Investment Opinions December 2017

Those are my principles, and if you don’t like them… well, I have others.  Groucho Marx

President Trump has finally passed the first important measure so far of his presidency, the tax reform bill. Inevitably in his world of superlatives this is the biggest and best tax cut ever. In reality it isn’t, there have been other larger ones, but it no longer makes a difference. This particular tax cut, being undertaken with borrowed money is dangerous and shows absolutely no understanding of economic reality by a president or by the sycophants surrounding him.  The new measure is said to be a Christmas present for all Americans; perhaps more appropriately there should be an addendum in parentheses, Americans like Mr. Trump. Sadly most middle income Americans have no idea whether or not they will be better off in 2018, as the cuts to their tax deductions are desperately unclear. Mr. Trump’s other achievements to date have been to roll back anything with the name of Obama on it, whether or not it was beneficial to the citizens of the United States. We must constantly remind ourselves that he is the legally elected president of the country and until this changes, this is the price that must be paid for democracy. American influence on the global economic and diplomatic stage has declined sharply.

For investors, 2017 has been a profitable year, though with little rationality and very high volatility. The low, indeed near zero, interest rates in the United States of America and Europe have encouraged corporations to borrow to finance their operations and any kind of return on their investments. Such demand is leading to the acceptance by investors of much lower quality than in the past, which is leading to a series of irrational bubbles, particularly with junk or high yield bonds. Perhaps the most obvious bubble investment is Bitcoin, which has risen in price from US$ 1,000 in January to around US$ 19,000 in November and now US$11,000 today. This massive increase in the price of a Bitcoin is odd as it is a completely unregulated market with nothing behind it and no governing body to oversee abuse. One has to think of the London South Sea Bubble or the Amsterdam Tulip and bulb craze. The original concept of Bitcoin was as an alternative currency, but this has been lost in the panic. The main Bitcoin producers (known as miners) are in Russia and the Ukraine. Bitcoin mining is an expensive and highly technical system and despite many best efforts, uncontrolled. There is now a new futures market for Bitcoins in the US, which in the past has normally been a prelude for a disaster in the market. Investors may congratulate themselves now on the high price of their units, but when the market declines they will find no buyers for their Bitcoins and their investment will swiftly become valueless. Those whose memories are long enough will recall the dotcom era. The only advice is to stay away unless one really wants to gamble on markets more risky than even the Chinese horse races.

Other strange sectors are ETFs. I have written about these before. The market for exchange traded funds began to allow corporate investors to increase or sell equity investments quickly when they wanted to. Since then the market has exploded and even retail investors have been dragged into products which they don’t and cannot understand and where they have vaguely heard there are few costs. In fact ETFs lag behind the markets they are supposed to follow and because their investments are effectively blind, they have neither corporate analysis or governance to rely on, nor the distribution of risk by an experienced manager. This market, while not as bad as Bitcoin, is still a recipe for disaster for the private investor without adequate advice.

We can see the bubble investments in the technology sector. Companies such as Tesla may make very interesting products, but at a cost much higher than the price they can sell their cars for. They have just announced another record loss and admitted that production is way behind schedule. This is still a good company compared with some being enthusiastically supported by the market place. There are indeed good and profitable technology companies in the FANG (Facebook, Amazon, Netflix and Google) sector, but there is also an awful lot of dross which promises to go sour when the excitement dies down.

Global interest rates have fallen as low as they are likely to. The end of Quantitative Easing is being seen in the United States and in Europe.  US interest rates have begun to rise slightly and Quantitative Easing is being cut back slowly, but American corporate profitability and efficiency is such that equity prices should not be affected. In Europe however, the head of the European Central Bank Mr. Draghi has a problem. He knows that the QE program needs to be cut back to reduce the Central Bank’s balance sheet and that interest rates have to begin to rise. However, as a good Italian, Mr. Draghi also knows that the inefficient Italian economy and banks coupled with the massive Italian national debt, cannot afford higher interest rates. So these have to be held back as much as possible. However, there is very little chance of Italy becoming more efficient or disciplined and repaying its debts, so the next crisis is destined to come in the near future.

The rise in the equity markets is largely based on the fact that most of these different markets declined sharply 10 years ago. Most of the efficient companies remained profitable and the present artificially low interest rates leave investors desperate for positive returns.

The American equity markets are presently strong, having undertaken the necessary measures to improve their efficiency. The Trump tax easing measures have helped, of course, but these were largely discounted.  The US technology sector is flourishing and housebuilding has renewed confidence relying on wage growth in all sectors from the lower to the higher incomes. Coupled with that, American equities have always traded at a premium to equities elsewhere in the world; their present levels should not be seen as being excessive especially as many US pension funds and institutions only invest in their domestic markets.

Europe is also booming, especially Northern Europe. Here the Goldilocks environment where everything is felt to be ‘just right’ exists at present and many companies are showing profitability and growth. The economies of France and Spain are also showing signs of strength, though South Eastern Europe is still heavily dependent on the largesse coming from its more northern neighbours.  As long as investors rely on fund managers who have the ability to select profitable companies from the Northern European states, Europe is still a sound investment.

A decade of stimulus has helped the Asian markets to finally regain enthusiasm but has also stoked speculative fervour. Japan has now begun to find new confidence in both the blue chip and the small company sectors, with foreign investors having been reluctant to step in. This has now changed, especially as just these foreign investors need to find a profit from the money under their control. The Japanese market is showing a great deal of promise.  India too is gaining ground as a source of profitable investment. Of the original BRIC countries (Brazil, Russia, India and China) India and China are showing most promise, though perhaps India more so than China at present. The other two, riddled as they are with corruption and failing corporate governance are well worth avoiding.

Some property markets are still more or less booming, Australian house prices have been fuelled by very low interest rates, with Sydney’s house prices having risen almost 70 percent and Melbourne’s 57 percent over the past five years. This has all the hallmarks of a bubble which will burst at the latest when interest rates begin to rise and demand from Chinese investors falls away. Much the same is true of property markets in Hong Kong with residential prices having risen over 180 percent since 2008. The Chinese central bank is clamping down on excessive lending by secondary tier banks and the ability of normal Chinese investors to compete in the monopoly world of Hong Kong is being severely reduced, something that will only be exacerbated as US Dollar interest rates rise again.

The almost desperate struggle to find a return on investments has meant that many banks, institutions and funds have begun to lower their risk thresholds and invest in debt from companies and countries they would otherwise never have considered. Ample liquidity has to be used, is the feeling not only by the traditional markets but also by the Chinese financial sector. Prudential lending and probably prudential reserve positions are being ignored, and once again investors need to observe fund managers carefully to see which are following careful strategies and which are merely seeking yield at the expense of quality. It is worth mentioning that the growth in high yield bonds, known in the 1980s as junk bonds is likely to be one of the first victims of a new realism.

The market for multi-asset investments has begun to prove itself, especially when equity volatility and thereby perceived risk has grown. Rising inflation and interest rates, albeit only slowly increasing, make it necessary for investors to seek new sources of diversifications. Funds that invest in Equities but also fixed and floating rate debt, commodities and currencies all have their place in this category, as long as the fund managers have shown their track record of being able to handle such strategies. Some, especially the black-box trend following programs have sadly completely failed; which is precisely why careful analysis and due diligence in reviewing fund managers is so essential.

In 2018 we will see tax changes in Germany, which have a small impact on private investors but which, together with the new MIFID II regulations will increase the amount and clarity of information that has to be supplied by intermediaries and Fund managers. This is nothing to be alarmed about and will hopefully ease the dangers of the miss-selling of inappropriate investments. The days of miss-selling to the ‘A&D’ (alt und doof) clients by the German banks in particular will be thankfully numbered.

There is still strong life in the global equity markets, as long as investments are carried out carefully and with due care and analysis. These markets will become increasingly volatile as institutions become nervous. One cannot discount a sudden nuclear or intense war between, for instance the USA and North Korea which would stir financial disharmony among the inexperienced ‘16 year old institutional traders’ who have no experience, but crises in Bitcoin, Block chain and the Technology stocks are unlikely to prove a ‘Black Swan’ moment and trigger total panic as in 2007/8. It pays to be wary and careful.

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.