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New article from Tatton Investment Management: Hot air for a hot summer?

27 July 2018

Lothar is on holiday – Jim Kean, Head of Investment, writes from New York:

The summer holidays are underway and the silly season (that period where newspaper editors are away and the interns and apprentices are in charge but only allowed to write about pets and the weather) begins next week.

This summer they may not be allowed to talk about the weather, since this time it is a serious story. The horror in Greece, and the floods and heatwave in Japan underline the effects that climate change is having. Rising global temperatures were over shadowed by trade discussions, but let's not forget the other Trump policy: the withdrawal from the Paris Climate Accord announced in November last year. Trump said then that the US would return on a basis that was “fair”. I’m writing this in New York City and can say, after watching an empty docked New Jersey Ferry spend 15 minutes with its engines on half-power forward trying to push Manhattan Island into the Atlantic, the US has some way to go in reducing its addiction to heavy machines.

At some point, this aspect of world policy will become very important to the trade issue. I was struck by the outcome of the Juncker-Trump meeting in which it appeared that suddenly there might be the equivalent of a US-Europe free trade area after the weeks of escalating friction. To bolster soy bean farmers affected by Trump’s China trade war, Trump ‘trumped’ that the EU will buy US soy beans. This is extremely unlikely since the EU doesn’t buy GM food. Indeed, British hopes that Europe would accept the relatively minor modification, one of gene “exclusion” has been dashed. Hot air it appears from the President.

Trump may be a more complicated animal than he appears, but he has shown his colours already in respect of climate change; he thinks that the world is using it as a means of gaining economic advantage over the US. He may win deals which make simple tariffs more equitable. But with the effects of climate change becoming ever more frequent, Trump may find that trade will still not as “fair” as he thinks it should be.

Back to markets and the potential hot air of corporate earnings. The earnings season shifted into another gear this week, again with the focus solidly on the US and on the FAANGs. The western world has become besotted with these global companies, not surprisingly since they comprise so much of the delivery framework for the services and goods which we consume. Netflix disappointed the previous week so we waited for news of Facebook, Amazon and Google (Alphabet as it now styles itself, rather mystifyingly). Without going into detail, Amazon and Google had really good figures, Facebook not so much. It wasn’t horrible but the company indicated that growth was high but decelerating, and spending would reduce profits next year. It may have mishandled the results conference call with analysts but, even then, the subsequent 20% fall in its share price was the thing of investor nightmares. By value, it was the largest single drop in a day ever - $119.1bn. The chart below, sourced from Bloomberg, shows the FAANGs indexed to a year ago, on a log basis.

It’s noticeable that they are individually becoming more dispersed and more volatile. At one level, the increase in dispersion is a good thing – diversification offsets the volatility. At another level, it suggests that the earnings “growth” driver is less apparent. The stocks have driven the phenomenal outperformance of the NASDAQ 100 but individually are losing leadership.

Now it may be that Facebook hit a liquidity air-pocket after its results, a little like the February fall in the NASDAQ, and the stock could be pretty resilient in the near future, now that it has got more bad news out of the way. However, some of the shine may have come off the group for speculators. John Authers wrote in the FT on Thursday, quoting another old favourite of ours, Jim Paulsen of the Leuthold Group. Jim points out similarities between the price chart for tech stocks into the millennium, and the FAANGs.

He is at pains to point out that valuations were massively more ridiculous in 2000 than they are for these current winners, and we would agree. The price action suggests that these stocks may be in a mini-bubble. Investors are always rational, as a group, about the consequences of “knowledge”, but rising prices tend to make investors ‘forecasts look more like fact than conjecture. It’s easy to think that price gains “confirm” one’s beliefs.

In terms of our investment position, we moved some weighting out of Asia into US stocks a few months ago, but earlier this month made the decision to begin reducing techs and smaller-cap US in favour of a more neutral weighting to the UK. In general, we’re a bit cautious on equities, with most of that centred on the US and Asia, especially in the emerging markets.

Below, we have a follow-up on the China article last week. Chinese authorities have stepped up action to counter the slowdown, but we think it will still get worse before it gets better. At the heart of the problems is a bad credit story; some companies are not saveable, and that includes some rather important ones linked to state-owned enterprises. The actions are designed to keep liquidity available in the system and to ensure spending continues while problem companies go to the wall. However, they’re not even part way through the process, and the most obvious policy of currency devaluation is not available. Chinese stocks rose slightly on the week but ended on a weak note, while other Asian markets were stronger.

We also look at Japan. The parallels with Europe abound, especially in relation to the extended monetary policy tools. And, like Europe, the central bank is having to consider whether its effects on the yield curve may be actually a detriment to growth rather than a support. We think they tested the water this week, may do so again quite soon, and that the consequence could hit US bonds.

We also take a brief look at the impacts of Trump’s policies on US auto-makers, employers of a lot of his supporters. Maybe the companies’ results had something to do with the outcome of the Juncker meeting. It might rain this weekend, but that’s not going to turn off the hot air just yet.

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