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Quotidian Investments Monthly Commentary – January 2015

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February 7, 2015
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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