Download Tatton`s Weekly 20 November 2015

20 November 2015
LOTHAR MENTEL
C H I E F
I N V E S T M E N T
O F F I C E R
SAMUEL LEARY
H E A D
O F
I N V E S T M E N T
C O M M U N I C A T I O N S
ISAAC KEAN
I N V E S T M E N T
A N A L Y S T
DISCLAIMER
This material has been written by Tatton Investment Management and is for information purposes only
and must not be considered as financial advice.
We always recommend that you seek financial advice before making any financial decisions.
www.tattoninvestments.com Twitter: @TattonIM
125 Old Broad Street, London EC2N 1AR. Tel: 0207 190 2959
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Source: Karin Caifa/CNN
Markets do not have morality, but they are a very good barometer for collective expectations about the
future in the near term. From this angle capital markets told us over the past week that our Western
societies are not expecting terrorists to succeed in their aim of terrorising us into changing our way of life.
In the wake of the shocking Paris attacks, the media had, over the weekend, reported an expectation of
severe stock market falls at the Monday market opening. The New York/Washington 9/11 attacks in 2001
had exactly this effect. The subsequent March 2004 Madrid train attacks and the 2005 7/7 attacks on
London, by contrast, caused a much smaller reaction from the stock market. The public was shocked and
enraged by the cowardly and senseless murders in Paris but, rather than retreating into fearfulness, there
was not only an immediate reaction of global solidarity but also defiance. This is what I believe was behind
the sanguine response of stock markets over this past week.
One can bemoan that stock markets are seemingly ignorant to this onslaught on humanity, but at the end
of the day, that’s not their role. The fact that they overall rose over the course of the past week, however,
didn’t have much to do with changing expectations as a result of the Paris attacks. The driver here was
another source of uncertainty gradually turning into certainty. This is the likely timing of the first rate rise
in the US and the extent of monetary tightening there over the next year.
In this respect, the release of the latest minutes of the US central bank’s rate setting committee confirmed
that, barring any sudden changes or shocks to the current economic development, the US Federal Reserve
is minded to raise rates at their pre-Christmas meeting. This increased level of certainty over monetary
condition outlook was welcomed by stock markets. To my mind, the positive rather than negative reaction
to this outlook of higher rate in the US somewhat confirms my view that ultra-low rates no longer have a
confidence supporting effect through lower cost of finance, but are increasingly seen as an expression of
negative expectations, undermining economic sentiment. Interestingly, the positive market response to
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European stock market performance following 13/11 Paris terrorist attacks;
Source: FT.com, 20 November 2015
the rate rise timing was strong enough to break the recently strong stock market correlation to the
development of oil prices. Even though the oil price fell to lows last seen in late August, stock markets
chose to ignore it this time.
Back on this side of the pond, the position of Russia appeared to change so rapidly that its stock market
moved up markedly. It seems that it is once again true that nothing unites more than an external enemy.
Market participants appear to expect that, by Europe uniting with Russia in its retaliation attacks against
ISIS in Syria, there is now an increased probability that the sanctions against Russia may soon be lifted.
Personally, I do not expect that the military cooperation alone will lead to an end of the frictions with
Russia over the Ukraine issue. Over the course of next year, however, united military action in Syria may
well lead to the international recognition and respect for Russia which president Putin seems to yearn for.
Hopefully, this will make it easier for Russia and the Europeans to negotiate more pragmatically towards
a solution for Ukraine. Perhaps markets are with their steep rise, in this case, getting a little ahead of
themselves, but I believe the prospect of decreased tensions between the Europe and Russia to be a good
thing in the long run.
So, in summary, a far more positive week for investors than one might have expected. Sadly though, before
anybody takes this as the signal of an early 2015 ‘Santa Rally’, I am afraid markets remain nervous and
prone to corrections in the near term. They have once again reached technically overbought levels from
which they have, in the past, quickly retreated at the slightest sign of reviving headwinds. In this respect,
we have to keep in mind that a near term repeat of terrorist attacks in Europe would most probably
severely test the Europeans’ sentiment and undermine their willingness to go out and do their Christmas
shopping. I very much hope that our combined security efforts will prevent such a repeat, but for the time
being I will adopt a ‘wait and see’ stance with regard to our portfolio positioning.
MARKETS ON NOTICE FOR DECEMBER US RATE RISE
The US Federal Reserve (Fed) put markets on notice that the conditions for the first interest rate increase
since 2006 “could well be met by the time of the next meeting” which takes place on December 16,
provided there were no “unanticipated shocks”. As noted above, US and global stock indices took the
confirmation positively and rose as a result.
The economic data has continued to be fairly positive, with manufacturing stabilising and strong consumer
spending trends. Additionally, we learnt from the quarterly earnings season that, if we exclude the energy
sector, actual corporate earnings have risen 1.6% and sales increased 1.2%. We believe that this suggests
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the underlying economy remains solid, apart from the woes of the energy sector, which means it should
be strong enough to assimilate a possible 0.25% rate increase.
The minutes from the US central bank’s rate setting committee, the Federal Open Market Committee
(FOMC), meeting held on October 27-28 indicated that “most” officials believed that the conditions for a
possible ‘lift-off’ “could well be met” by its next meeting in December. We note that some members were,
back in October, concerned about “weaker-than-expected” readings around conditions in the labour
market. This meant that there was then broad agreement that the FOMC should wait for further data
before altering monetary policy.
However, we believe that the much stronger-than-forecast jobs data seen at the end of October (after the
meeting) should have allayed much of those concerns and also that the FOMC may now have a robust
enough backdrop upon which they can increase rates. That being said, committee members “prudently”
discussed “options for providing additional monetary policy accommodation” should the recovery begin to
lose momentum. We do not believe this is a likely scenario, but it is a sign that the Fed stands ready if
needed.
The FOMC also discussed the “equilibrium” real interest rate (or natural/neutral rate) and suggested that
this would remain near-zero in the short-term and rise “only gradually” over time. In the longer-run, rates
were likely to remain “lower” than those seen in “previous decades”.
The underlying economy continues to be supported by solid consumer spending. Over the past year,
Personal Consumption Expenditures (PCE) rose 3.2%, contributing about 2.2 percentage points (pp) to US
GDP. This solid performance of consumer spending in 2015 was boosted by robust income growth. Average
weekly hours worked and average hourly earnings have increased at a 4-5% rate all year.
While economy-wide take-home pay has been held back by slower income growth in the public sector,
overall wage and salary income growth is still up 3.7% year-on-year.
Economists expect non-farm payrolls (new jobs) to continue increasing at a rate of well over 100,000 per
month. We believe this is a solid backdrop, even with some slowing in payroll growth (last reading
270,000!). We expect nonfarm payrolls to increase by 150k per month in the first half of next year and
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125k per month in the second half. On the back of subsequent increasing labour market tightness, we
expect nominal wage and salary income growth of just under 4.0% in 2016, with rising wages offsetting the
impact of slowing job gains.
The positive labour market data should start feeding through into inflation through labour cost pressures.
We believe we are seeing the early signs of this, with consumer prices rising in line with forecasts at 0.2%
in October reflecting a large rise (+2.0%) in hospital services prices, which constituted 25% of the monthover-month gain.
We think that the positive reaction from the markets to the apparent confirmation of a possible move in
December suggests that investors have come to accept that the monetary policy change may well be a
positive sign and have begun altering their investment positions accordingly. We monitor the CoT
(Commitment of Traders report) which tracks for signs of a shift in global currency movements. Traders
appear to be setting themselves up for a December rate rise, as investors added a further $6.2 billion to
their net long dollar (i.e. betting it will appreciate) positions. Net long positions on the dollar now stand
at $33.9 billion, having risen by $20.8 billion in the past three weeks alone.
We can think of a number of reasons why the Fed might want to avoid any further delays to hiking rates:
The improved confidence in the economic outlook, reduced uncertainty in global financial markets,
reducing the risk of accumulating too much debt at “crisis” interest rates or other financial imbalances
and maintaining credibility with markets (the Fed have flagged that it wanted to raise rates at some point
in 2015 and we are now close to 2016).
JAPAN BACK IN [TECHN ICAL] RECESSION
For the first time in its history, Japan has entered its fifth technical recession in 5 years, after the country’s
economy contracted -0.8% in the 3rd quarter. This was lower than expectations of a -0.3% decline but
economists were widely predicting Japan would tip into another recession.
Looking beyond the headlines, it seems that most of the drag was due to businesses reducing their
inventory levels, while investments remained weak. Consumption actually positively contributed to
growth. Investors were anticipating that the Bank of Japan (BoJ) would need to step up its action to
support the economy and expand its quantitative easing (QE) programme.
However, the BoJ decided against such a move and kept its monetary policy unchanged. At its monthly
meeting, the BoJ maintained its overall assessment that "Japan's economy has continued to recover
moderately, although exports and production have been affected by the slowdown in emerging
economies."
We note that the BOJ made a slight adjustment to its language regarding inflation expectations. While it
continued to say "Inflation expectations appear to be rising on the whole from a somewhat longer-term
perspective," it said "some indicators have recently shown relatively weak developments." This marks the
first time that Governor Kuroda has added a caveat regarding inflation expectations in an official
statement.
We find it interesting that not only market-based indicators, such as index-linked break-even inflation
rates, but also various surveys of consumers and companies show a clear slowdown in inflation
expectations. We think that the BOJ is gradually being pushed by the market to acknowledge this fact.
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Digging into the GDP data, we were disappointed to see a fall in business investment, but encouraged to
note a rebound in consumer spending. Domestic consumption rose +2.1% quarter-on-quarter, which
contributed +1.2 percentage points to real GDP.
Capital expenditures continued to decline, down 5.0% quarter-on-quarter, following a 4.8% decline in AprilJune. The 10.1% large increase in business investment (Capex) seen in January-March has now been almost
wiped out over the two following quarters. Exports and imports came in at +10.9% and +7.1% respectively,
meaning overseas demand contributed +0.4 percentage points to real GDP. We note that this was the first
positive contribution in three quarters. Inventory made a negative contribution of 2.1 percentage points,
after having made a significant positive contribution for two quarters in a row.
Economists foresee the possibility that slowing Chinese growth spills over to its Asian neighbours, which
further impacts both overseas demand and business investment.
Domestic firms appear to have delayed their fairly extensive capex plans, amid concerns over medium-tolong-term demand trends in the Japanese economy, in respect of foreign demand. We would not be
entirely surprised if firms decided to either defer or downsize their current investment spending.
Japanese Prime Minister Shinzo Abe was instrumental in ‘the great monetary experiment’ by initiating the
Japanese Quantitative and Qualitative Easing (QQE) programme in April 2013 and expanding it in October
2014. The obvious question that arises is, why have these large efforts apparently failed to boost growth
and inflation in Japan?
It may be that the issues faced by Japan are structural, such as an ageing population, low investment
appetite for companies and a fairly widespread deflationary mind-set.
Japan’s struggles with economic growth might indicate that even the world’s largest QE programme has
its limits - on top of some unintended side effects.
UK AUTUMN (BUDGET) STATEMENT: CHANGES TO ENTREPRENEURS
RELIEF & TAX ON PENSION CONTRIBUTIONS EXPECTED
At next week’s autumn statement, Chancellor George Osborne may reform Entrepreneurs Relief (ER) and
the tax relating to pension contributions as he seeks to find further savings from government budgets. ER
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in its current form is predicted to cost the government £3 billion in 2015, constituting a useful saving for
those selling their businesses – thereby an incentive to build new businesses that grow the UK economy.
Changes to tax breaks on pension contributions also look likely and would impact those on middle and
higher incomes the most.
Entrepreneurs Relief allows those selling their businesses to pay Capital Gains Tax (CGT) at a lower rate.
Rather than facing tax at 28%, individuals pay just 10% on the sale of a business up to a maximum lifetime
limit of £10 million.
Analysts said that 43,000 individuals claimed ER in 2013-14 and the cost to the tax payer has risen from
just £360 million in 2008-09 to £2.9 billion in 2013-14, which is £2 billion more than previously forecast by
HMRC.
The relief on CGT are seen as being at risk after the chancellor did not specifically mention it as part of
the government’s “triple-lock pledge” of not increasing income tax, national insurance or VAT until 2020.
Some believe that changes to the 10% rate is more likely than outright removal and it is possible that limit
could rise to 15%.
For pensions, the amount on which tax relief can be received has fallen by £10,000 to £40,000 as of April
2014. Next year is likely to see a further reduction, but just for higher earners. Those with incomes
>£150,000 will be subject to an “annual allowance taper” – sliding scale – which would see those allowances
fall to a low of £10,000. This reduces a higher earner’s allowance by £1 for every £2 of income over
£150,000. This means that for those on an annual salary of >£210,000, individuals will only be able to claim
income tax relief on pension contribution of up to £10,000 every year. Of greater concern however, is the
threat of the reduction of the higher rate of tax relief on payments into a pension. This would now not be
much of a surprise, as according to the data from HMRC, the cost of tax relief on pension contributions
has risen to £35 billion today, from £17.6bn in 2001-02.
Some analysts think that the government could eventually completely scrap the upfront tax relief – making
pensions more like ISAs – and introduce a flat tax rate of 33%. We think that individuals should seek advice
from a taxation specialist in order to take advantages of any remaining allowances.
Additionally, the “lifetime allowance” for total pension contributions is set to fall from £1.25 million to
just £1 million in April next year.
UK: INFLATION STAYS NEGATI VE DESPITE RISING WAGES
UK inflation remained mildly negative in October, but incomes have continued to rise, while consumer
spending is being underpinned by a healthy trend.
The Consumer Price Index remained at -0.1% in October, matching expectations. The headline reading was
dragged lower by falling costs of both education and food, offsetting a positive contribution from clothing.
Education cost growth fell from +9.1% to +4.8%, which the ONS said was impacted by changes in tuition
fees at the start of a new academic year.
Encouragingly, the rate of core inflation, which excludes volatile items like food and energy, rose +1.1%
year-on-year in October. This suggests that underlying inflation remains above critical levels but
nevertheless below the Bank of England’s long-term target of 2% at the headline level.
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We think this data lends support to Bank of England’s governor Mark Carney’s view that he sees no current
need to raise interest rates. Many economists had been expecting that after 12 months the drag from last
year’s dramatic fall in the cost of oil during late summer should have started to fall out of the data by
now. However, the fact it does not yet seem to be occurring, suggests that inflationary pressures remain
subdued, despite a solid recovery in the labour market and strong consumer spending trends.
Retail sales in October fell 0.6%, missing estimates, but we note that this slight dip follows a sharper than
expected increase of 1.5% in September. Additionally, the volume of goods sold rose 3.8% year-on-year.
While retail sales are generally volatile, subject to various seasonal factors, the underlying trend remains
healthy, with month-on-month growth at 1.5% (annualised).
When we look at retail sales on an annual basis, growth was up +3.0% and total retail sales gained +3.8%.
The increase in total sales was fairly broad-based across most of the main retail sectors, with fuel store
sales rising +11.3% year-on-year, non-store retailing sales jumped +13.9%, non-food store sales gained
+2.9% and food store sales added +1.0%.
It would seem that the explanation for the October number, is relatively simple. Consumers have decided
to delay spending and wait for the large discounts offered by retailers on both Cyber-Monday and Black
Friday. We think the prospects for both retail sales and consumer spending look fairly bright for Christmas.
Consumers have had a decent run of late, on the back of rising real wages and continued low energy prices.
Wage data for October shows that workers saw the largest increase in real incomes in nearly 10-years,
with wages rising the most for the lowest paid.
The Office for National Statistics (ONS) said that median weekly earnings for full-time staff increases 1.9%
in the year to April, which is the quickest rate of growth since 2004. In cash terms, average wages rose to
£528 a week or £27,000 on an annual basis.
We find it especially encouraging that those under 21 and those in low-paid work saw the biggest rises in
wages. The bottom 10% of earners saw a 3.4% increase in wages, versus a 0.5% gain for the top 10%. Those
in lower paying jobs have been aided by the above-inflation increase in the minimum wage, which should
rise to £9/hr for under 25s by 2020.
We think the combination of October’s positive data should bode well for the longer-term prospects of the
UK economy.
FUNDAMENTAL INSIGHT PIECE:
‘LOWER FOR LONGER’ WILL CONTINUE UNTIL SAVINGS GLUT ENDS
Globally, interest rates as set by central banks remain lower than at any point in history. Additionally, the
continuation of the ‘great monetary experiment’ of quantitative easing (QE) is seeing unprecedented levels
of money flowing into the economy – now from the central banks of the Eurozone and Japan. All prevailing
economic theories would suggest that these zero or negative real interest rates, together with the huge
money supply, should increase aggregate spending, subsequently sending up inflation.
However, as noted above, the UK Consumer Price Index (CPI) fell to -0.1% in the year to October,
unchanged from September’s reading. In the US, consumer prices were up only 0.2% year-on-year in
October, after flirting around the 0% mark or below since the beginning of the year. These figures come
amid interest rates of 0-0.25%, 0.25-0.5% and 0.3% from the US Federal Reserve (Fed), the Bank of England
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(BoE) and the European Central Bank (ECB) respectively, the lowest in any of their histories. On top of
this, the BoE has through its QE program bought £375 billion worth of financial assets since March 2009,
while the ECB continues to purchase €60 billion in assets a month and the Fed currently holds around $4.5
trillion. Yet, this gargantuan monetary stimulus has still only led to rather muted global economic growth
and a deflationary rather than – as textbooks would suggest – rapid inflation.
The root cause of this slowdown has been widely debated in academic and investor circles and one of the
hotly debated fundamental reasons may be that too much is saved, rather than spent for consumption (by
individuals) or capital goods (by corporates). This so called ‘savings glut’ phenomenon, has not been
reduced by the ever more accommodative (loose) monetary policy of central banks as one might expect it
to. Larry Summers argues that, under normal circumstances, interest rates will fall until [the low level of
returns on savings has encouraged] spending to have increased sufficiently so as to equate savings with
investment at the full employment level. The problem, argues Summers, is that nominal interest rates are
bound from below by 0%, while the ‘natural’ interest rate (those required to equate savings and
investment) have no lower bound.
19/11/2015
As the above chart shows, the corporate sectors of the 6 largest high-income economies have all (with the
exception of France) been running surpluses since the financial crisis. The orthodox explanation for this is
that the crisis provided such a collapse of business sentiment that corporations are still fearful of losing
their money on investments.
This explanation doesn’t seem to quite cover it however. Interestingly, the ‘secular stagnation’ (where
economic overhangs slow global growth for an extended period of time) had been going on since a while
before the crisis, as also shown in the chart above. Paul Krugman, Nobel Prize winning economist, identifies
secular stagnation as a situation where low confidence levels over future incomes cause people to save
more money than the economy can absorb, leading to the natural interest rates being negative. He claims
that this leads to a liquidity trap, where conventional monetary policies such as injecting money into the
economy have no effect.
Our observation is that the central bank actions of QE can be interpreted as merely a counterbalancing on
the side of money in circulation. Savings that have been stashed away in low risk deposits and fixed interest
investments significantly lower the volume of money in circulation, because the previous rate of turnover
is reduced. What quantitative easing in such a situation does is to a large part just to compensate for the
lower monetary turnover, so economic activity can continue at the previous rate. What it doesn’t appear
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to do is change sentiment and behaviours enough to get companies and individuals to put there money to
work once again.
Back to the corporate savings surpluses, Martin Wolf noted recently in the Financial Times, that the surplus
of the corporate savings has to be balanced off against deficits elsewhere. In the largest high-income
economies, this has translated into fiscal and household deficits, with governments running up large debts
in order to account for the hoarding of capital from the corporate sector. Wolf comments on this that “So
long as the sector runs a structural financial surplus, macroeconomic balance is likely to need fiscal
deficits”.
This savings glut is in our view the main cause of the slow growth and inflation we have been seeing over
the past few years. The lack of immediate spending or investment puts up a serious barrier to demand and
limits the opportunities for growth. In such a situation, zero or negative real interest rates become the
new normal.
The low rates savings glut world has had some interesting consequences as, even amid global doom, there
can be local boom. The undersupply of investment opportunities means that those opportunities that are
available are chased ferociously. The huge money supply also means that individuals and businesses can
borrow cheap to invest, often resulting in an over investment into a particular asset class.
The boom in US Shale Oil was a good example of this. The high oil prices (because of oil price speculation
fuelled by cheap funding) and cheap debt meant that investing in US Shale began to look very attractive,
leading to an over-investment. Once the such created additional supply lead to a supply overhang versus
demand the oil price crashed, with current price levels less than half those seen just a year ago. A similar
situation was arguably the cause of the US housing bubble, and now is at the risk of occurring again in the
UK housing market.
Central banks have little in their arsenal to combat these localised asset bubbles, as the aggregate growth
of the overall economy is too low to warrant a rise in interest rates. In this sense, we seem to be moving
to a situation where the creation of asset bubbles, rather than classic inflation, is the main drawback to
loose monetary policy. At this current stage of global economic development, it seems that the savings
glut is more a driver of general macroeconomic trends than monetary or even fiscal policy.
So, why is this happening? The short answer is that no one really knows for sure. Economists have offered
a variety of explanations, some of which have some merit but most of which seem to fall short at a point.
One explanation is that confidence in the economy has simply deteriorated too much from the financial
crisis, as well as other shocks both before and after, to be repairable with any immediate effect.
Others have noted that technological advancements have accelerated to such a degree that the old
‘classical’ corporations are beginning to become unsure of their future positions in the world, prompting
them to save more and invest less. Some have even suggested that rising global inequality has left the
main consumer base without enough money to buy the potential goods resulting from investment, meaning
corporations are deterred from investing.
Whatever the reason, we believe that the era of low rates and slow growth will continue until these
structural corporate surpluses are being reduced through investment in productive capital. This will likely
call for a change of tack from the usual tools of incentivising spending, and may require such methods as
taxing overly large savings. In any case, we believe that the classic tools of the central banks will likely
continue to make little difference in the secular stagnation world.
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PERSONAL FINANCE COMPASS
GLOBAL EQUITY MARKETS
MARKET
FTSE 100
CURRENCIES
CLOSE
% 1 WEEK
1W
TECHNICAL
6346.3
3.7
228.0
FTSE 250
17147.9
2.2
372.3
FTSE AS
3478.4
3.4
113.2
FTSE Small
4570.8
0.8
36.8
CAC
4919.2
2.3
111.2
DAX
11131.6
4.0
423.2
Dow
17732.8
1.6
284.7
35.3










S&P 500
2081.2
1.7
Nasdaq
4655.4
1.4
66.4
Nikkei
19879.8
1.4
282.9
TOP 5 GAINERS
COMPANY
JOHNSON MATTHEY
HIKMA PHARMA
SMITHS GROUP
ASTRAZENECA
ROYAL MAIL
COMPANY
EASYJET
G4S
INTL CONSOLIDATED
LLOYDS BANKING
CARNIVAL
CDS
17.3
17.5
28.2
13.0
45.8
DEVELOPING
Brazil
Russia
China
South Korea
South Africa
%1W
0.05
-0.70
-0.12
0.69
-0.17
GOVT BOND
UK 10-Yr
US 10-Yr
French 10-Yr
German 10-Yr
Japanese 10-Yr
%
-6.7
-3.3
-2.4
-1.0
-0.5
SOVEREIGN DEFAULT RISK
DEVELOPED
UK
US
France
Germany
Japan
LAST
1.52
1.07
122.76
0.70
187.15
CMDTY
OIL
GOLD
SILVER
COPPER
ALUMIN
LAST
44.2
1082.1
14.3
209.6
1466.0
%1W
1.3
-0.2
0.0
-3.7
-1.7
FIXED INCOME
TOP 5 LOSERS
%
12.9
10.2
9.9
9.4
9.1
SPOT RATE
GBP/USD
EURO/USD
JPY/USD
EUR/GBP
GBP/JPY
COMMODITIES
CDS
398.3
252.1
95.8
53.5
249.6
%YIELD
-5.6
-1.0
-7.7
-14.9
6.2
% 1W 1 WEEK
-0.11
-5.6
-0.02
-1.0
-0.07
-7.7
-0.08
-14.9
0.02
6.2
UK MORTGAGE RATES
MORTGAGE BENCHMARK RATES
Base Rate Tracker
2-yr Discount Rate
2-yr Fixed Rate
3-yr Fixed Rate
5-yr Fixed Rate
Standard Variable
RATE %
2.6
1.7
1.9
2.3
2.8
4.5
GLOBAL RESEARCH TEAM
Lothar Mentel – Chief Investment Officer
[email protected]
Mark Murray – Fund Analyst
[email protected]
Sam Leary – Head of Investment Communications
[email protected]
If anybody wants to be added or removed from the distribution list, just send me an email.
Please note: Data used within the Personal Finance Compass is sourced from Bloomberg and is only valid
for the publication date of this document.
The value of your investments can go down as well as up and you may get back less than you
originally invested.
LOTHAR
MENTEL
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