MONTHLY MARKET COMMENTARY

DECEMBER 2016

UNITED

KINGDOM

Alliteration is our theme for delightful yet depressingly daylight-less and distinctly draughty December. Far from having a disposition to drift directionless through dark days, we dare to defiantly denounce the disreputable and dysfunctional in favour of the desirable. After the Triple Trumping of America last month, we look forward to 2017, a year which has, in terms of the unexpected at least, much to live up to. Do the major political events of 2016 suggest an end to economic globalisation and the return of ‘localisation’? The general question is one recently posed by a respected economist. For this section of our monthly market missive, we wonder what it might mean for UK listed businesses, the ones in which we currently do, or may, invest. For those we are so regularly told are global, with overseas earnings dwarfing anything that comes from these shores, the post-referendum environment, especially the weakness of sterling to the US dollar, has helped. However, there is (must be) a floor to that weakness, and whilst we may not be there yet, when it comes the benefits diminish. What then of the income itself? If globalisation really does come under pressure, as voters (if not governments) seem to be suggesting, then UK listed businesses reliant in large part on overseas trade might expect a somewhat tougher time. Likewise, those that are listed and also local in their trading (UK-centric, perhaps part of what one might call UK plc) may do rather better, subject again to the currency situation. As has often been the case, this turns our attention back to the smaller, more niche and arguably nimble businesses. Many of these have a home in the UK in both listed and operational senses; whilst the very best investment we can ever make is probably in ourselves, excess returns from UK equity investment are much more likely lower down the cap scale than among the behemoths. Late 2016 and early 2017 promises more uncertainty for the UK, and we are certainly not bullish for the short term. However, we are positive for the medium-term outlook. Keeping to the old asset allocation rules of balancing equities and bonds not only looks dangerous at this stage, it also needs reviewing, forward testing if you will. In this environment (low interest rates, increasing inflation, global GDP being tested and with the prospect of protectionism) we believe investors need a new perspective. Expect to read more on this in the coming months. We remain on the cautious side of UK equities, and despite the relatively sanguine market reaction to Trump’s triumph and Renzi’s rebuttal, we do not yet feel we should be turning on the taps of risk.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

UNITED

KINGDOM (cont’d)

Term or word(s) to watch: shrinkflation. Lovers of Toblerone and Maltesers are just the latest consumers to spot the emergence of a worrying trend – the shrinking of the product rather than raising its price when margins are squeezed. Why is this ‘worrying’? Well, it suggests to us that inflation should be a bigger number than it is – if you were planning on buying a confectionery item, for example, which is 10% smaller, but costs the same, do you buy 10% more of it? Probably not, but there is in effect 10% inflation. So the consumer just eats less chocolate. Where is the harm in that? Well, ‘cost engineering’ (as some call this phenomenon) isn’t a recognised diet, as far as we are aware, but it does indicate that some multi-nationals are increasingly desperate to maintain margin and don’t feel consumers will stomach pure price inflation. Except perhaps for the apple devotees, as they are seeing significant price rises … of course, we refer to the maker of the Mac, where a 13 inch MacBook Air, the cheapest laptop in the range, retails at £949, up from £849 just a few weeks ago. No upgrades or extra kit, just more money for the same thing, due to ‘the exchange rate’ – proper inflation, or a shrinking in terms of what you get for your money.

NORTH

AMERICA

The most recent economic data in the US has been fairly positive. The November service industry activity figures have risen to a one year high, and manufacturing PMI figures also increased to 54.1 from 53.4 (any number above 50 suggests businesses’ confidence is positive). These figures suggest that the US economy is strong enough for the Federal Reserve to raise interest rates at their December meeting, or early in 2017. US financial stocks in particular have reacted strongly to the data – higher interest rates generally mean banks can make higher margins and profits – and have pushed the Dow Jones Industrial Average index to a new record high. Turning to the elephant(s) in the room(s) (the elephant being the symbol of the Republican party and those rooms being the Oval Office and Congress), Trump’s election surprised financial markets, which had been anticipating a Clinton win. During the campaign, Trump’s mooted domestic policies included a large infrastructure spend, simplifying the tax code and a cutting of the tax rate plus replacing the existing Affordable Care Act (known as Obamacare) with a better system. The big concern for global markets is his isolationist/protectionist rhetoric. Emerging markets in particular will be worried about this (and we cover their concerns in the appropriate section later).

MONTHLY MARKET COMMENTARY

DECEMBER 2016

NORTH

AMERICA (cont’d)

Despite the headline grabbing policy ideas, detail has been very thin on the ground and it is currently far too early to know what impact Trump’s policy will have for the US economy. Indeed, at the time of writing, we do not even have clarity on just what these policies will be or who will be advising the President-elect. The market expects a rate rise in December and under Trump we may see policies which further strengthen the dollar. We have said that we see the US market as relatively expensive compared to other equity markets; however, against this backdrop, this premium could be justifiable. We remain comfortable with our current underweight to the US but constantly review this – to quote Warren Buffet ‘Since 1776 it has never paid to bet against America’.

EUROPE

Italy – a breath-taking beauty; but banks? Hopefully hanging on for help from her hitherto heroic hang-up hereinafter referred to as Europe, politicians and people performed in the plebiscite, now the prospect of a pristine PM promises what? Renzi was the fifth premier of his country ‘seen off’ during Angela Merkel’s leadership of Germany, and the next incumbent will be Italy’s 64th in 70 years. Gulp. The next elections are not due until 2018. The Five Star Movement has gained popularity and was behind the ‘no’ vote in last weekend’s Reform referendum. Italy can look at UK GDP growth since the euro was established of around 40%, compared to their own 6% in the same period. Markets have not suggested that the outcome of the vote is terminal for Italy’s membership of the EU. It is however another sign of dissatisfaction with the establishment, backing up Brexit and Trump, and should it make its way across Europe (France, Germany, Holland), this may be seen, with the hindsight of our future selves, as a key moment. More positively for ‘traditional’ politics, France has decided that François Fillon will represent the centre-right Republican party in next year’s Presidential election; he is viewed as much more likely to see off Front National’s Marine Le Pen. The options are further limited (at least for now) as the socialists are pulling themselves apart and may not get a candidate into the vital second round when voting commences. The Eurostoxx index is down over 12 months in local currency terms, and Italian bank shares are not helping that recover. Despite positive PMI figures, there are clearly strains in Europe, and this has led to our increasingly negative view.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

EUROPE (cont’d)

We are removing European equities from our Model Portfolios, as we see more downside than upside, preferring (as you will read elsewhere) the likes of India and healthcare on a risk/return basis.

JAPAN

The enigma that is the Japanese market continues to vex investors. The ascent of the US dollar in response to the election of Trump as President has meant some respite for the yen in the sense that we have now seen some weakening and some pressure taken off the market. Overseas investors continue to be net sellers of Japanese stocks though it must be acknowledged that the amount of selling has declined significantly. The yen does now look as if it could be in for a sustained period of weakness as the strong dollar story looks ‘baked in’ and this has to be helpful. Japanese company earnings have been reasonable and valuations remain attractive from a long-term perspective, leading some commentators to think the investor case for the country means it could be the stand out market for 2017. Maybe. What can be said with some uncertainty is that the Trump-induced dollar strength has probably earned Japan a stay of execution in the eyes of many investors. In some ways, Japan could be the primary beneficiary of the fact that other markets are laden with other risks – valuation levels in the US, political uncertainty in Europe and persistent question marks over the future of Asia and emerging markets in the new Trump world. Those questioning the Bank of Japan and thinking policy makers are mad as march hares may easily be made out to be moaning minnies, making a mountain out of a molehill by those more able to see method in their madness. Maiko. What investors can certainly take solace from as we end the year is that their interests are aligned with the Japanese authorities, who very much have to continue to push ahead with their agenda to reflate the economy. This is going to mean continuing to add to their positions in ETFs throughout 2017, and the Government Pension fund is increasing allocations to domestic equities to rival the holdings of the central bank. If the free float of companies dries up, however, investors may then have to deal with the sort of illiquidity that has become entrenched in the domestic bond market. We remain hopeful for what 2017 will bring – the investment case undeniably has flaws (which doesn’t?) – and our Japanese exposure remains in portfolios.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

ASIA

The new five pound note featuring Sir Winston Churchill came into circulation in the UK in September and has been in and out of the news ever since. There have been stories of collectors paying hundreds of pounds for notes from the first batch of banknotes (those with the serial code beginning AA01 being the most highly prized), and more recently we have had the revelations that they contain traces of tallow – an animal waste product – which may mean they are not entirely ‘suitable’ for vegetarians. Whilst this coverage has been a minor story in the UK, in India bank notes have been the lead story. On 8 November, Prime Minister Narendra Modi made an unscheduled television announcement that the 500 and 1,000 rupee notes (roughly £6 and £12 respectively) would no longer be legal tender just hours afterwards. Indians now have until 30 December to exchange these for new notes, but they can change up to only 4,500 rupees (now reduced to 2,000) into new notes and have to deposit the rest into a bank account whilst showing ID. The scale of the move is quite staggering with nearly 90% of cash effectively being taken out of circulation. Part of the rationale behind this move was to help combat counterfeit bank notes; some estimates suggest this represents up to 25% of the notes, with these coming across the border from Pakistan. The move helps convert money from India’s black economy into legitimate channels. India has long been a cash economy, which means the government has not been able to tax certain areas. The decision also gives them more information on individuals’ wealth, which was previously easy to conceal, and is already more ‘open’. On a short-term basis, the move will be painful for the Indian economy, with a shortage of cash. There have already been some protests organised by opposition parties as part of ‘a day of rage’ against the change, although reports suggest this had only patchy support. In the long term, the reforms currently being put through by Modi are transformative for the economy and will make India even more competitive. India has been particularly effective in using technology to implement reforms. One such example seen over the last decade has been the introduction of the world’s biggest biometric ID programme, where every citizen has been able to obtain a unique 12-digit number, along with recording biometrics such as fingerprints and an iris scan. This number can now be used to open a basic bank account for every citizen, which the government can pay subsidies straight into.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

ASIA

(cont’d)

When this was introduced for heating oil payments, alongside a move to allow Indians to not have to use local government depots to purchase said oil, the government found many previous claimants disappeared. This means the system is working … Modi has commented that he needs two full terms to implement his full reforms. So far we are in the first term and with key state elections next year, including Uttar Pradesh, Modi looks to have retained public backing, which can only help. Whilst the numbers for India’s market may be adversely impacted by the withdrawal of cash in the short term, the key reforms taking place here are transformative. Paired with India’s favourable demographics, we view India as one of our favoured markets not just in Asia, but globally.

EMERGING MARKETS

Along with India and the UK, Venezuela is also introducing new bank notes with six new bills entering circulation on 15 December, ranging from 500 to 20,000 bolivars. Soaring inflation has dogged Venezuela with the IMF forecasting a 2,000% increase in prices next year, with bags of cash being needed to pay bills at supermarkets and the new notes easing this. Venezuela has suffered from a collapse in oil prices and the negative effects of the socialist economic policies pursued by its government. Things have become so bad that the current highest bill in circulation – the 100 bolivars (roughly two pence) – is worth less than the cost to print new ones (estimated at roughly seven pence) – you know things are bad when printing money loses money! Venezuela is far from being a typical emerging market – indeed, it was kicked out of the MSCI Emerging Markets index in May 2006, with the standalone index being discontinued in February 2008. Whilst Venezuela faces its own challenges, wider emerging markets are more concerned with the potential impact of President-elect Trump. A particular concern would be the introduction of protectionist policies. From emerging Asia’s viewpoint, during his campaign Trump mentioned a potential 45% tariff on Chinese goods and, at the time of writing, his comments have irked China because of his tweets and accepting a phone call from the leader of Taiwan. A US-China trade war would undoubtedly drive Asian markets downwards with exporters likely to be hit the hardest. China itself has the currency reserve firepower to be able to cope, but smaller nations may be more vulnerable.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

EMERGING MARKETS (cont’d)

Latin America will also be concerned, particularly Mexico. In Trump’s campaign, a 35% tariff on Mexican goods was floated and NAFTA (the North American Free Trade Area – a trade agreement between Canada, USA and Mexico) came under sharp attack. Trump also commented that he would impose a limit on money being sent home by those working north of the border. Finally, Russia must also be considered, and whilst currently rather out in the cold, Trump has been more positive towards Russia indicating a potential softening of sanctions. The EU’s stance may also soften, especially with the UK’s voice having less influence after Article 50 is invoked. Russia also looks set to benefit from the agreed OPEC reduction in oil supply (more on this elsewhere). Of course, there is still very little detail on what Trump’s policy entails with his team still being assembled. Some speculate that he will moderate his language and transform from a frantic figure, feverously flip-flopping to find favour from Floridian constituents to a contrite, Congress constrained, cool-headed Commander-in-Chief. Over the very long term, we would still anticipate emerging markets to outperform developed markets given favourable demographic trends. The impact of the new US President remains to be seen, though we think China and India are more resilient than other emerging markets, hence our favouring these two countries over a broad emerging markets fund within most portfolios.

HEALTHCARE

One of the areas we have been following for some time is healthcare. If ever there were a pure ‘play’ on some of the key themes worthy of investors’ consideration such as demographics and increased spend in emerging markets, healthcare is it. The US election acted as a major headwind for the space as the ultimately unsuccessful Clinton had led many to think that the sector would face aggressive price caps and increased regulation. Trump’s victory removed much of this uncertainty and the sector has consequently rallied – it is still trading at an attractive level relative to the wider market from a historical perspective; the sector is at par versus the wider S&P 500 whereas it usually trades at around 1.2 times. A potential negative for the sector is the movement away from defensive bond proxies as the Trump reflation trade (Trumpflation?) gathers strength; we believe the other positive characteristics of the space comfortably outweigh this. A really attractive feature of this specialist area is the range of opportunities within it – from large, established market-leading names to smaller companies which are the innovators in niche areas.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

HEALTHCARE

(cont’d)

Relatedly, there is also a diverse range of ideas from a risk perspective – more defensive opportunities for lower risk clients and more adventurous, biotech type names for those with a higher appetite for risk. Looking at specialist areas is likely to form an increasing large part of investors’ thinking as geographical allocations increasingly mean less and less in a world of high correlations and multinational companies whose country of domicile might not mean that much. Another example of how thinking more deeply and with a fresh perspective is required – an argumentum ad antiquitatem ain’t adequate. We have hitherto been using a healthcare allocation only in more adventurous portfolios, but the resolution of the US election has strengthened our conviction in the space and we are introducing holdings more broadly.

FIXED

INCOME

The shockwaves from the Trump victory continue to reverberate, not so much on wider equity markets as on the currency and bond complexes. We had known for some time that bond markets were in bubble territory – with trillions of dollars worth of bonds actually paying negative yields, but many investors had complacently overlooked the possibility of an ‘event’ which would initiate the unwinding of the 30-year bull run. Two days in the middle of November saw more than $1 trillion wiped off global bond markets as the Trump reflation story gathered pace and sovereign debt yields climbed markedly. Not everyone is quite prepared to abandon the low yield story yet, however – Trump’s economic policies remain a significant unknown – and pension funds and insurers are still going to be a source of demand. We also have a major demographic obstacle in the way of an ‘overnight’ rotation out of bonds – baby boomers hold the vast majority of investable assets and the bond market is a key beneficiary of this, or has been … The phrase ‘bond vigilantes’ was coined in the 1980s to describe activist market participants selling bonds to push up yields, thereby forcing the US government to make cuts in the deficit. Maybe we are seeing a pre-emptive strike from them here – issuing a warning to Trump’s expansionary fiscal policy. They can certainly have a dramatic effect – perhaps their collective motto should be the alliterative ‘Veni, vidi, vici’. More interestingly, perhaps, for wider markets is the effect these moves may have on US companies at the micro level.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

FIXED

INCOME (cont’d)

Much of the advance in the US equity market in recent years has been attributable to buy backs which have been financed by debt issuance in an act of financial engineering. Whither this source of market support should yields pick up materially? US corporate debt has risen about 75% to around $8.4 trillion the last 10 years – the figures are even more striking if short-term company borrowings via the money market are added in. Basically, it may be best not to assume that equity markets are going to find a higher rate environment uniformly positive! Our focus remains on higher quality investment grade and high yield corporate bonds, though the concerns flagged above mean we are cautious even here and have made slight reductions in our exposure. Having been so circumspect with regards to fixed income for so long, we are unlikely to entertain more risk as the environment has, at least potentially, deteriorated.

COMMODITIES & SPECIALIST

Prior to the US election results, commodity traders were speculating on which assets would see a ‘Trump Bump’ and those facing a ‘Trump Dump’ in the event of a Republican victory. One key beneficiary of the elections is copper as investors eye an increase in infrastructure spending in the coming years. The ‘Trump Bump’ effect has led to a 15% rally since the election, helping copper to its highest level this year. At the other end of the spectrum were gold and oil, with the latter falling by 3% on the announcement. It is hardly surprising that oil saw a ‘Trump Dump’ given the President-elect’s disdain for OPEC, accusing the cartel of holding the US ‘hostage’. Many predict that his victory will see an increase in US shale production levels as Mr Trump seeks to wean the US off energy imports. One method for increasing US production is to repeal some of the laws restricting the extraction of shale gas imposed by the Obama administration. This could add a significant number of barrels to the market, and, when combined with the possibility of thawing relations with Russia, OPEC now faces a changing political landscape. A further complication is the hard-line stance that Donald Trump is expected to take on Iran, a key OPEC member. During his campaign, he threatened to rip up the historic deal between Washington and Tehran, which reduced US sanctions on Iran in return for a limited nuclear programme. Of course, it could be argued that this was an empty threat; perhaps another Trump trail talk turnaround?

MONTHLY MARKET COMMENTARY

DECEMBER 2016

COMMODITIES & SPECIALIST

(cont’d)

With supply from the US likely to increase and balance sheets laden with debt, the latest agreement to cut production could be the solution to the problems facing OPEC members. Whilst the economics behind the agreement are simple, arranging a 1.2 million barrel per day production cut between the 13 member nations (some with deep rooted political and religious divisions) is a contentious affair. Even more surprising is the agreement of non-OPEC members to reduce their output by around 600,000 barrels per day. Whilst the news quickly sent oil higher, most traders acknowledge the fragility of the agreement, with Iraq questioning the need for such measures and some African nations granted exemptions. The cartel’s compromise to constrain crude production certainly gave commodities bulls something to celebrate. However, it is worth exercising caution as competing countries could yet cause the cut to crumble. We continue to hold oil in higher risk portfolios. We are also increasing our gold weighting across Model Portfolios as a hedge against currency risks and inflation.

PROPERTY

No torrent of news flow here – Brexit related concerns are still dominant – but a few interesting bits. Nationwide Building Society is withdrawing from commercial property lending – really just a localised business decision for them, but the moderated expectations for commercial property values have contributed. Great Portland Estates and British Land have also reported that the referendum has hit property values. All these things contribute to changes in sentiment and attitudes to the sector which have undoubtedly hardened since 23rd June. Progress has stalled this year after stellar returns going into 2016, and we urge investors to continue to discriminate within this sector as we do with others. There is still a good story here – investors just need to think about their exposure in more granular detail. Yes, London exposure looks inadvisable at the moment, but the opportunities elsewhere are real. Take regional property – essentially this market is still mid-cycle. Lack of supply is enabling rents to make progress in the regions, which should have a positive feed through to net asset values. Investors see commercial property as a diversifier in portfolios, but the degree of correlation with equity markets varies tremendously and this will be the key determinant of how much diversification is really offered – our focus is away from those larger listed names which tend to diversify minimally from equities in portfolios.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

PROPERTY (cont’d)

Commercial property continues to offer attractive levels of income with relatively low risk and volatility, and 2017 should be a year of decent if not extraordinary returns. We remain overweight in most portfolios.

CURRENCY

The five pound note may be suffering from a tallow tantrum, but will sterling see a further taper tantrum soon? The Fed are expected to raise US rates sooner rather than later, and though the prospect of a Bank of England rate cut before Christmas now seems remote, were the Fed to move, expect the US dollar to strengthen again. In that scenario, the high of the last five years (£1/$1.71) will be a very distant memory, and the recent low (£1/$1.21) will surely be tested. Since 1953, the mark of £1/$1.10 has only been broken once, during the ERM crisis in the 1980s – might this be tested again, and soon?

UK INTEREST

RATES

It has been more than seven years since we were able to write about UK retail rates rising; ridiculous. In 1960, the average UK savings account interest rate was 3.38%. By 1990, they topped out at a barely credible (we put that in for the younger folk) 13.56% and in 2015 (2016 not yet available as it is the average of the whole year) we saw the all-time low, 1.4% (all rates gross). It is a complete guess, but we would not be surprised to see the 2016 figure at around 1.25%. For the last two years or so, it has been possible for the non-taxpayer (or tax sheltered cash) to achieve a little more than inflation – in 2017, this looks very unlikely.

MONTHLY MARKET COMMENTARY

DECEMBER 2016

NUMBERS OF THE MONTH

Our monthly look at numbers which may or may not have grabbed the headlines.

The Autumn Statement’s

forecast of how much worse

off UK Government finances

will be by 2020, since

March’s Budget

£122,000,000,000

Estimated value of

banknotes withdrawn from

circulation in India – 86% of

all notes in circulation

c. RS 6,326,000,000,000

c. £72,959,000,000

The returns of a £1 bet on

Trump becoming President,

Leicester winning the

Premier League and Brexit,

if placed last summer

£4,530,905

Hilary Clinton’s margin of

victory in the US popular

vote (but not enough to get

the 270 electoral college

votes needed) – she won by

more than this in California

1,322,095

MONTHLY MARKET COMMENTARY

DECEMBER 2016

MARKET DATA

Index 30.11.16 1 month 1 Year 3 Years

Bovespa (Brazil) 61,906.36 −4.65% 37.20% 17.96%

RTS (Russia) 1,029.05 4.08% 21.48% −26.65%

Dow Jones Industrials 19,123.58 5.41% 7.92% 18.88%

MSCI United Kingdom (largest 85% of UK listed stocks)

1,974.24 −2.39% 6.48% 0.55%

MSCI United Kingdom All Cap 1,264.08 −2.06% 5.78% 2.38%

S&P 500 2,198.81 3.42% 5.69% 21.76%

Numis UK Smaller Companies 4,846.31 0.32% 4.81% 5.05%

IBOXX UK Sterling Gilts All Mat. 124.28 −1.36% 4.08% 12.23%

Hang Seng 22,789.77 −0.63% 3.61% −4.57%

BSE (India) 26,652.81 −4.61% 1.94% 28.19%

IPD UK All Property* 0.53% 1.75% 39.67%

MSCI United Kingdom Small Cap 359.99 −0.24% 1.60% 13.63%

M-DAX (Germany) 20,876.52 −1.28% −3.32% 27.81%

Shanghai A (China) 3,403.22 4.84% −5.66% 46.42%

Nikkei 225 18,307.04 5.06% −7.29% 16.89%

CAC 40 (France) 4,578.34 1.53% −7.65% 6.59%

*Figures delayed by one month

The Monthly Market Commentary (MMC) is written and researched by Simon Gibson, Richard Smith,

Scott Bradshaw and Jonathon Marchant for clients and professional connections of Mattioli Woods plc,

and is for information purposes only. It is not intended to be an invitation to buy, or to act upon the

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Sources: www.bbc.co.uk, www.bloomberg.com, Financial Express, www.forums.j.auxonline.info; www.able2know.org;

www.lionsofrepublicindia.blogspot.co.uk; www.lebedinsky.com; www.score.rims.k12.ca.us; www.creation-

thewrittentruth.blogspot.co.uk. All other sources quoted if used directly; except fund managers who will be left

anonymous; otherwise, this is the work of Mattioli Woods plc.