern that too many funds are claiming to be ESG managers without any standards of practice attached. A set of harmonised standards will improve investors’ ability to select the funds that really make a difference.

For some investors, wanting to invest with a conscience does not necessarily mean investing entirely in ESG-labelled funds. According to the investment philosophy of hedge fund TCI, the most effective strategy to invest ethically is to take a long-term activist approach by remaining a holder of shares regardless of their carbon footprint and using engagement to bring about change from within. TCI will actively vote against company directors if they fail to meet reduction targets and demands such as disclosing carbon dioxide emissions[vii]. It is still relatively rare for company directors to be challenged in such a manner. Bill Gates is quoted as saying, “Divestment, to date, probably has reduced about zero tonnes of emissions… It’s not like you’ve capital-starved (the) people making steel and gasoline.” As stated by Sarasin & Partners[viii] the directors of the world’s biggest fossil fuel groups were reappointed with an average of 97% investor support. This may leave the higher polluters, stocks in need of scrutiny from investors, neglected, with little incentive to change. Managers of many conventional funds do not vote for change as their investors do not demand it, and managers of ESG funds may vote for change within a portfolio of companies that are already actively tackling climate change. Clients looking to implement an ESG screen to their portfolios may wish to diversify across a variety of strategies using different philosophies.

Finally, there is a need for further transparency through more frequent and accurate disclosures. Organisations such as the Global Reporting Initiative (GRI) and Governance and Accountability Institute (GAI) acknowledge the abundance of poor quality ESG information from which asset managers are making their decisions. According to the CFA Institute, governance factors can run across more than 150 variables, yet the ability to distil data down to a few relevant factors remains disjointed. As more data becomes available and with greater transparency, the ability to correlate governance factors and climate factors to returns will improve investment strategies.

Following the UN 2019 Climate Summit in New York, it is evident that there is an urgent need to address the mounting challenges faced by global warming. To reduce greenhouse gasses by 45% over the next decade and to net zero emissions by 2050 will require drastic changes in all areas of society and by all parties. The opportunities for investment whilst allocating capital to the benefit of future generations might require a more activist form of investing aided by more transparent and accurate data.

[i] BBC: What is Extinction Rebellion and what does it want?

[ii] United Nations: Climate Action

[iii] Internal Displacements: Mid-Year Figures

[iv] Forbes: The Remarkable Rise of ESG

[v] KPMG: The Rise of Responsible Investment

[vi] CFA: Enterprising Investor

[vii] FT: TCI does more on climate action than ethical green funds

[viii] Sarasin Asset Management: Environment, Social and Governance issues

By Tim Sharp, Hottinger Investment Management 

The US dollar index (DXY) is up 1.4% year-to-date when many started the year with a weak dollar stance on the back of a flip flop in policy by the Fed scaling back potential tightening measures.

UBS publish in their FX Outlook 2020[1] that the short-term dollar trend seems to have switched lower with a weakening economic outlook that they expect to lead to continued weakness in the first half of 2020 and further easing by the fed before activity recovers in the second half of the year. They further argue that this scenario will see US investors less likely to invest in overseas assets, with the threat of global slowdown thereby undermining any strength in emerging market assets that may have resulted from the weak dollar.

Knowing where we are now, we have made the case a number of times this year for a strong dollar and find it interesting that there are analysts who now believe that the dollar should have been stronger during 2019 due to its superior growth rate amongst the developed countries. The second half of the year has seen a growth scare and a corporate profits scare followed by a rebound in consumer sentiment measures that have increased dollar volatility but also underlined the safe haven flows that underpin dollar strength.

Capital Economics calculates that the trade-weighted dollar is at its highest since Trump became President in 2017 and more than 25% higher than its post global financial crisis lows in 2011. However, they argue that the dollar is only 6% above its average since the 1970s and is a lot lower than the peaks of the mid 1980s and early 2000s[2] which means that there is still room for the dollar to strengthen from here.

Absolute Strategy Research (ASR) has recorded that over the past 20 years weak global growth momentum and rising policy uncertainty have tended to be associated with a strong dollar. Furthermore, this pattern continued in 2001 – even with the US at the centre of the global recession – when the dollar fell after the recession had ended. Therefore, for there to be broad-based dollar weakness, there would need to be stronger global growth outside the US, encouraging US investors to invest in foreign assets with non-US real yields to rise relative to US real yields[3].

The Financial Times article by Jonathan Wheatley on December 5[4] highlighted the current risk of contagion returning to the emerging world, most notably in Latin America. Argentina, Bolivia, Brazil, Chile, Ecuador, Peru and Venezuela have all been affected by crises, coming to a head in the last quarter with most countries having little or no room for fiscal stimulus.

Our website article dated October 22[5] also highlights the changes in China as it moves from capital investment to a more consumer-based economy and the very low likelihood of the Chinese authorities adding enough stimulus to reignite the global economy as they have in the past.

In summary, it looks unlikely that emerging markets will be able to provide the impetus to global growth in 2020 and ASR points out that the dollar’s refusal to weaken significantly suggests many of their central banks will be unable to lower rates much further without risking capital flight.

Safe haven flows, as the US-China trade war and interest rate differentials remain, will continue to favour the dollar, despite attempts by President Trump to meet his campaign pledge to eliminate the trade deficit and make the US more competitive through a weakening of the dollar. With the support that a low exchange rate lends to trade, it is likely that other developed nations would prefer the situation to continue in the light of US protectionist policies and the macroeconomic backdrop.

We continue to believe that the global economy is in late cycle, not mid cycle, and that the US is about to join the major economies of Europe, including the UK, on the brink of a shallow recession in 2020 that is unlikely to be saved by a US-China phase 1 trade deal. ASR summarises that the dollar has been the main channel of transmission for US monetary policy, pushing the dollar higher and thereby creating a drag on global financial conditions and depressing global growth. This will continue unless the Fed eases further.

Finally, although it is still too early to speculate on the outcome of the 2020 US presidential election, the differing views of the candidates will undoubtedly influence the path of the dollar going into the second half of the year. President Trump has taken a lot of credit for the state of the US economy and the returns from US financial markets, so it will be interesting to see how he approaches a weaker period during the presidential race. His attacks on Fed Chair Powell in recent weeks and his tweets regarding the use of negative rates by Europe would suggest that he intends to lay the blame firmly at the feet of the Fed, with the potential consequence of undermining the Fed’s independence. Democratic candidates could have different impacts on the dollar, with Lombard Odier suggesting that a Warren presidency would be dollar negative while a Biden or Bloomberg presidency would probably be dollar neutral[6]. However, the US presidential election will be held on November 3 next year, so plenty of opportunities yet remain for the incumbent to exert his influence and for global markets to follow their own path.

[1] UBS Global Strategy. FX Outlook 2020: Wither the dollar?

[2] Capital Economics. Global Markets Update. 2^nd December 2019

[3] Absolute Strategy Research. Global Asset Allocation: Staying defensive on high 2020 recession risk.

[4] https://www.ft.com/content/7e4e580e-168e-11ea-9ee4-11f260415385

[5] https://hottingergroup.wpengine.com/sino-stimulus/

[6] Lombard Odier. The dollar and 2020 US presidential elections: protectionism and trade policies at the forefront by Vasileios Gkionakis, PhD. Global Head of FX Strategy.

By Kevin Miskin, Hottinger Investment Management 

The returns from global markets in November suggest that investors continue to feel more optimistic about the prospects of a truce in the US-China trade war and a positive outcome to Brexit. There is also a general feeling that the US economy is mid-cycle rather than late-cycle.

The MSCI World Equity Index gained 3.1% during the month. US markets outperformed, with the cyclically-oriented NASDAQ leading the way with a rise of 4.5%. Whilst US companies reported their third straight quarter of declining earnings, the figures were better than anticipated and investors looked ahead to expectations of a robust recovery in 2020. The latest round of corporate activity – including the takeovers of high-end jeweller Tiffany & Co and discount broker TD Ameritrade – also buoyed US stocks. This firmer sentiment underpinned other developed markets, which posted positive returns for the month. Notably, the FTSE250 index of UK mid-cap stocks, which has acted as Brexit barometer due to its domestic bias, gained 4%.

As a result of the upbeat market sentiment, risk-off assets traded lower during the month. Developed market government bonds marginally weakened in price and widened in yield across the curve. The benchmark 10-year sovereign yields in the US, UK and Germany ended the month at 1.77%, 0.57% and -0.36%, respectively. Meanwhile, gold declined by almost 4% to US$1,454.

The economic backdrop was broadly positive during the month. US GDP for Q3 was revised higher to 2.1% and showed an improvement from the previous quarter. Elsewhere, Europe grew by a modest 0.2% in Q3, with Germany only narrowly avoiding recession. The UK posted growth of 0.3% between June and September, having contracted in the previous quarter. The widely-viewed Purchasing Managers Indices (PMI) were also supportive. Capital Economics estimates that a developed market composite PMI strengthened to 50.7 vs. 50.3, which is still at a level consistent with a Q4 slowdown but has led to hopes that Q3 was the nadir. At a sector level, manufacturing showed a broad pick-up in activity while services PMI strength was limited to the US and Japan.

Whilst there were no changes in interest rates among the major economies during the month, there was some notable commentary from central bankers. In her inaugural speech as ECB President, Christine Lagarde continued Mario Draghi’s theme of a coordinated eurozone fiscal policy, with monetary policy having very few tools to implement. In the US, Federal Reserve Chair Jerome Powell indicated in a speech to Congress that the central bank is unlikely to cut rates further and that it would take a “material reassessment” to prompt a change of policy. He added that current low rates of unemployment should help boost household spending. The comments left him in the Twitter firing line as President Trump announced that the US had been disadvantaged by not following Europe into negative rate policy. And in the UK, it emerged that two members of the rate-setting committee had surprisingly voted in favour of an immediate cut.

Thus far, investors have profited from taking a ‘glass half full’ view of political events and positioning for the economic cycle to have more legs. However, investors should be aware that markets are no longer priced for disappointment. According to Unigestion, the MSCI World Index requires earnings growth of 18% over the next twelve months to justify current valuations, with S&P 500 companies and European stocks pricing in earnings growth of 24% and 21%, respectively. These are lofty expectations considering that a definitive Sino-US trade deal has yet to be agreed, the Chinese economy is slowing and the UK Withdrawal Act has yet to be ratified.

The outlook for the UK economy remains highly uncertain. With less than two weeks to go before the general election, opinion polls suggest that a Tory majority is the most likely scenario. It would be likely that a Tory government would be able to pass the withdrawal agreement by the end of January 2020, leading to the beginning of trade talks with the EU. We believe this would lead to an initial relief rally in sterling and UK equities, but the longevity of this rally would depend on the perceived progress of the trade talks.

There is also the possibility of a hung parliament, which would delay Brexit further and raise the possibility of a ‘no deal’ exit, with likely detrimental consequences for UK equities. What is certain is that both of the main parties have pledged generous spending packages including substantial increases in the national living wage. As a result, we will be looking for signs of any pick-up in inflation and we do not believe gilts are attractive at current levels given the implied risks.

In terms of asset allocation, we retain our conviction that the global economy is late cycle and, as such, that there is a heightened possibility of a drawdown in equity markets. This risk is most significant in the United States, but Europe and the UK would certainly not be immune. We have taken several defensive measures over the last 12 months, but this past month in particular we have been looking at the correlation amongst equity markets to investigate the possibility of reducing drawdown through diversification.

 

By Laure Henicz, Hottinger Art

The global art market may be weakening, but the Christmas season is only just beginning for bargain hunters. Here is a short overview of auction house trends and some clues as to collectors’ next moves.

After four years of consistent growth and some spectacular developments, – notably the Salvatore Mundi, which sold for $450 million in 2017, and the dazzling 2018 sale of the Rockefeller collection – the global art market began to slow down in 2019.

Brexit, the US-China trade war, issues in the Middle East and escalating tensions in Hong-Kong have created a great deal of economic and geopolitical uncertainty worldwide. With New York and London having been jostling for the top two auction hotspots and Hong-Kong having cemented its own position as the third hub, global auctions unsurprisingly recorded a decline of 20.3% in first half of 2019[1]. This trend has recently been confirmed domestically by a disappointing fall in 2019 auction sales at the UK’s three leading auction houses; Sotheby’s, Christie’s and Phillip’s, which were all a third smaller than last year and saw relatively few highs during the year[2].

With the art market expected to remain flat and historically procyclical, all signals paint a bleak picture of a definitively nervous and volatile environment where confidence in the primary and secondary market is deteriorating. In addition to declining auction sales and increasing numbers of unsold pieces, auction guarantee levels have also begun to fall, having more than doubled since 2016[3].

However, in such a volatile environment full of skittish sellers, the art market has revealed itself to be quite the playground for savvy bidders on the look-out for opportunities. Trophy buyers have temporarily stepped back and their influence on prices has therefore diminished.

In this regard, it is also interesting to note that the impressionist and modern art market has declined in 2019 (33.8% down from 2018)[4], notably due to a recent shift of focus by many Asian buyers from this, their traditional area of preference, to the post-war and contemporary sector[5]. The old masters art market has remained steady since 2008, whilst the post-war and contemporary art market climbed 2.7% in the first half 2019, accounting for 40.7% of total auction sales in the first half of the year (versus 27.5% of the art market for impressionist and modern art)[6].

At this particular point in time, Afro-American artists and above all artists from booming western and eastern Africa, where a significant number of female creators are now active[7], appear to be the next diamonds-in-the-rough just waiting to be found and polished. In spite of the fact that prices remain volatile, buyers’ appetite for these still-emerging segments should only get stronger as collectors and curators are expected to dive in and try to address gaps in their collections, seeking to achieve a better reflection of the world’s artistic diversity.

In summary, it would appear that the environment for collectibles has been as adversely affected by the current geopolitical and macroeconomic risks as traditional financial markets, as well as feeling the effects of the changing tastes of the Chinese consumer. Going into 2020, the opportunities in emerging markets seem to have moved back to the forefront of investor thinking amid fears of a weaker global environment in general.

Amid such a fragile and volatile art market, prudence and a passion for establishing meaningful, inspired and coherent collections remain the two golden rules to sail safely within the ocean that is the art market. It requires skill and nerve successfully to navigate more than 260 major art fairs each year[8] and to create lasting value in your fine art collection and art estate. But these uncertain times will also be times of opportunity for enlightened connoisseurs.

 

[1] Raw Facts. Auction Review. First Half 2019, an ArtTactic report, 2019, p. 3

[2] “Bargain Hunters Rule the Art Market”, by Kelly Crow, The Wall Street Journal, November 17, 2019

[3] Art & Finance Report 2019, 6^th edition, a Deloitte & ArtcTactic report, 2019, p. 57

[4] Contemporary Art Market Confidence Report – September 2019, an ArtTactic report, 2019, p. 4

[5] “Bargain Hunters Rule the Art Market”, by Kelly Crow, The Wall Street Journal, November 17, 2019

[6] Contemporary Art Market Confidence Report – September 2019, an ArtTactic report, 2019, p. 4

[7] Modern & Contemporary African Artists. Auction Market 2016-2019, an ArtTactic report, 2019, p. 4

[8] Boom. Mad Money, Mega Dealers, and the Rise of the Contemporary Art, by Michael Shnayerson, Public Affairs, 2019, p. 363