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Quotidian Investments Monthly Commentary – February 2016

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March 4, 2016

The first two weeks of February saw an even further worsening of the decline in equity valuations that has bedevilled global stock-markets since the first trading day of the New Year. Fear-motivated panic, stoked by those who have a vested interest in creating volatility, reached a crescendo by the end of the second week of this month at which point the FTSE100 index sank to a reading of 5499.

As the usual Cassandras who issue them know full well, the trouble with doom-laden statements is that they have a nasty habit of becoming self-fulfilling. It is food for thought that in the spring of last year Footsie had risen to its apogee of just over 7200; February’s low-point represented a fall of 25% on the main UK market index from its all-time peak last April.

Despite the continuing negativity and volatility in financial markets profitable business is still alive and well in many parts of the world. There is no rhyme or reason behind the extreme gyrations that still prevail across the board in equity valuations.

  • I particularly want to expand on the views expressed in my January report as to the market’s direction and the reasons behind it……..and to reassert that I do believe these bear market conditions are, to a large degree, synthetic and will have reversed by the end of May.
  • For the time being, though, you will have seen that the madness still persists and the reason I describe this markdown as artificial is drawn, inter alia, from the market’s reaction to the fourth quarter results now being issued in the US and the UK (our two main areas of investment).  Of our individual company holdings, thus far in this results season 11 of them have now reported.
  • Of those, 3 (Manhattan, Gilead and Biogen) have produced brilliant figures, well ahead of market expectations.  Another 6 (Electronic Arts, BioMarin, Celgene, Apple, Alexion and Starbucks) have produced figures that equal or beat expectations by a little way…….and only 2 (Amazon and Regeneron) have produced disappointing numbers.
  • Despite that, all of these shares have been savaged in the current market negativity.  The point is that demonstrably these are real companies making tremendous real profits in the real world……yet the market is determined to mark everything down on the back (apparently) of falling oil prices!  
  • As I say, it is transient and actually presents a great investment opportunity for investors to increase their exposure to carefully selected equities at a very low ebb in global markets.  It may continue to get worse before it gets better but I still see May as being the most likely time of a return to more positive conditions.
  • The Healthcare (Pharmaceuticals & Biotech) sector has been particularly badly marked down although actual corporate performance has continued to be robust.  At some point in the relatively near future that reality will return to valuations.

The economic situation in the USA is a template for the global economy.

In February, Janet Yellen (Chairman of the Federal Reserve) appeared before the US congress to testify on the state of the US economy, its monetary policy and associated financial issues germane to the equity markets. To summarise her major points:

  • The US employment market continues to strengthen. Labour market data shows persistent jobs and wages growth and growing confidence. In her testimony on 10th February Yellen cited the 2.7 million increase in payrolls last year and the 13 million in cumulative jobs added since 2010. She also emphasised that unemployment was now running at a rate of only 4.9% and that there were “noticeable declines” in underemployed and ‘discouraged’ workers.
  • Economic growth is good but not yet great — Yellen noted “moderate expansion” in GDP, emphasising household spending in general and housing and auto sector growth in particular. But she also acknowledged that “subdued foreign growth and the appreciation of the dollar” were holding things back and she noted weak activity in the energy sector.
  • The Fed chairman highlighted declining stock prices, rising borrowing costs and a rising US dollar saying that they “could weigh on the outlook for economic activity.” She also made reference to the risks associated with China’s economic slowdown and weaknesses in commodity-linked economies.
  • At the same time, though, she blunted those concerns by saying that “ongoing employment gains and faster wage growth” should help the US economy. She also said that “highly accommodative monetary policies abroad” would be likely to boost global economic growth. In other words she basically said the Federal Reserve would not be by forced by plunging equity markets into a change of course to cutting US interest rates nor launching another round of Quantitative Easing.

After the truly dreadful second week of February, equity markets have since reacted positively to Yellen’s testimony.

Elsewhere in the world:

  1. China’s economy is struggling through a transition from being an export-led manufacturing-intensive economy to being more reliant on domestic consumption.

By some measures China is already succeeding on the economic front, in spite of its fractured stock market.

True, China’s industrial sector is going from bad to worse with the Manufacturing PMI contracting steadily. But at the same time, China’s service sector (including financial services, retail, travel and leisure, health care and education) is thriving; more than making up for the slowdown in factory output.

The reality of that is supported in these figures:

  • China’s retail sales hit a record high of $4.2 trillion in 2015, and sales are expected to top $6.5 trillion within the next 5 years; a 50% growth rate.
  • Domestic passenger rail traffic is up 10% over the past year, and Internet traffic more than doubled last year alone.
  • Last year, and for the first time, China’s middle class (at 109 million consumers) exceeded America’s middle class (at 92 million).   

And that is the reason why the service sector of China’s economy is growing so rapidly; a thriving and upwardly mobile middle class. An annual GDP growth rate of 6% plus is far from shabby. The USA and Europe can only wish that they should have such growth “problems”.

At the moment that is not reflected by their stock market. However, China’s stock-market tends to be a trailing indicator of the economic situation whereas in the West we are more used to stock-markets being leading indicators of economic development.  Time alone will bring the Chinese market into line with what we clearly identify above as positive trends for their economy.

  1. Cyclical problems will fade; structural ones will not. The elephant in the room in respect of equity valuations remains that of huge and ever-increasing sovereign debt in so many countries around the world. Strangely, national politicians and world leaders seem somewhat reluctant to draw attention to their own profligacy and apparent inability (or unwillingness) to reign back government spending and reduce sovereign indebtedness.
  1. The attraction of German equities and why:

Germany’s debts are equivalent to just 71% of their GDP which is much more manageable than that of most countries. In comparison, the UK’s indebtedness now stands at 87% of GDP and the average for the Eurozone is 93%. There are many examples of countries where debt is well over 100% of GDP.

Household debt in Germany stands at 83% of GDP whereas in the UK the equivalent figure is 125%. Thus the German consumer has more discretionary income to spend and, in so doing, will boost the local economy.

Germany has a particularly low birth rate and a shrinking population. This might explain their enthusiasm to take in a substantial number of refugees from the Middle East and Africa. In the long term that will most likely be of great benefit to their economy.

The Eurozone’s monetary policy has to cater for the less well managed economies of southern Europe (Greece, Italy, Spain, Portugal and others) and as a result is currently too loose and likely to remain so. This will benefit the value of assets in Germany (shares and property).

  1. The USA’s Nasdaq market has been hammered in the first two months of 2016.

After being the best performing global market for the past three years it has been virtually unwatchable this year and currently stands down -17.50% from its December 2015 high.

We don’t think that that blood-letting has been a fair reflection of economic reality. After years of relatively smooth upward momentum the Nasdaq was due for a typical correction but the speed and depth of its recent downturn defies common-sense.

However, we note and are reassured by the fact that when this kind of severe pullback has occurred in the past there has usually been a pause for breath over the following few weeks before the long-term uptrend has resumed. We anticipate the same response to this recent short-term downward pressure.

On 29th February the FTSE 100 closed at 6097 (a fall of -2.33% for the 2016 year thus far); little changed from the end of January although having suffered significant falls mid-month.  

By comparison the Quotidian Fund’s valuation at the end of February is down by – 21.32% for the year to date; only a slight decline since January in spite of the mid-month market collapse.

Falling oil prices and a supposed slowdown in China are simply diversions intended to take attention away from the fundamental truth of sovereign financial mismanagement.

Supporting evidence for this assertion comes in the performance of the Chinese stock-market and its supposed effect on global markets. We were asked to believe that the decline of 7% in China’s equity market on the first trading day of this year was the proximate cause of the huge and sustained falls in global equity markets that then followed. It is interesting to note that on 25th February the Chinese stock-market again fell by 7%; however, the reaction this time was that equity markets around the world rose by 2% or more! So much for the New Year fairy story.

Politicians worldwide have proved adept at kicking the sovereign debt problem into the long grass or introducing measures to postpone the necessary action and simply knocking it further down the road. However, as I asserted in January’s report, until governments find the political will to control their spending and begin the process of reducing their national debts then we will continue to experience short term periods of volatility in financial markets. Far be it from me to sound cynical but one sometimes wonders if many our global political leaders actually do know their ACAS from their NALGO.

Our relatively recent experience of Gordon Brown’s inept mismanagement of the UK’s Treasury provides vivid proof that the socialist ideology of spending one’s way out of debt has been entirely discredited. The UK is still dealing with the financial consequences of his many failings.

Sadly, Europe is still dominated by similar left-wing ‘thinking’ and the less said about the USA under Obama’s insipid and financially incontinent stewardship the better.

Quotidian’s portfolio is focused on quality assets and we remain entirely confident with our current holdings; we also remain resolute and have not been panicked into selling any assets as this downturn has persisted. Thus we have not crystalised a paper markdown into an actual loss.  

Historically, big stock-market falls have been the trigger for a big rebound. When the current bedlam subsides we are confident that our asset holdings will return to realistic valuations.

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