The major mover in the month was the price of oil which went up by 5.59%.Oil also influenced the next best performing asset class, the FTSE index, which rose by 6.42% and which was driven by its 2 significant oil price sensitive components, BP and Shell. It was additionally boosted by merger activity (Sainsbury and ASDA).
Gold continued to disappoint following its solid start to the year. In April it fell by 0.77%. UK Bonds fell too, by 0.36%. (See interest rate charts below).
Major equity markets are down for the year to date although following quite a solid bounce in April, by less than they were before. The FTSE is down by 0.45% ytd, the European index, which rose by 5.21% in April led by France and Italy, is still down by 0.42% ytd. (Germany is down 2.78% ytd). Japan is down 1.2% ytd.
Following years of dominance, the US market finally looks as though it could lag behind this year. It is down by 3.24% ytd, despite its rocket boosted start in January. Its April bounce was noticeably smaller than that of other markets, rising by 0.27%. The US market has become narrower in the past year with fewer stocks making the running – albeit the very large ones such as Amazon and Apple, while the broader index has become lackluster. It could be that the rocket boosted start to the year will come to be seen as the “blow off top” to the bull market which began after the financial crash. This is jargon meaning that January might have been the final flurry of this cycle.
Chart 1 – S&P Index 2017 – 2018. Strong rise in 2017, strong start to 2018 but weak since then, hardly a bounce in April.
Chart 2 – FTSE Index 2017 – 2018 somewhat uneventful throughout 2017, weak start to 2018 but a big bounce in April
Bull markets do not give up without a fight and this eight year bull market will likely be no exception. By this I mean that markets do not fall in a straight line. Countertrend rallies in falling market can be very powerful and they often trick investors into returning too soon. My sense is that this is what April’s bounce was, and no more.
The interest rate environment is deteriorating as predicted in these reports (see below), inflation is emerging (also commented on below), Brexit talks are not going well, German economic growth is slowing and European banks are precarious – not only in Italy and at the perimeter but none other than Deutsche Bank in the financial heart of the Continent itself. Facebook and Google are subject to data abuse probes, which could lead to new regulation in those sectors which could impede those companies.
Despite the above, there was actually very positive news in the month. The threatened trade war seems more like posturing than had been feared and the entente in Korea is a major good news story and one which would have been unthinkable even as recently as a year ago. But even here paradoxically, the short term stock market impact appears to have been overall a little negative. The S&P’s large aerospace and defence sector fell heavily, presumably on fears of fewer orders from the Pentagon – although I have no doubt that the US will seek out other wars to fight in its place.
Chart 3 US Aerospace and Defence Sector underperformed in April. 5 year chart for the sector
There are many drivers of share markets but the most important one tends to be the long term interest rate with a lag of between 6 and 18 months. The chart below covers a period of nearly 30 years and shows the US and UK 10 year bond yields (US in brown, UK in blue). It shows how the trend has been for them to fall over this 30 year period, corresponding with overall rises in stock markets in that time. In 2016 we wrote that we believed the bottom had been reached in yields (the low point in the bottom right of the chart) and so far this is looking correct.
Chart 4 Has the US 10 year bond yield broken out above its 30 year down trend?
Likewise, the 30 year chart for the US and UK for 2 year bond yields. Looking at this you would conclude that the time of easy money was behind us.
Chart 5 2 year bond yields, 30 year chart for the US and UK. Easy money days are over?
It is always difficult to call the bottom in a market but it does look for interest rates as though we have seen it, certainly in the US and UK. As well as saying the bottom has been reached, we can say that the 30 year trend of falling rates has probably come to an end too although we won’t really know this for a long time because these are very long cycles which we are commenting on. Chart technicians might conclude this fact from the break out of the interest rate from the trend channel ie the brown line has popped out above the upper trend channel line. In this case the old upper limit would become the new lower limit meaning that US 10 yr yields would not fall much below 3% again. (We can’t see the same for the UK yet but UK interest rates have been pretty closely correlated to the US in the past.)
If the 10 year US yield has broken out of its downward trend, it would be consistent with a more fundamental input ie not chart based, which is the rising level of inflation and also the rising level of awareness about inflation I.e. the status of the current common knowledge on the matter of inflation.
Inflation and the Common Knowledge Game
The latter point is important because markets change course not when people know something (you can be alone with your special and factually correct knowledge for a long time) but instead when people know that others have acquired the same knowledge ie only once it has become common knowledge. The subject of inflation is about to move from the category of specific personal knowledge to common knowledge very soon. Everyone knows from personal experience that inflation is actually quite high and rising, especially in the things we need to buy regularly like food, in contrast to things we buy infrequently like televisions. But the official narrative is still that it is low and hovering around 2%.
Chart 6 – The US runs a persistent deficit in trade with China and the EU
Common knowledge is the act of the crowd watching the crowd ie the crowd must not only see something but see that the rest of the crowd has also seen it. The common knowledge game is played everywhere. In the past it was why floggings were conducted publicly – so that everyone could see everyone seeing what happens to you if you break a given rule. A recent example was Harvey Weinstein where everyone knew what went on in Hollywood but where it took an event to occur (seemingly out of the blue) following which everyone knew that everyone else knew too. At the moment the official narrative is that inflation is benign, just like Hollywood was before. Soon it will be like Hollywood is now.
Ben Hunt, whom I have quoted before in these reports, is the author of a Common Knowledge theory to investment. Most recently, he has applied some original computer analytics to trying to measure where the common knowledge is right now with respect to inflation. The purpose of this is to help to define how close we are to the event (which might appear to come out the blue) which would signify its official arrival on the scene. The results of his study suggest that it will be soon. His paper is here. If this is true, then we need to increase our exposure to inflation proofed assets if we can find them (more below), and reduce our exposure to assets which do not get along well with inflation, if we hold them.
Ben Hunt’s method involves running a computer search for how often the word inflation is mentioned in articles published from all sources, how central to the article the reference to inflation is (whether peripheral or the paper’s focus) and how this has changed over time. He has been able to measure that inflation is featuring more frequently and has started to figure more prominently in peoples’ thinking than at any time since the financial crisis despite the official figure for inflation still being reported as low. His conclusion is that inflation is about to become the dominant narrative in the investment markets which will have consequences for bonds and different stock market sectors.
Chart 7 – Heat map showing results of Ben Hunt’s study (full explanation in his paper, except below) Blue is early data, red is later data.
“What you’re seeing above is the Bloomberg narrative on inflation from April 2017 through to March 2018. Not only do you have 2,400 unique articles in this year-over-year period, a 75% increase over 2016, but more importantly you have strikingly more narrative cohesion across the published articles. Entire narrative clusters have come into being over the course of the past 12 months, clusters like “strategists” that are in the geometric heart of the entire interlaced network, meaning that they are providing a gravitational core to the narrative superstructure. Moreover, these new clusters are truly ABOUT inflation, where this is the core topic of the article, not a side issue. It’s a difference in meaning and sentiment associated with the unstructured data of the individual articles that a human cannot possibly capture in the aggregate, no matter how voracious and comprehensive a reader he is, but is processed and visualized in a few seconds by the Quid NLP algorithm.” Hunt’s explanation.
This is a clever piece of analysis designed to give us an early warning of changes in what (the masses of other) investors are believing. In Hunt’s view, this is perhaps the only area where artificial intelligence – the use of computer power to measure changes in the way the investment crowd thinks – can be successfully applied to investing.
Inflation and non-inflation assets
So what to do? Stagflation, or inflation combined with low growth is a difficult environment for investors to make money.
Cash is not good in an inflationary environment but it is useful to hold in order to pick up assets cheaply if and when they fall from current high valuation levels. Also, in the US at least, it is now earning a return. We hold cash also via short dated instruments which at least have some yield.
Government long bonds are terrible in inflation as we know but they have a safe haven status in the event of a stock market shock. Inflation indexed bonds are curious hybrid instruments which on the face of it sound like the ideal investment in rising inflation. In our mandates, we hold 15% of the fund in these instruments. They can be quite volatile and for whatever reason do not seem to offer the crash protection of the equivalent conventional bonds. Also, they are not undiscovered ie they are expensive and need inflation to rise by quite a lot before they look good value.
Within equities, rising borrowing costs impact companies with high levels of debt unless borrowing was at a fixed rate and the debt is being paid down out of cash flows. Here inflation is actually lowering the borrowing costs in real terms. All things equal, however, inflation is not good for companies unless they have pricing power and are able to pass price rises on to their customers. One example of this ironically is the US aerospace and defence sector where contracts with the Pentagon are priced on a cost plus basis. Another example is consumer staples producers. Generally our stock selection method already favours companies without much leverage (debt) and also with pricing power to the extent that we can judge this.
One of the components of inflation and one of the causes of its increase is the price of commodities and in particular, oil. The price has been strong recently from what we understand because of Saudi supply contraction. This will be temporary. The Saudis are trying to sell Aramco, the state owned oil company, on the stock market but would like a high oil price to get as much for the company as they can. Third time lucky – they have twice been thwarted in their attempts to dispose of it because they coincided with a weak oil price. The US fracking industry has materially affected the economics of the oil industry, as we know. US fracking has recently turned cash flow positive and the US is expected to switch from net importer of oil and gas to a net exporter within 5 years. So the recent oil price rise could be short lived. On the other hand, oil is a hedge against inflation and so deserves its place in our portfolio. This latter stance is further supported by charts 8 and 9 below
The S&P GSCI Index is widely recognized as the leading measure of general commodity price movements. It is made up of the major commodities including oil and gold. There are many factors determining whether it is rising or falling – not least, activity in China – but there is a strong relationship between its movement and the prevailing rate of inflation. Since 2000 the commodity index has been weak.
Chart 8 – SPGSCITR Commodity Index
There is a long term relationship between the level of the commodity index and the profitability of companies. Broadly you could say that when the commodity index is high, inflation is a problem, companies are paying up for raw materials while struggling to pass on price rises and so profits suffer. In these circumstances share prices fall or rise only modestly. On the other hand, when commodities fall the reverse applies, profits are strong and shares can rise. The chart below covers a long period and it shows the cycle of relative performance of commodities against shares. Since 2009 commodities have lagged behind shares and based on this chart, the next 9 years should see a pronounced outperformance of commodities over shares. This would be consistent with the inflation theme and so for the time being oil and gold remain in our portfolio.
Chart 9 – Long Cycle since 1970 showing relative performance of Commodities against the S&P Equity Index.