John Townsend’s Investment Opinions January 2020

There is only one good, knowledge and one evil, ignorance. – Socrates

A very Happy New Year and a Happy New Decade to all.

There have been many changes in the past decade. Everyone has their own list of events, some good, and some bad. The one certainty is that the next 10 years will have many more changes and there is no certainty as to what these changes will be.

The investment markets are influenced on their returns by the acts of politicians. Some acts are obvious, such as those in the US at present, some are less clear, as in Germany, but will probably have a long lasting effect.

Cleon was an Athenian General who died in 422 BC. In his lifetime he earned a reputation amongst his peers for being a loudmouthed, unscrupulous and war-mongering demagogue. He accused his peers, especially Pericles of maladministration of public money, though the latter was able to clear his name. Cleon went on to dominate Athenian Politics, misusing the democracy that was applied there. He was rough and unpolished, but he knew how raise the emotions of the poor Athenians who in turn supported him in making false charges against his political opponents so as to remove them from power. He criticised the Athenian generals, but was himself a failure when it finally came to leading an Athenian army. The actions of Cleon led inevitably to the downfall of the Athenian Golden Age.

Although an aristocrat, he found it politic to break off all connections with his own noble background. His influence lay in a forceful and bullying style of politics and a tone which was both anti-intellectual and anti-aristocratic. In his treatise ‘History of the Peloponnesian war’ Thucydides described Cleon as being an opponent of peace because if tranquillity were ever to be restored, his crimes would be more open to detection and his slanders less credited.  Lessons can be learnt from history, even from 2,500 year ago.

Careful investing means having to look beyond the immediate and past movements in the markets. Whereas major US corporations and their shares have contributed too much of the profits in the past years, some could now be running out of steam.  Many companies in the US and in Europe have borrowed heavily while interest rates were (and are) low, in part to buy back their own shares, which in turn has helped to raise equity prices. This increased debt has also been used to cover inefficiencies. The problem is that much of this additional debt will come back to haunt the lenders when interest rates begin to rise again as one day they will and when companies fail as a result. A major change in the past decade has been that it is no longer the banks that lend to companies and foreign governments, it is the investment funds. When the crunch comes, the banks will have earned their fees as arrangers, but the funds will have carried the risk and will bear the brunt of any down turn. It is time to limit investment in fixed income products severely.

Investors have to be able to understand the risks their funds are taking. ETFs are the archetypal ‘fake’ investments. An ETF does not carry out an analysis, but instead follows a market blindly; when an index changes its composition, so will an ETF.  The difference between the selling price of the old asset and the purchasing price of the new one is then disguised in the undisclosed costs. In a strong and rising market, a lack of decision making analysis does not show. When an economy weakens, critical analysis becomes essential to understand the risks and avoid or at least mitigate them. An ETF invests using borrowed money attracted by the seeming lack of costs. Analysis and risk management costs money. Analysts mitigate losses; without such knowledge there is no understanding and therefore no protection against sudden market movements.

Investment sectors in the coming decade must include equity funds which earn dividends from the companies in which they invest. These companies have to pay dividends from earnings and not from increasing their debt. Only careful analysis will identify these.

There is an increasing market for sustainable investments. This market will continue to grow rapidly and the prices of shares from companies whose activities are clearly sustainable have risen and will continue to rise based on the demand for such assets. The bandwagon effect has of course taken hold and many fund management companies have labelled their funds as being sustainable, even when their assets are not. This is called ‘greenwashing’. There are inevitably many agencies which offer sustainability ratings. Some of these are credible, others, again, are not. The United Nations has issued a list of 17 Sustainable development goals which investors should adhere to when selecting their investments. Many of these goals are contradictory and professional fund managers have had to sub-divide these criteria into five broader groups to make conscientious investing possible.

Economic markets too have their problems. Investors have benefited greatly from the rise in demand for US and European equities, but the US economy seems to have reached a plateau which Europe has yet to arrive at. The warning signs are there and caution is called for. Third-world investments especially in Asia, including China, presently show a great deal of promise.

Japanese companies have quietly become profitable again. Japanese institutions are investing domestically and abroad and the stock markets, which have been at a low level for too long a time, have begun to rise, especially as alternatives to the US markets are being sought. The usual divisions between value and growth stocks are not particularly relevant here. Good companies are being supported by rising demand. Fund investors should concentrate on finding competent and experienced fund managers to access this market.

Chinese companies have been vilified because of the involvement of the Chinese state in many aspects of their activities. In truth, those companies which are big enough to warrant overseas investment do probably have governmental oversight, but many are inherently dynamic and profitable. There is an argument that larger companies even with state oversight, still have a spirit of entrepreneurship, yet are unlikely to suffer the economic volatility in times of adversity, particularly because of government support. The banks are another matter however. The Chinese government, having clamped down on excess lending from secondary banks, especially for investments outside China, is now encouraging local banks to support small and medium companies which could be suffering from concerns over the trade dispute with the USA.

There is presently an attempt at cooling the so-called trade war started by President Trump when playing to his red-neck US crowd. He might have had more success had he reined together the other global economic players, but teamwork has seemingly never been his strength. In the end, it is US farmers and industry that have suffered more than any Chinese sector. Many US companies are now terrified that the markets for their products (the biggest market for Apples iPhones is in China) will dry up. There will be a treaty of sorts and Mr Trump will claim the usual resounding victory in this, an election year. In reality the US has missed its target and has gained only scorn and increasing distrust from China as well as from traditional US allies and much of the rest of the industrialised world.

The investment markets will not continue their steep upward path in 2020 and beyond. There will be increasing volatility and investment portfolios will need to be adjusted to meet these challenges. This means that the proportion of equities in even the most dynamic portfolios will need to be reduced. Above all, portfolios will need to be diversified within investment sectors and between them. There can be no alternative to broad diversification. The hype over low cost ETFs should be ignored in favour of safer returns from the best performing managers with real analysis, high returns over their indices (Alpha) and a proven track record.

Past performance is no guarantee of future profitability.

John Townsend’s Investment Opinions July 2019

Truth is always strange, stranger than fiction. – Lord Byron

Tainted politics is taking an undue place in the financial Markets: President Trump’s one man and teamless US government (with the support of a very few loyal , ambitious, but not especially capable henchmen) and Boris Johnson’s directionless  accession to the prime minister’s position in the United Kingdom both carry the hallmarks of an incoherent, disruptive and anarchistic style. To this end both countries are at risk of descending into economic and political chaos with no clear direction and no ability to protect themselves in the event of a coherent threat, whether economic or political. Mr Johnson, who once failed at a career in Journalism largely for manufacturing stories, has been unflatteringly described by his past editors. He has, by all accounts, all the moral direction of a windsock.

The US President, a self-described dealmaker, is imposing tariffs on his own international allies with Europe and Japan in particular bearing the brunt of his newly imposed penalties. There is no logic to these tariffs, other than an attempt by Mr Trump to flex his muscles in the run up to the next US presidential election. The biggest danger of his actions is that the opposing countries could feel themselves forced to devalue their currencies. In any event, it seems that the United States is also planning to devalue the US Dollar to make US exports more competitive. This devaluation competition would be destructive to all western trade.

The threatened trade war with China started by the US president (because trade wars are apparently easy to win) seems to have had little effect on China. Here the annual growth rate has slipped from 6.5% to 6.2%, though this is probably as much due to internal changes made to their economic policy by the Chinese government than any effect the US tariffs are inflicting. The 6.2 % level is still within the limits set by the Chinese government of between 6.0% and 6.5 %. Here it should be noted that the US president seems to have misunderstood the cash flow from imposing tariffs, which is an additional cost to the US consumer not to the Chinese suppliers.

The US economy is buoyant at present and interest rates seem to be set for a decrease of 0.25% again after a similar sized increase in September of 2018. There are however economic clouds on the horizon which could cause weakness in the US economy.  With money being so inexpensive to borrow, there are many US companies expanding through investment, but equally there are also many which are keeping themselves afloat with heavy borrowing. This is potentially troubling for the high yield (and therefore higher risk) investment funds which seek extra performance by investing in non-investment grade companies. They will suffer badly when interest rates begin to rise once more and the US economy weakens. I have chosen to avoid these funds in my client portfolios.

Inflation rates both in the US and in the Eurozone are at very low levels, (1.8% and 1.3% respectively). Growth is equally low at around 1% per year. It is hard to see, given how much money is being made available at present, that inflation will rise appreciably or at all. Interest rates in Europe have also been structured to stay low, even after Mr Draghi leaves his role as the head of the European Central Bank.  Mrs Lagarde will have little freedom to raise Euro interest rates when she takes over. The EU does however now have two problem members, Italy and Poland, which could affect political stability. Both have vocal anti EU Political voices. Low interest rates will undoubtedly help Italy to stay afloat, without that country having to make any difficult internal economic adjustments. Poland, which is the EU’s biggest net recipient of cash, does not pay interest on their EU support and so will be less affected by any future rise in interest rates. In truth neither can afford to leave the shielding wings of Europe, but they can and do stir up unnecessary controversy with their demands which appeal to their local constituents.

The US president’s irrational decision to unilaterally cancel the Joint Comprehensive Plan of Action (JCPOA), a multilateral agreement to limit the production of Iranian nuclear material, was in truth intended as a cancellation of yet another measure signed by President Obama, who Trump loathes. Quite why former president Obama is disliked so intensely by Mr Trump is not clear, but the measures the former put in place have been cancelled wholescale without replacement.

Iran has an intractable problem in that it has different internal factions who compete for power and often do not talk to each other. There is the officially recognised government, with whom the foreign governments interact, but there is also the Iranian Revolutionary Guard Corps, with whom foreigners do not communicate, which is the spine of the current political structure and is a major player in the Iranian economy. The IRGC has taken its own violent steps against oil tankers in the Arabian Gulf and the kidnapping of a British vessel in international waters in revenge for the seizing of an Iranian vessel full of oil destined for Syria. The revolutionary guards are not under government control and western foreign ministers’ speaking sternly to their Iranian counterparties has very little effect. The other parties are mainly religious while having an effect the Iranian people, are not important in the international field. It would have been much wiser to have left the treaty untouched.

Saudi Arabia and its allies in the Gulf are the implacable enemies of the Iranians. This has much to do with the Sunni (Saudi et al) versus Shia (Iran and Northern Arab states) conflict within Islam. The Saudis have garnered the support of US president Trump and his son-in-law and feel themselves strong enough to take military and economic measures without regard to other international opinion. This has many of the hallmarks of the League of Nations between the two world wars.

There is however good news from the Emerging markets sector, especially in the Asian region, where good fund managers with capable analysts are now achieving good sustainable returns. In an ever more complex investment market, it is essential to use only those fund managers who have adequate corporate analysis teams  and can take decisions based on  ‘bottom up’ as well as ‘top down’ criteria. There are many excellent companies to be invested in. The big US and European companies are covered by several teams of analysts and cannot make a move without causing a reaction. Smaller, non-US and European, Companies have far fewer analysts watching them and therefore allow more room for valuable research results.

The Japanese economy is proceeding quietly along its own path. Western economic powers are lamenting the increased ‘Japanisation’ of their economies. The Japanese central bank however has been supporting its domestic economy with low interest rates and adequate financial liquidity for many years. This has included buying Japanese government debt and the equities of many big Japanese companies. The second biggest holder of Japanese government debt is the ubiquitous housewife Mrs. Watanabe, it is unlikely that these investors will ever wish to offload their investments and Japanese paper will therefore, despite being relatively unexciting, produce a steady return. While these measures have not led to a high growth rate, they have encouraged corporate profitability and Japanese companies are now healthy.

The Chinese growth rate has reduced slightly to 6.2%. But the Chinese government is working to change the direction of the economy, reduce domestic debt and he domestic dependence on loans from the unregulated banking sector. US tariffs are having only a limited effect, with most goods, such as agricultural commodities which the Chinese used to buy from the US and are now the subject of revenge tariffs, being bought from other countries. Foreign car companies however, especially those with factories in China and those selling cheaper models, are suffering badly with demand for their vehicles drying up. I suspect this is likely to be temporary as the economy gets used to the new government borrowing policies. Again the emphasis on investing in Chinese company risk is to have very highly trained and experienced analysts.

There are still major discussions relating to the difference between passive investments such as ETFs which actively follow a real or artificial index and Active investments such as managed funds. Passive funds theoretically have lower costs as they have no front end fees and no management fees, they do however have the costs of switching their investments when the indices change, though these costs are rarely if ever publicised. Actively managed funds, especially when carefully analysed and well managed, have the advantage of earning a positive margin over an index, known as Alpha. They are normally compared on a net basis after all fees and charges. A client orientated portfolio of actively managed funds is therefore likely to perform better than a portfolio of supermarket index funds. I am a firm believer in seeking out medium term ‘Alpha’ and combining uncorrelated strategies into portfolios with above average returns.

The key to successful and profitable investing in the fund markets is to plan ahead, to stay calm in financial storms and to use the best quality managers who deliver consistent Alpha and as far as possible do not all invest in the same stocks and strategies, thereby avoiding ‘bunching’ of risk.

Past performance is no guarantee of future profitability.

John Townsend advises clients on their investment portfolios for Matz-Townsend Finanzplanung. He is a Fellow of the Chartered Institute for Securities and Investment in London.