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As indicted at the end of last month’s Quotidian briefing, the most important economic and market-moving news in September was the Federal Reserve’s decision on US interest rates at their mid-month meeting.

According to market commentators, downward pressure on equity valuations in August had been aggravated by concerns that the Federal Reserve would increase US interest rates for the first time since 2006 at this month’s meeting.

In the event, the Fed decided to leave interest rates unchanged and one would be forgiven for thinking that that was good news. However, the same siren voices that had predicted the end of the world if rates had been increased now changed their tune and put a profoundly negative spin on the decision to postpone any rate rise. Having gently recovered and moved upwards again in the early weeks of September, the market was hit once more by a tsunami of negativity following the Fed’s announcement.

The explanations for this irrational reaction varied between:

  • It must mean that the US economy is a lot weaker than the Fed is letting on.
  • The Fed is worried about making the financial and political turmoil in Europe and the Middle East even worse (with potential knock-on effects on the US economy).
  • The Fed doesn’t want to make the US dollar even stronger and thereby make US goods and services even less competitive.
  • As interest rates rise so the cost of repaying debts will rise for the already heavily leveraged governments in Europe and the Far East and the Fed doesn’t want to potentially cause a new and even larger global sovereign-debt crisis.

Whilst some of these assertions are no more than guesswork and others may have a degree of merit they are not, in our view, sufficiently persuasive to justify the major equity downgrading that then occurred. However, when equity markets are in determinedly negative mode then bad news is emphasised or created whilst good news is ignored.

It is worth remembering that the Federal Reserve has two main purpose;

Firstly, its role is to maintain the unemployment rate in America at or close to its long-term average of 4.9% (the official unemployment rate in the USA is currently 5.1% having been at nearly 10% as recently as 2012).

Secondly, the Fed is responsible for keeping inflation under control (and that is deemed to mean at an annual rate of 2% on average). Inflation in the US is currently lower than that figure and the Fed would like it to increase to their target range.

Janet Yellen (the Federal Reserve chairman) is, of course, well aware of the pervasive impact on society generally (and particularly those who are reliant on pensions and savings to generate their income) of over six years of zero interest rates.

She would clearly like to make a relatively modest increase in interest rates at this stage of the economic cycle and it is very likely that rates will increase marginally before the end of 2015. Given what has happened over the last six weeks this should now be received as a positive move by the equity markets.

One important effect of this long period of interest rates has been to impact on income generated by pensioners. Many investors (especially the elderly) have been prepared to take a much higher risk profile in their investment strategy in their search for worthwhile returns. This has been and will continue to be another positive for stock-markets.

The latest Chinese economic data issued towards the end of September wasn’t encouraging; new orders are falling, output is falling, employment is falling, and prices are falling. In particular, China’s Purchasing Managers Index sank to a reading of 47 in September from 47.3 in August and now sits at its lowest since March 2009.

As a consequence, global equities are continuing to fluctuate wildly in the short term and have contributed to the current air of pessimism. As has been said before in our monthly musings, though, in the longer term numbers from China need to be taken with a large pinch of salt.

On 30th September the FTSE 100 closed at 6248 (which equates to -7.68% for 2015 to date). This represents a decline of 2.98% in the hyper-volatile month of September.

By comparison the Quotidian Fund at the end of September was +9.19% for the year to date, having declined 4.90% in the month. Despite this downward revaluation, we remain in positive territory for 2015 (which is more than can now be said for any of the global equity markets) and 16.88% ahead of our benchmark (being the FTSE100 index).

Up until now the Healthcare and Biotech sectors have been areas of the market which have remained buoyant and immune from pricing gyrations. It is no coincidence the the Quotidian Fund has been focused therein. However, in the last week of September even that segment of the market was very aggressively marked down.

That negative tone was set in train by virtue of a tweet issued by Hillary Clinton who declared that she intended to introduce a plan to reduce and limit the prices of medicinal drugs. There is an inherent absurdity in that comment and the medium used to transmit it but that did not stop immediate, substantial and sustained downward pressure on equity valuations in the Healthcare and Biotech sectors.

The irrational nature of this reaction is that support for Clinton’s campaign to become the Democratic party’s candidate in next year’s US general election is fading badly (which might explain the motivation behind what she imagines to be crowd-pleasing initiatives such as this statement on drug pricing).  More popular candidates have emerged whose momentum is currently swamping the Clinton bandwagon and the Democratic nomination is now looking a very close call.  Even if she does eventually prevail within the Democratic party, her inept intervention over Healthcare and Biotech has damaged her credibility with the business world and harmed the prospect of the Democrats defeating the Republicans in next year’s race for the White House.  

Her comments can thus be seen as no more than self-serving political waffle but they have had a profound but transitory effect on market valuations. We saw seven successive days of downward revision of prices in Healthcare and Biotech shares and three of those days were very steeply negative. As a result, we believe that stocks in those sectors are now grossly oversold and we expect a strong rally in the weeks and months ahead.

In October the third-quarter earnings season will be upon us and it will be nice to get back to talking about products (supply and demand), profitability and economic reality instead of political matters. Many analysts have lowered their forecasts for corporate profits and earnings per share. If the reality turns out to exceed these ultra-conservative forecasts then it will add another much-needed boost to equity valuations.

We therefore believe that the FTSE will end this year significantly higher than its current subdued level and much closer to the 7000+ point it last achieved in April.  Similarly, we anticipate that the US market (and especially the Healthcare and Biotech sectors) will move higher from here.

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2015 initially picked up as 2014 had ended. Extreme volatility returned at the start of the year and, after a short period of recovery and calm, chaos hit stock-markets again in the middle of the month. The Dow Jones Industrials Index has now had three wild swings this year already. First it plunged more than 700 points then it rallied more than 600 and then it again dropped another 700 points. These fluctuations and the general uncertainty in other major indices such as the S&P 500 and Nasdaq in the USA and the FTSE, Dax and CAC in Europe have been similarly astonishing.

Some comfort can be drawn from the fact that the latest of these oscillations was at least founded on an economic basis in the form of a completely unexpected move by the Swiss National Bank.

Following its decision in December to reduce their interest rate to minus 0.50% (the rationale for which was explained in our December report) the SNB went a step further on 16th January and reduced that rate even further to minus 0.75%. This in isolation would not have been a market shaker but simultaneously (and completely out of the blue) the SNB also removed the long-standing ‘peg’ between the Swiss Franc and the Euro.

That move came as a complete surprise to markets because the SNB had been maintaining a minimum exchange level of 1.20 francs to the euro since September 2011. It had also promised that it would defend that peg “with utmost determination.”

Abandoning the ‘peg’ was therefore a move that shocked traders all around the world and what followed has never been seen before in the currency markets.

Their supposed aim was to prevent Swiss deflation but the SNB had had to buy billions of euros in order to maintain the ‘peg’ and print Swiss Francs in order to do so. But, with the well-touted prospect of Quantitative Easing set to be introduced by the European Central Bank during January with the obvious side-effect that would have on the Euro itself, Swiss policymakers realized that they just could not keep defending the 1.20 level and so they (quite rightly) threw in the towel.

The result was swift and severe. The euro plunged 40% in value against the Swiss Franc in little more than a blink of the eye.

At the same time the Swiss stock market also fell more than 10 percent in a matter of minutes amid fears that the move would eviscerate earnings for Swiss exporters. This fall was mimicked in equity markets globally.

Taking the FTSE as an example, at 10:28am on 16th January (the time at which SNB’s announcement was made) the main UK index was up around 1.50% for the day. By 10:30am the FTSE was down roughly 1.50%.

Thankfully, the usual round of data releases from the US in January helped to temper market pessimism and nerves.

On the unemployment front the U.S. economy added another 252,000 jobs in December 2014 (beating the widely anticipated forecast of 240,000). In addition, November’s reading was revised higher to 353,000 and October’s number was revised upwards to 261,000.

The 2014 overall gain of 2.95 million jobs was the highest of any year since 1999.

The US unemployment rate fell again in December to 5.6 percent from 5.8 percent in November and currently is at its best reading since June 2008.

On 22nd January Mario Draghi eventually delivered the long awaited statement from the European Central Bank in respect of its Quantitative Easing initiative. Little of his announcement was new or surprising simply because Francois Hollande, in a speech made four days earlier, had already let the cat entirely out of the bag (rarely has the tale of the ‘wide-mouthed frog’ been more apt).

First, Draghi confirmed that the ECB would launch a 60-billion-euro-per-month ($69 billion) QE program on March 1. The initial program will run through to at least September 2016 meaning that it will ultimately total around 1.1 trillion euros. More significantly, though, he also inferred that it would mutate into open-ended QE if this first round failed to deliver the required results.

Second, he announced that the ownership of the ‘distressed’ bonds being purchased will be split between the ECB and each member-country’s national central bank. This rather simplistic ideal is an attempt to force some of the risk down onto the individual countries that make up the euro zone in the hopes of spurring national governments (especially those in the spendthrift countries of southern Europe) to take their share of the stimulus efforts and to rein in the profligacy. Some hope. Alice in Wonderland springs to mind.

Having already witnessed the effects of Quantitative Easing both in the USA and the UK the markets, predictably, reacted positively. However, we’ve been down this road before and so we have a good understanding of how it will now play out.

QE gives an artificial boost to real asset values (eg. in equities and property) and creates a bubble in those market’s valuations. In the longer term, however, QE is counter-productive; eventually there is a price to be paid and those bubbles will inevitably deflate (unless QE becomes an open-ended and endless program). The trick will be to anticipate that point of deflation and consolidate profits before they dwindle.

To put it rather more crudely, QE is like giving a drunk man a gift of £10 in the hope that he’ll use it to get a taxi safely home; in your heart of hearts, though, you know exactly what he’s actually going to do with it, you just don’t know which wall he’s going to use. Likewise with governments and their fellow-travellers, the banks.

The real problem, as we see it, is that the economy of the Eurozone is stagnant and veering towards moribund. Printing trillions of euros will treat the symptoms and, for a short period, paper over the cracks, but ultimately it won’t cure the disease. The Eurozone is over regulated, overburdened with bureaucracy and over-taxed. Unless those three economically hobbling issues are properly addressed and corrected then the Eurozone will slide to its economic demise.

Equally damaging is that Eurozone banks are still not lending anywhere close to enough to creditworthy companies and individuals and are therefore stifling economic activity and expansion. Despite the trillions of euros now being printed and pumped into the Eurozone a continuation of this failure to lend will effectively strangle economic renaissance at birth.

The signal of a return to economic reality will be the next increase in interest rates. Global leadership for that will come, as ever, from the USA. It is possible that the Federal Reserve will make that decision to raise rates at its next meeting on April 29 and we have that event strongly on our watch-list.

Having started 2015 at a reading of 6566, the FTSE 100 closed the month of January at 6749, up + 2.79% for the year to date. By comparison the Quotidian Fund finished January at + 5.55% for the month and, consequently, also for 2015 to date. Our investment performance therefore continues to remain well ahead of the market.

Whilst this is very cheering news it would be remiss of me not to emphasize the rather obvious fact that a 5.55% profit in one month is not normal and is certainly unlikely to be repeated on a regular basis! Whilst that level of return indeed owes much to our stock and sector selection it is also buoyed by the short-term exaggerated effect of the ECB stimulus.

To conclude with our view of the near-term future:

The expected outcome of the Greek election result saw the installation of a coalition government led by an extreme left-wing party (hand in glove, quaintly, with an extreme right wing party). This result had been entirely expected and had already been priced into global equity markets. No doubt, however, the Greek stockmarket will be subjected to a severe negative reaction.

The new Greek government is focussed on ending austerity measures in that country and, as part of that process, reneging on repayment of the substantial loans made by the ECB the keep their country afloat some two years ago. This action would threaten the fundamental fabric of the Eurozone and, indeed, the construct and continued existence of the Euro itself.

Whilst a great deal of the invective from Greece in the immediate aftermath of the election is tinged with political bluff, it does present the EU with a catch 22 situation.

If a deal is done with the Greeks in order to save the Euro it will only open the door for Spain, Italy, Portugal and any other of the Eurozone countries overburdened with debt to push for the same relaxation of Euro ‘rules’. That road would potentially lead to the collapse of the Euro.

If the EU does not arrange a deal then that might well force the Greeks out of the Euro and out of the EU. In that instance Greece would thus become the first domino to fall as the Euro dream collapses and threatens an unravelling of the EU project.

This dichotomy will severely test the resolve of the arch-Federalists who currently run the European Union. After nurturing and protecting the ‘Federal Europe project’ through the past 60 years (and marginalising democracy in order to do so) they will not lightly or easily be blown off course. On past form, no doubt a deal will be cobbled together that will allow Greece to enjoy extended financial headroom whilst continuing to remain a member of this cosy but deeply flawed EU club.

In tangible support of the current feel-good factor pervading equity markets the earnings season for 4th quarter of 2014 is now under way. Excluding the energy sector the figures released so far show that corporate earnings in the USA are reasonably good and are mainly above expectations. There are signs, though, that the increasing and sustained strength of the US Dollar over the past 12 months is having a negative effect on the export sales and profitability of some American industrial manufacturers.

Having said that, the latest results from Apple (a company that seems to attract a great deal of misplaced criticism) released in the last week of January were exceptional. In the last quarter of 2014 they produced profits of $18 billion on substantially increased sales. That is the largest quarterly profit figure ever produced by any company, anywhere.

As indicated earlier, at some point in the not too distant future the Federal Reserve will have no choice but to allow interest rates to begin rising to more historically ‘normal’ levels.

Rates must rise because price inflation is beginning to eat away at the consumer’s ability to pay and that situation will begin to diminish consumer confidence. Demand will therefore begin to fall which will cause the supply side of the economy to become subdued. The resultant downward pressure on corporate profits will affect stock-market valuations and equity prices will fall.

Most pertinently the Federal Reserve must raise rates because, if it does not, bond investors around the world will simply dump their bonds and thus effectively force interest rates to go higher. There is anecdotal evidence to show that bond investors are already disgruntled in the extreme at lending money to governments at the pitiful returns currently on offer.

An old City cliché asserts that “Gentlemen Prefer Bonds”. After nearly 20 years of governmental greed and profligacy the days of borrow (cheaply) and spend (excessively) may be coming to an abrupt end. Gilts investors are understandably peeved at being asked to continue to finance sovereign overspending with what has long become reward free risk.

We are wary of chasing any wildly overextended one-way market moves based on central bank promises that could be rescinded at a moment’s notice. One can predict with reasonable confidence that the Euro will continue to decline in value against the US Dollar and Sterling (and the Swiss Franc).

That will limit the attractiveness of Eurozone equities to us even though their valuations will undoubtedly benefit from the ‘bubble’ effect mentioned above. The cost of hedging the currency risk is likely to outweigh the gain in equity values.

Instead we will continue to focus on individual stocks and sectors that offer distinct value. This is a strategy that is more likely to be effective in an artificially inflated market.

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The main corporate news as January gave way to February concerned Apple’s latest quarterly results. The total of sales that Apple procured from China in that quarter was $16.1 billion which represented a remarkable 157% increase from the previous quarter and a 70% increase compared to a year earlier.

In other words, it was largely thanks to China that Apple reported the largest profit in its history. The most important thing to take from that statistic is that this past quarter marked the first time ever that Apple has risen to the number 1 spot in China’s smartphone market. I can’t overemphasize just how important it is to be number 1 in China.

For years Apple has failed to reach that position and at one point it had dropped down to sixth place for market share – behind Huawei, Lenovo, Samsung, Xiaomi and Yulong. The simple reason was that the Chinese wanted larger screens and with the latest iteration of the i-phone they now have exactly that.

It turned out to be the one spark that has caused sales in China to mushroom upwards and take profit figures with them.

It will also be the key to unlocking even bigger sales in the coming quarters. With an estimated 1.2 billion mobile phones in China, Apple has to date barely scratched the surface of the Chinese smartphone market.

In wider economic news, at a meeting of finance ministers and central bankers from the Group of 20 nations they essentially endorsed the use of currency depreciation as a tool to spark economic growth. That decision will no doubt create more market volatility similar to what we saw after the Swiss National Bank’s actions last month.

On a positive theme, the latest US employment and payrolls report was released on 6th February and was indeed a positive surprise. It showed that the number of new non-farm jobs created in the previous month was a higher than expected figure of 257,000 and that the US unemployment rate continues to fall.

Even better news for US consumers, though, was hidden in the detail of the report and this was the marked increase in take-home pay for the average American. Higher take-home pay equals higher discretionary income which, in turn, equals strong consumer spending thus keeping the US economy on an upward trajectory.

These statistics were mirrored in the UK when exactly the same message emerged from employment and income data released here on 18th February.

On the geo-political front markets have been buoyed in the short-term by the relatively good news from Ukraine/Russia but I believe that the new cease-fire agreement is likely to only be temporary (just like the previous one agreed in Minsk last September).

Mr. Putin constantly shifts between diplomatic and military options depending on which he believes will give Russia the greatest tactical advantage at any given time. He is running rings around the Western leaders; whilst he’s been content to use diplomacy, he has never once taken the military option off the table. The latest Ukrainian cease-fire is little more than one more tactical victory in a well-planned, protracted chess match against the West. We have yet to see the end game.

The FTSE reached its highest level for 15 years on 17th February when it closed at 6989.13. Its all-time record closing point of 6930.2 was achieved on the last working day of 1999 and it is a salutary fact that it has taken so long to re-attain this peak.

This puts into clear focus the travails that have adversely affected global stockmarkets generally and the UK market in particular for much of this century to date. The bursting of the dot-com bubble followed by the long and harrowing global financial depression took a severe toll on equity markets. Economic indicators, led by the USA, suggest that a viable recovery is under way. Needless to say, it will not be one-way traffic and market volatility will continue to create short-term concerns.

At 28th February the FTSE 100 closed at +5.80% for this year to date. By comparison the Quotidian Fund finished February at +12.35% for 2015 to date.

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Markets remain volatile; already in this first quarter the S&P 500 Index has risen or fallen over 1 percent intraday on 17 occasions. By contrast, during 2014 the stock market moved 1 percent or more on only 10 days per quarter.

Every good report on the economy is met by speculation of an imminent move by the Federal Reserve to increase interest rates in the United States. Any hint of a rate increase sends shudders through the markets and propels equities downwards.

Adding fuel to this speculation, the latest US employment report was released on 7th March and was another humdinger. The American economy created 295,000 jobs in February, a figure far above the average prediction for a rise of 235,000. That February number was also up sharply from 239,000 in January.

The unemployment rate sank to 5.5 percent from 5.7 percent and is now at its lowest level since May 2008.

In the immediate aftermath of the release, US gilt yields spiked higher across the board. Conversely, equities were marked quite substantially down on widespread concerns that the Federal Reserve would be prompted to increase interest rates sooner rather than later.

There is no shortage of tricky cross currents for investment managers to navigate at the moment. In our view the best strategy in this situation is to review the portfolio and ensure that we stick with highly-rated stocks in economically beneficial sectors whilst avoiding those vulnerable to interest rate shocks.

The other main influence this month was the latest Federal Reserve meeting on 19th March. The Fed’s dilemma at that meeting was that it has clearly been hitting the target on the growth side of its mandate but it has equally clearly been missing the goal on the inflation side of its mandate. The problem it therefore has to resolve is when to raise interest rates. That situation is further complicated by the recent strength of the dollar which now threatens to dampen additional progress in the US economy. An untimely increase in US interest rates would promote even greater unwanted strength in their currency.

US economic growth is still noteworthy and their job market is in good shape although housing remains in the doldrums. The Fed also dropped its pledge to be “patient” about raising interest rates, a move that opens the door to a rate increase in the foreseeable future.

But the most important thing is that the Fed made a number of veiled hints in relation to the dollar and the side effects of its recent remarkable strength. Specifically, their statement noted that “export growth has weakened”; that “inflation has declined further below the Committee’s longer-run objective” and that the “Committee continues to monitor inflation developments closely.”

In her post-meeting press conference Fed Chairman Janet Yellen commented further on the dollar. She said “we are taking into account international developments” in currencies, and cited the “depressing influence” of the dollar’s rise on inflation as well as exports.

No doubt this is the Fed’s attempt to prepare the market for returning to historically more normal interest rates (because of improved economic and job growth) but simultaneously talk the dollar down (to prevent imported deflation).

Our view currently is that US interest rates are unlikely to increase before June at the earliest and, although it is not a fashionable opinion, that rates may stay on hold for some time beyond that for fear of causing a decline in corporate profits. If we are proved to be wrong then we will, of course, change our opinion.

On 20th March the FTSE reached its highest ever level of 7024 before settling back marginally to close at 7022. Its previous all-time record closing point of 6930.20 was achieved on the last working day of 1999 and it is a salutary fact that it has taken so long to re-attain and exceed this peak. The challenge now will be to sustain this 7000 level, although by the end of March the FTSE had slipped back to a reading of 6773.

Economic indicators, led by the USA, continue to suggest that a viable recovery is under way. However, the global glut of cheap money and its resulting consequence of creating an ever strengthening US dollar is beginning to have a negative effect on American corporate earnings and profitability. If this dollar strength is allowed to continue unchecked then it will result in falling equity valuations. We remain vigilant.

At 31th March the FTSE 100 closed at +3.15% for 2015 to date. By comparison the Quotidian Fund finished March at +13.63% for the same period.

It is fair to say that Quotidian’s performance over the past three years has been excellent and in the first quarter of 2015 it has been exceptional. Of course, it is the intrinsic nature of stockmarkets to see a period of correction after such a prolonged bullish phase and it is therefore unlikely that our pace of growth since 1st January will be sustained throughout the year. We do, though, have a sizeable cushion against the effect of any potential market adjustment.

Having said that, our mandate is global and our strategy is to try to be in the right market sectors and the right companies in those sectors at the right time. Our analysis therefore focusses on finding companies that have:

a long enough history for us to opine with confidence on their financial stability

a long history of share-price reliability and relatively low volatility

a strong focus on research and development in their specialist areas

We will maintain that approach and our vigilance as we seek to navigate the rest of the year.

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First quarter earnings reports were in full swing during April and became the main economic focus of the markets.

The banking sector generally benefitted from stronger capital markets which led them to better than expected earnings and profits.

Lower oil prices and a strong US dollar were cited as the proximate causes of some disappointing numbers in those industries relying on the manufacture of consumer products.

Healthcare, however, remains a promising sector to invest in for stability and growth potential.

In aggregate, S&P 500 profit estimates for the quarter have fallen 8 percent since January 1st. This is the largest decline in earnings expectations since the financial crisis in early 2009

At this rate, S&P 500 earnings are expected to drop nearly 5 percent year-on-year, the first outright decline in quarterly profit growth for American blue-chip stocks since 2012.

So far 85 companies in the S&P 500 have announced negative earnings while just 16 have guided estimates higher. Perhaps more troubling still, top-line sales growth is forecast to fall 3 percent this quarter, putting profit margins under pressure.

But some of the best performing sectors so far this year are still expected to post year-on-year profit growth and we have highlighted Healthcare (with expected profit growth of 10.7 percent) beating all other sectors.

On 29th April the usual official government numbers were released and confirmed that US Gross Domestic Product grew by just 0.2 percent in the 1st quarter. That was much worse than the 1 percent forecast of many respected economists and less than one-tenth the 2.2 percent growth rate in last year’s fourth quarter. Very disappointing.

US exports also declined at a 7.2 percent rate courtesy of the strong dollar. In addition, core inflation slowed to a 0.9 percent annualized rate – the lowest rate in more than four years.

Those figures confirm that, as we’ve stated in earlier reports this year, most of the US first quarter economic woes were caused by two factors: falling energy prices and an unfeasibly strong dollar.

One bright spot in the economic releases was the US Employment report which showed that jobs numbers were much better than expected; in fact they were the best employment figures seen for 15 years and a source of some welcome optimism.

Those factors tend to support our earlier assertion that the Federal Reserve is more likely now to delay the start of gentle interest rate increases until later this year.

Indeed, the strategic message from the Federal Reserve was basically unchanged with the slowdown in US growth attributed to “transitory factors.”

The last week of April was relentlessly negative in global stockmarkets, and particularly those in the USA and the UK. We viewed those declines in both jurisdictions as synthetic. In particular, the last trading day of the month saw our equity holdings marked down by 2.50% across the board; a highly unlikely scenario if this was based on genuine economic factors.

Our stance was supported by the fact that, as I write this report, the first trading day of May has seen all those holdings marked up again, strangely, by 2.50%!

On 30th April the FTSE 100 closed at +6.01% for 2015 to date. By comparison the Quotidian Fund finished March at +14.01% for the same period.

The UK faces a General Election on 7th May and the local market is no doubt positioning itself in the event of an unhelpful result. Opinion polls are notoriously unreliable and, if taken too seriously, can lead to inaccurate conclusions. We believe it is prudent not to act prematurely upon a speculative view of the outcome but to wait until the conclusion is clear. Naturally we will take whatever action we deem to be appropriate as soon as we see the factual evidence.  

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By the end of April 356 companies in the USA (representing 80 percent of the S&P 500 by market capital weighting) had posted first-quarter results. Aggregate profits were better than analyst’s forecasts and so provide a reason for guarded optimism.

Fast-paced profit growth, especially in biotech, keeps pushing health care stocks higher (up 24 percent over the past 12 months) and they lead the field in performance so far this year too, up 5.4 percent.

This is further evidence to support our belief in the importance of being selective and focussing on the stocks and market sectors that are delivering the best results and superior performance.

With the UK General Election now out of the way (and having delivered a market-positive result), concerns have now returned to the issue of sovereign debt generally and Greece in particular.

Greece is now at its tipping point. Its government is desperately trying to stave off default on a 750 million euro repayment to the International Monetary Fund.

Whether or not Greece gets short-term concessions will not really matter because in June it faces another 2.6 billion euro repayment and by July and August it will be required to make a further 8.7 billion euro repayment, 7 billion of which is owed to the European Central Bank.

There is simply no way Greece can pay off that debt; it just does not have the money. Merely in order to make a minor 200 million euro payment early in May the Greek government had to call in all excess cash from its regional banks.

Nor can Greece rollover the debt without paying excessive interest rates and thus bankrupting the country even further.

Greece itself is not solely to blame for this crisis. Yes, it has its black market economy and a grossly inefficient system of tax collection but, sadly, in 2001 Greece was effectively forced to join the euro through dubious financial manipulation devised and sponsored by a foreign investment bank.

It is therefore no surprise that it is now having trouble repaying that debt.

The wider issue is that it’s not just Greece that is about to reach the tipping point. Many other European countries are struggling under the burden of worrying levels of sovereign debt.

Whilst Greece is certainly the worst, Italy isn’t far behind and nor is Portugal.

Greece’s sovereign debt is equivalent to 175% of its Gross Domestic Product (GDP). Italy and Portugal are both indebted to the tune of 130% of GDP. Ireland, Cyprus and Belgium all carry debt in excess of 100% of GDP whilst France and Spain are burdened at a level just short of 100%.

If push came to shove not one of these countries is capable of servicing its debt, not even France.

Europe’s sovereign debt crisis is merely the starting point. This crisis is not confined to Europe and one of the most important aspects of the debt crisis as it unfolds over the next few years will be how it impacts the financial markets.

In our opinion government bond markets are fraught with risk and are heading towards the abyss. In recent years we have often described Gilts/Bonds as reward free risk and our view has not changed.  

However, surprisingly and perhaps perversely, the history of sovereign debt crises indicates that stock markets perform exceptionally well when the public sector, not the private sector, is going bust.

Despite all its detractors and its domestic economic problems, in our view the US stock markets currently represent the safest, deepest and most liquid bastion of capitalism in the world. Quite simply, from a financial perspective the USA’s biggest companies will outlast its government.

On 31st May the FTSE 100 closed at +6.37% for 2015 to date. By comparison the Quotidian Fund at the end of May was +21.69% for the same period.

That is a quite remarkable achievement at this stage of 2015 and positively reflects the strength of our focussed approach to stock selection based on our strategy of aiming to be in the right sectors of the right markets at the right time.

We are obviously aware, though, that markets can make one look very foolish very quickly and so we remain dedicated to the task at hand with the intention of maintaining our pre-eminence over the market index.

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The long-running and somewhat tedious game of poker being played between the Greek government and the financial leaders of the EU dominated market sentiment throughout the month of June and became the proximate cause of equity market volatility towards the end of the month.

The fact that the EU continued to supply substantial liquidity to Greek banks (not just once but on three occasions) in the last week of the month does indicate far more about the likely denouement of this ‘crisis’ than the meanderings of various political leaders.

In our view, the timing of interest rates by the Federal Reserve in the USA has a much more significant effect of the direction of stock-markets over the next year or two. Following the Federal Reserve policy meeting in June we heard confirmation from Janet Yellen that the pace of rate increases would be slow and measured, unlike the mechanical, robotic increases we were familiar with when Greenspan (the man whose financial stewardship of the US economy, in our opinion, caused the financial depression of 2007-2012) was at the helm.

In light of that, stock-market investors may have less to fear from higher rates than has currently been priced in.

Whilst the focus of the market was diverted by these two issues it is easy to overlook a large number of positives:

  • S. tax receipts were up 0.3% year-over-year in May which is remarkable given just 3.0% nominal GDP growth.
  • Despite the problems with Greece, the ECB’s balance sheet increased by 12 billion euros last week and is scheduled to continue to increase at least for the next year. This is part of the expanding global stimulus.
  • Key US data is all trending upwards:
    • Construction spending is up
    • Vehicle production is up
    • Vehicle sales are up
    • Trade is up
    • Unemployment claims are down
    • House prices are up
    • Small business confidence is higher
    • Employment is improving
    • Hourly earnings are improving and the number of U.S. job openings has finally surpassed the previous peak set in 2001.
    • Mortgage applications in the USA increased by 9.7% week-over-week.
    • Many countries are taking measures to spur growth

Evidence of economic growth continues to present itself and provides cause for optimism as a counter balance to the prevailing doom and gloom.

Of course a stock-market pullback is inevitable at some point but we believe that the concerns over Greece have now been overdone.

Generally, a market correction is defined as a decline of 10% or more. That hasn’t happened to the S&P 500 Index since 2011, although the index came close in the summer of 2012 (-9.9%).

We have had a number of pullbacks in the range -5% to -7% or so but it has been over 150 trading days since the S&P last declined by 5% or more, and more than 900 days have passed since the last 10% correction.

Our analysis indicates, though, that it usually takes no more than 56 trading days for the markets to recover from a 10% correction.

On 30th June the FTSE 100 closed at 6520.98 (which is –0.69% for 2015 to date). This represented a decline of 6.64% in the month of June.

By comparison the Quotidian Fund at the end of June was +20.79% for the same period….being a fall of just 0.74% in June.

We remain focused on protecting our gains whilst seeking opportunities to benefit from this period of volatility.

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Mainland China’s Shanghai Index had moved substantially higher in just the 12 month period up to June 2015. An extraordinary gain of 150% was largely made possible by a massive expansion in margin lending, most of it off-the-books (where brokerage accounts can be leveraged up 5-to-1 or more). This, combined with the Chinese penchant for risk-taking (some might call it gambling), led to very considerable over-valuation in many stocks and, of course, of the market itself.

However, and not before time, officials in Beijing finally recognised that stocks were getting overheated and they decided to crack down on margin trading. Since then, shares on the Shanghai stock exchange have plunged about 30%. The China stock market meltdown has accelerated in spite of Beijing reversing course and pulling out all the stops early in July in an attempt to support plummeting share prices.

In the UK, for the past six months many commentators have been predicting a market correction and, given the market’s propensity to allow sentiment to overcome economic reasoning, these predictions often become self-fulfilling. From its peak above 7100 in April the FTSE index had declined to 6400 by 8th July…..a fall of 10% which represents the usual definition of a correction. With their attention drawn to events in Greece and in China, the media do not yet seem to have grasped that fact.

Our historical analysis indicates, though, that it normally takes no more than 56 trading days for markets to recover from a 10% correction. That being so, we have taken short-term advantage of what we see as an oversold UK market.

In America, the Federal Reserve has continued to lay the groundwork for increasing interest rates. The Fed chairman, Janet Yellen, suggested in her July post-meeting summary that the first increase in interest rates would likely come in September. As ever, a few days later a similar announcement was made here in relation to UK interest rates. Unlike the apparent delight in obfuscation and the delivery of surprises which was the hallmark of previous Federal Reserve regimes, this increase (when it comes) has been so well signalled that it shouldn’t cause a real or lasting problem to stock-markets.

Finally, the second quarter earnings reporting season is upon us and is bound to be full of surprises in the weeks ahead. Largely as a consequence of a strong US dollar in the early part of this year it will be a close call on whether or not we see much growth in US corporate profits overall. With that in mind we continue to be ultra-selective in the assets we choose to form the current Quotidian portfolio. Our aim remains to seek the optimum balance between risk management and the achievement of above average investment returns.

On 31st July the FTSE 100 closed at 6696 (which equates to +1.98% for 2015 to date). It represents an increase of 2.69% in the month of July.

By comparison the Quotidian Fund at the end of July was +24.69% for the same period….being an increase of just over 4.00% in July.

In the third week of July alone the FTSE100 dropped by 3% following a negative report from China in respect of that country’s manufacturing output. These numbers caused global commodity prices to decline even further and, as the main UK market index is heavily biased towards energy stocks, miners and metals it took the brunt of the decline.

However, figures from China are notoriously unreliable. In the previous week a set of very encouraging GDP numbers from that country had created a positive reaction in the FTSE100. As ever, the market over-reacts positively to one piece of good news and then over-compensates in the opposite direction to one piece of negative data. And all this from figures that are historically unreliable and will in due course, no doubt, be quietly adjusted.

As stated earlier, we have taken advantage of what we interpret as an oversold market in the UK. If we prove to be wrong in that assessment then we will change our view and our investment positions.

In the US market the overall price/earnings ratio is currently above average at x18.5 but it’s still a long way off the pre-crash P/E ratio of x29. In our view, for the moment there is still profit to be made in equities generally and US equities in particular.

The Quotidian Fund is currently in a position of considerable strength and we remain focused on protecting our gains whilst seeking opportunities to benefit from this period of volatility.

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So much for the lazy, hazy days of summer. As you will have seen, extreme volatility and fear bordering on panic returned to haunt global stock-markets from mid-month onwards and kept us glued to our screens.

Rather than rehearse much of the detail with which you will already be familiar, let me precis the salient points which led to stock-market conditions last seen at the height of the global financial depression in 2009-2010.

On Tuesday 11th August China wrong-footed financial markets by suddenly devaluing its currency, the yuan, by nearly 2%. That may not sound like a lot but it was their biggest downward currency move in two decades.

Superficially, China’s motivation for doing this was to make their exports more competitive in foreign markets and, on the other side of that same coin, to make imports into China more expensive.

This move caught equity markets completely off-guard and was interpreted as a desperate attempt to jump-start China’s sagging economic growth. Currency markets immediately marked the yuan down by yet another 2%. According to market analysts, though, it would take a much larger depreciation in the yuan to significantly boost exports. It is estimated that a 10% drop in the currency’s value would be needed to fully restore China’s export growth.

At a more profound level, this devaluation was in keeping with Beijing’s long-term goal of opening up its financial markets and being more flexible with exchange rates. The US and the International Monetary Fund have insisted on this more open approach as a prerequisite for the yuan to be more widely used in global commerce.

The risk in the move they have made is that a sliding Chinese currency could trigger massive money flows out of China in exactly the same way as we’ve seen with capital flight from other troubled parts of the world over the past two years. Of course, this would then deal another blow to China’s already struggling stock-market.

Whilst one might view the actions in Beijing as being entirely self-interested and self-serving it is difficult to be too critical or proscriptive. China has simply followed a well-travelled road. Quantitative easing, currency manipulation and protectionism have been hallmarks of US policy for many years and indeed of the UK and major European countries too. Likewise, China’s neighbours and biggest trading partners (Taiwan, South Korea, Malaysia, Singapore and others) have for years been depreciating their own currencies at China’s expense.

It may be over-generous but it is tempting to interpret Beijing’s actions as being more naïve than devious as the old guard gives way to the new and China slowly mutates from a command-controlled communist style economy towards a more capitalist free-enterprise system.

According to Bloomberg, dollar borrowing in China has expanded five-fold since 2008 as Chinese companies and also individual equity investors have taken on billions in dollar and euro denominated debt in order to leverage their investments. The costs of servicing that debt were substantially increased by the yuan devaluation and this is likely to have contributed to the stock-market sell-off which began on 12th August and continued to then escalate around the world.

Factors which exacerbated the gyrations and general decline in equity prices include the forced exit of investors from over-leveraged positions, computer-based trading, low trading volumes and therefore low market liquidity, market makers cynically widening spreads and emotional investors being dislocated.

The financial media is not blameless. Too often they seem to prefer to manufacture ‘crises’ and then fan the flames of fear by using extremely emotive language to ultimately generate panic. Good news does not sell newspapers nor television advertising space. Sadly, creating and promoting bad news is a self-fulfilling process that helps only to exacerbate ugly days in the market

The breadth, depth and speed of intraday market action over 10 consecutive trading days was extraordinary. Ten successive days of relentless downward pricing culminated in a very steep markdown on 24th August by which time all major equity markets had fallen beyond the level usually accepted as being a correction. Even the razor-sharp minds and professional Cassandras inhabiting much of the fourth estate have cottoned on to the fact that their long-touted and heralded global market correction has now actually taken place.

On 31st August the FTSE 100 closed at 6248 (which equates to -4.85% for 2015 to date). This represents a decline of 6.70% in the month of August.

By comparison the Quotidian Fund at the end of August was +14.82% for the year to date….being a decline of 7.82% in August. Despite the downward revaluation in the month, we remain strongly in positive territory for 2015 and 19.67% ahead of the FTSE100 index.

As long term readers will already know, our research indicates that it normally takes no longer than 54 trading days for markets to regain the ground temporarily yielded through a market correction.

To further support this assertion the CBOE Volatility Index (VIX) is an objective measure of stock market fear. On 20 August, volatility as measured by the VIX index was still well below several of the panic-striken peaks seen in previous crises. However, the extreme VIX frenzy on 24th August (at one stage it spiked to a reading of 90) was the highest recorded in the past six years. Historically, over the past 30 years whenever the VIX has spiked sharply higher (and above a reading of 50) it has almost always been at, or very near, a stock market bottom.

We believe this to be a reliable signal that stocks are grossly oversold and we expect a strong rally in the weeks and months ahead (although, no doubt, there will be further bumps along the way).

The most important economic and potentially market-moving news in September will be the Federal Reserve’s decision on US interest rates at their mid-month meeting. They have signalled their intention to increase rates for the first time since 2006 and it will now be very interesting to see the effect of August’s extreme stock-market volatility on the Fed’s decision making process and timing.

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Italy is facing its greatest financial crisis in the post-war era. The country’s banking system is bankrupt and no one in Europe seems willing (or able) to fix it. Since 2009 Italian bad debts have multiplied from less than 3% of total loans to more than 18% today. As a result, many Italian banks have far more bad debts than they have capital to back them up.

To put that into better focus, banking regulators generally begin to worry when banks’ non-performing loans reach 5% of the bank’s assets. In Spain, for example, during the height of their housing bubble burst in 2010 (when the whole country appeared bankrupt) non-performing loans never went much above 10%.

In Italy today the total value of non-performing loans is an unprecedented 18% of assets. Italy now has the biggest concentration of weak large banks in the world; nine institutions in all. Moreover, five of Italy’s nine weakest global banks are megabanks, each with over $100 billion in assets:

  • Unione di Banche Italiane, with $132.8 billion in assets;
  • Banco Popolare SC, with $139 billion;
  • Banca Monte del Paschi di Siena (the oldest bank in the world), with $197.6 billion;
  • Intesa Sanpaolo, with $796.9 billion; and
  • the largest of all, UniCredit SpA, with over $1 trillion.
In theory, the solution to any banking crisis is essentially straightforward: You bankrupt the shareholders and the bondholders and then you recapitalize the banks. According to most estimates, Italy would need about $40 billion to get the job done; a large but still manageable number.

There is, however, one very nasty glitch to this ‘simple’ plan. In Italy, the bonds of these banks are not owned by institutions but by very many small retail investors. According to Bank of America Merrill Lynch, small investors own 235.6 billion euros of bank bonds and the banks do not want to panic them (with all the civil unrest and social deprivation that would bring in its wake).

To make matters worse, Italy also has more public debt than any other EU member except Greece whilst having an economy that is nine times larger than that of Greece. In a full-blown banking crisis, not only would Rome be hard pressed to come to the rescue but Brussels and the EU would have a tough time saving Rome.

So we find ourselves in a standoff. German Chancellor Angela Merkel (and even the Italian-born head of the European Central Bank, Mario Draghi) refuse to budge on this issue and will not bail out the Italian retail bondholders. Italy’s technocratic Prime Minister Matteo Renzi (put in place by the EU itself) is desperately trying to reason with them but, thus far, the talks are at a standstill. If Italy is forced to do a “bail-in” (which is banker’s terminology for bankrupting the bondholders) then the political and social backlash could tear Europe apart.

Italy already faces a very strong independence movement in the Five Star party and it has been winning local elections at a rampant rate. If Merkel and Draghi force Renzi to effectively wipe out 15% of the country’s wealth as a result of bank recapitalization then the backlash will be huge.

Italy is the third-largest economy in the Eurozone and if it goes then the eurozone will probably crumble soon thereafter. If the all the parties concerned can’t come to a practical agreement soon then the situation will go from bad to worse. The euro will come under increasing pressure and the political crisis in Italy along with the collapse of their banking system will most probably result in Italy leaving the EU. The EU will then collapse.

The EU project in its current form and with its deliberately anti-democratic aim of creating a Federal Europe will ultimately be a failure of epic proportion and we predict its demise by 2021. Perhaps then (if not before) we can return to the original concept of a pan-European free trade area without all the federal baggage. For those who still harbour lingering doubts about the very positive benefits of Brexit, the Italian crisis and its likely denouement would strongly suggest that the UK has dodged a bullet.