GHOSTS OF JAPAN · by globalisation, the poison quickly spread, causing the heart of the financial system, intra-bank lending, to briefly stop. ... A person who has survived a heart

GHOSTS OF JAPANQUARTERLY ECONOMIC OUTLOOK Q4 2019

Contents

01 Foreword 1

02 Ghosts of Japan 2

03 Asset allocation 13

04 Economies and markets 15

Global 16

UK 17

US 18

EU 19

EM and Japan 20

1

Equity markets across the world ended the quarter broadly where they began having recovered from a slight loss of confidence during August. This stability came despite no improvement in economic data, and a further fall in government bond yields signalling a cautious economic outlook. In a similar vein Gold continued to rally as other safe haven assets became prohibitively expensive. Leading economic indicators, particularly in the manufacturing sector, gave no reason for optimism with the evidence suggesting that companies were completing backlogs with lower expectations of new business. This is particularly the case for export led economies, notably Germany, with trade figures still depressed as the dispute between the US and China shows no signs of being resolved, in addition to the Chinese economy being in a structural slowdown.

Supportive of equity markets was the continued loose monetary policy with both the European Central Bank and the US Federal Reserve cutting interest rates as expected. There is though now a general acceptance that such moves whilst benefitting financial markets are ineffective at driving a revival in the real economy. Years of cheap credit have not ignited capital investment, so why should a further small cut do the trick now? Attention therefore has turned to fiscal policy, and whether a more direct injection of stimulus in economies might be more catalytic for growth. New Chancellor Sajid Javid announced a spending package which is expected to breach fiscal rules, although this could be seen as more of an electioneering move than an economic policy.

More significantly the German finance minister hinted at Berlin being willing to loosen its purse strings in the face of an expected technical recession in Germany. For Sterling based investors the possible path of the Pound continues to be the largest short term determinant of returns as markets struggle to divine the likely path of Brexit. Constitutional crises might make for good news headlines, but they do little to shed light on whether the UK will leave the EU with or without a deal. Our Investment Committee agreed to maintain our cautious stance reflected by our neutral position in equities and overweight position in gold and cash. Given the many possible outcomes in the Brexit debacle and the corresponding volatility in Sterling we decided to maintain our partial currency hedging position in our overseas equity holdings.

01 Foreword

DAVID BAKER

Chief Investment Officer Mazars Wealth Management

2

Growth has been consistently slowing across the globe. In the past two issues, we dealt with the impact of China’s slowdown, as the world’s marginal buyer goes through the necessary pains of transformation and the impact of elongated cycles on growth. In this outlook we will take a look at the factor we think is weighing heavy on output and productivity: debt.

Karl Marx once famously predicted that “capitalism will eventually collapse under its own weight”. He was –almost- correct. However, it is not monopolies which threaten the system, as he had originally thought, but rather its propensity to create too much debt. The question we are faced with is: has debt finally reached growth-crashing levels, perpetually pushing rates down, to the point where deflation becomes a secular threat? In other words, has the global economy become “Japanised”?

Debt in and of itself is not bad. Credit is the lifeblood of the economy, especially if the borrowed funds are directed towards endeavours that lead to further growth. Debt frees up capital not being used and puts it to work. The only stipulation is that the original capital stays safe.

However, debt has certain thresholds beyond which the interest payments can pose a great threat on growth itself. For companies, that level is idiosyncratic and has to do with individual growth levels. For countries, where growth often tends to correlate, Carmen Reinhart and Kenneth Rogoff (“Growth in a Time of Debt”) set a broad sovereign debt level at 70%-90% to GDP, before debt becomes a threat to growth. For Euro countries (which cannot print money individually) the level is closer to 50%-70%, and for emerging markets the common wisdom says it is closer 50%. Of course, other factors also play a role. The average cost of debt, who owns it (internal or external), whether it is in a soft or a hard currency (“can we print money to inflate it away?”) and of course whether growth can make a comeback and help authorities pay off their debt. Internal idiosyncrasies and attitudes towards debt can also have an impact. In many western democracies a deficit is a good thing, as it helps prop up social services –and thereby votes. In some countries, however, debt is frowned upon. Characteristically, in Germany, the word for debt is “Schuld”, the same word as “Guilt”.

02 Ghosts of Japan

Chart source: Mazars Calculations, OECD

Global Growth Slowing

Japan led the way in low rates

3

Conversely, in the UK, a “Gilt”, or government debt, was a piece of paper with a gold (gilded) edge, to make it more attractive.

In the western hemisphere, the steep post-WWII growth, one based on a technological and diplomatic advantage, was eventually supplanted by debt-fuelled growth as the economies turned more towards the service sector. Before the Global Financial Crisis, total debt stood at $172tr. Now it stands at $246tr. Total global debt-to-GDP was 225% in 1999 and has increased by 94% (!) to 319% in 2019. The question we are now faced with is, “is too much debt itself slowing growth”?

The answer is not easy: In the last few years, growth, yields and inflation have been stubbornly low, despite the large amount of money printed by central banks. In 2017, eight years after Lehman’s demise, growth finally seemed to have become self-sustainable. Trade was picking up, output growth rate was accelerating and central banks were getting ready to roll back ultra-accommodative policies. Alas, hopes were short-lived and the whole “green shoot” was really optimism fuelled by Mr. Trump’s impending tax cuts. Once the much-expected manoeuvre was completed, it proved nothing more than a pro-cyclical economic stimulation, with very little long term effect. In the process, dollar repatriation hurt emerging markets and some parts of Europe, and exacerbated the Chinese slowdown. Two years later, central banks are back into interest-rate cutting and money-printing mode and growth is slowing.

In a world overwhelmed with debt, the situation is problematic. We are not growing fast enough to render debt inconsequential, nor are we able to stoke inflation and diminish the real cost of our debt. Conversely, central banks are forced to keep interest rates low, lest they risk exacerbating the cost of debt servicing, a practice called financial repression. Meanwhile, capital is being misallocated and driven away from worthwhile projects into financial assets sponsored by policy makers to make sure investors don’t shy away from taking risks.

Despite precipitously high levels of debt and low growth rates, only a few countries feature growth lower than their cost of debt. In the process, they are hurting savers, retirees, pension funds and all those who rely on fixed income payments for a cash flow.


Global Debt Increasing

G 20 Growth revised lower

02 Ghosts of Japan (continued)

4


Discussion over “helicopter money” (essentially zero-coupon perpetual bonds, supported by central bank buying) is running rampant, as a cure against low growth and potential deflation.

This problem is not a first in human history. In fact, Japan, an economic super-power in the 1980s, has been suffering from this conundrum for over 30 years. What was once a paradigm to avoid, “Japanification”, now more and more looks like a permanent state for the global economy. From this vortex, not even China, the growth powerhouse of the last two decades, seems able to escape.

A short history of debt

To understand where we are going, we must, always, understand the origins of the issue. Our debt binge has roots stretching back 50 years. In the early 70s, faced with intense budget pressures, the US broke with the gold standard, the pegging of global currencies to gold, and the world turned to “fiat currencies”. The Modern Monetary Theory was born, which posited that in this new world, debt was not an issue. Any one country could issue as much debt as it saw fit, and it was up to the markets to punish it on a currency level or not. What followed were 15 years of economic malaise, rampant inflation, recessions and record-gold prices. Then, in the early 90’s, US banks eventually managed to break free from the shackles of the Glass-Steagall legislation, which had limited their lending. Their global peers could not help but follow. Wealth could now be created freely out of thin air. As China was growing to be the global purveyor of cheap goods, inflationary pressures abated. New financial instruments allowed risk to spread out, and even hide. In 2008, some of that debt eventually became too toxic and through very fast transfusion mechanisms enabled by globalisation, the poison quickly spread, causing the heart of the financial system, intra-bank lending, to briefly stop.

In the days following Lehman’s collapse, the global financial system all but broke, taking the economy down with it. Consumers, investors, business owners and executives alike collectively and simultaneously lost faith in the market’s ability to effectively allocate assets and ran for safety wherever it could be found.


Inflation trends lower

Global debt levels trend higher

5

In “Main Street” projects were cancelled, companies sold, and jobs were cut across the board, whilst in “Wall Street” one after another of the banks fell victim to the Global Financial Crisis, an event so important that now owns its own acronym (GFC).

It took the Federal Reserve, the owner of the world’s reserve currency, the US Dollar, and de facto central bank to the globe, an arduous 6-9 month campaign and trillions of Dollars printed, let alone in extended credit, to restore balance to the system.

A person who has survived a heart attack is almost certain to change habits, and that is what happened in the aftermath of the crisis.

The global stance against risk was never the same again. Eventually people became convinced not to withdraw their money from banks, they increased their savings and paid down some of their debts, as the traumatic experience suggested that there are merits to thrifty behaviour. Meanwhile, investors and business stakeholders were happy to take the almost “free money” offered by central banks, but became very sceptical about investing in big projects which had a chance of failure. After all, the next crisis might have been lurking around the corner. In the years that followed, capital spending remained subdued, as companies preferred to pay earnings back to their shareholders, rather than invest. Credit became just a quick and cheap way to finance shareholders, instead of expanding operations. Rather than paying out big dividends, CEOs also preferred buy backs of their own shares, effectively reducing the supply of equity.

Nations, however, generally do not have the same stance for debt as companies. For sovereign governments, debt has but one function: to finance their budget deficit, as most of the west are not running surpluses. One can only hope that the extra money borrowed each year go to projects that would increase output, thus making credit worth it. But as Milton Friedman would argue, governments seldom exercise good judgment in spending taxpayer money.


Share buybacks instead of investment


6

The more reliant on public vote the regime, the more sensitive it is to social financing, and thereby the more prone to running primary deficits. Despite being woefully reminded by the case of Greece that government spending has limits -and indeed many Eurozone countries entered an austerity regime- a lot of governments found no other way to expand, other than incurring more debt. This was especially true in the case of China, where the transition from manufacturing to consumption was certain to slow growth. The government decided that debt should make up the shortfall, so that the world did not lose faith in China’s ability to lead the global economy early in the 21st century. Meanwhile, western central banks, certain in their own ability to print enough money to keep the economy going and finance their countries debts, absorbed private sector debts onto themselves.

The conundrum

We are now in a condition where risks have been transferred from the consumer, to corporate, government and central bank balance sheets. This is the condition Modern Monetary Theory prepared us for: the ability to run high levels of debt and then print our way out of trouble. The problem is however that no-one was ready for the whole world to have to deal with debt simultaneously. Also, this system leaves some countries more vulnerable. European countries do not, individually, have control over their currency. Some countries, like Turkey, have a lot of debt in other currencies, such as the USD, so devaluation only increases their debt levels. And some others, like Argentina in the past, have pegged their currency to a foreign one, as a way to bestow credibility on it, only to find themselves quickly at the mercy of that currency’s movements and interest rate policies.

Strategies against debt

How will the global debt problem play out? No one knows for certain. But we can make some educated guesses, based on past experiences. As we said, debt in itself is not a problem, it becomes one when growth is not enough to pay for it. As global growth slows, debt becomes more unbearable. This slows growth down further. The problem is now evident even in Japan, where high levels of debt seem to further contribute to the economic slowdown.


Europe feature tighter budgets


Stronger USD does not help EM

7

So we must look at both sides of the fraction: strategies to reduce the numerator (Debt) and strategies to increase the denominator (GDP). To overcome this vicious cycle, governments use a combination of measures, trying to balance those constructive to GDP against those meant to cut expenditure.

GDP constrictive measures

When debt becomes unsustainable, three things need to happen: Expenses need to be reduced, burdens need to be justly shared and, eventually, one has to recognise a debtor’s limits in paying back what is owed. So the first three steps are: Austerity, wealth redistribution and, ultimately, debt forgiveness.

Austerity

Austerity is the simple practice of reducing expenditure. To do so, countries aim for higher primary surpluses, usually by curtailing social security or health services which is their biggest expenditure, and companies aim for a reduction in headcount. Cutting expenditure alone, however, does not help enough. In terms of companies, headcount reduction and synergies make sense and are often rewarded by markets. For most countries, however, democracy and social security go hand in hand. Reducing social security often results in social tensions as the social contract is broken, which see governments toppled and the reform agenda stall.

Income/wealth redistribution

As austerity burdens are imposed, it is very important that they are done so justly. In terms of companies that means executive compensations linked to performance. But in terms of nations it is quite more complicated. There’s both a “real” and a “perceived” need for income redistribution. The real need is that growth should empower the marginal buyers. That means take power from higher income buyers who have a higher propensity to save and give it to those who have a higher propensity to spend. The problem with this approach is that those who have the higher incomes also have a propensity to invest, i.e. make money more productive.


Europe lower deficits


8

Also, because of their importance in the economic structure and the simple truth that capital is flexible (capital controls are very rare) wealth re-distribution efforts often fail, sometimes further helping populist leaders who vow to succeed.

Debt forgiveness

Ultimately, when debt has become too difficult to deal with and burden sharing becomes onerous, the final solution is forgiveness of part of the debt (or elongation to the point that it’s no longer relevant). This is additive to growth for debtors. While it takes an asset off the balance sheet of creditors, this asset (what they are owed) is already a non performing one and thus not additive to growth. Debt forgiveness in a small scale does not need to become growth detractive. On a large scale, however, it is both politically toxic and ultimately destructive for the fixed income market, as investors will have greater fears of haircuts and place higher premiums on bonds.

GDP additive

Money printing

This is where central banks come in. To increase money supply and counter the effects of those measures that are constrictive to growth. By lowering interest rates and proceeding with Quantitative Easing, they balance the losses of debt cuts, lower expenditure or the effects of income and wealth redistribution.

The endgame

As the world is laden with growth, interest rates are set to remain very low, even for a generation. GDP growth needs to stay above nominal yields to effectively pay off debt. That means central banks need to maintain low rates and even negative rates when growth is slowing down.

However, while this solves the default problem, it does not solve the growth problem. Many national economies are now in a position of what we call ‘Secular Stagnation’, i.e. low growth, low rates and low inflation. QE transmission mechanisms generally favour the higher incomes and institutions, but have not effectively helped consumers (so much for trickle-down economics).


Global Debt levels higher in a decade


9

The next solution discussed is “helicopter money”. A government might issue a no-coupon perpetual bond, which the central bank will buy in exchange for money. That money, created out of thin air can be funnelled to consumers in the form of tax -cuts, subsidies and other methods more efficient than QE.

In the process, central banks try to stoke inflation, to inflate the debt away. Since a lot of that debt is institutional (held by a central bank) the inflation effects might be mitigated.

The endgame, however, is reduction of debt levels. Evidence of debt clearance cycles have been evident in ancient Mesopotamia, Egypt, Athens and Judeo-Christian tradition. Currently Japan has been substituting debt for equity in its pension funds, potentially paving the way for some debt cancellation.

The risks

To escape “Japanification”, big risks will have to be taken. Investors should take this into consideration. First and foremost, debt cancellation will have profound risks, for both creditors and the fixed income markets and might lead to bond risk premia going forward.

Before we get there, however, we are risking over-achieving inflation goals and ending up with runaway inflation, which would hurt both current debt holders and the general fixed income markets. Even if inflation is not stoked, currency devaluation is a possibility, which is why investment in gold has risen over the past few years.

The biggest, most pronounced risk is the loss of independence from central banks. Modern Monetary Theory which allows countries to go in debt and central banks to print their way out of it, already undermines the independence of those central banks, by linking their policies to their governments. Debt cancellation and currency devaluation can become competitive, sparking currency wars.

US interest spending to rise



10

Have we also created a bond bubble?

Low growth and aggressively dovish central banks are all positive for bond prices. Despite a recent selloff, $17tr in global bonds continue to trade with a negative yield. The spread between the US 10 Year Treasury rate and the Fed Funds Rate is negative and at the lowest level since the 2008 crisis. Germany is paid to borrow for 30 years and the 10 year Bund is at the lowest level since East Germany re-joined the west. The 10-year yield for Greece, a country below-investment grade and no with control over its currency which would help to pay off its debt, is almost 0.4% lower than the yield on the respective US bond, the only country whose “reserve currency” status allows it to print money with little or no inflationary implications. Recently Greece joined the countries that borrow at a negative yield, i.e. they are paid to borrow.

Meanwhile, borderline investment grade bonds (BBB) have surpassed the $7 trillion mark, suggesting that a lot of companies have been taking advantage of low rates, building up their debt. Unlike countries, most of which can print enough money to pay for their debentures, and who are never really ‘profitable’ enough to pay it off over the longer term (incredibly poorer countries who are forced to curtail spending have higher primary (ex-interest) surpluses), companies are expected to reduce their debt over time, as big debt ratios are usually a red flag for equity investors.

Why are investors flocking into bonds despite low yields? Partly because of the reversion in central bank rhetoric into a more dovish territory, and apparent lack of inflation, which have pushed yield curves down. Investors also assume people are flocking in bonds. The Fed has already cut rates twice this year and is widely expected to cut again by December. In September the ECB decided to restart QE, planning to buy €20bn per month for an indefinite period.

Still, negative yields make little sense. Investors lending money to the German government for 10 years are assured to lose 0.5% each year, or 5% if they hold until maturity. Why would anyone buy an investment guaranteed to lose money?


10 Year Bond Yields


11

If the US Treasury is yielding 1.8% per annum at the time of crisis, it stands to reason that people preferring it to an equity expect less return from equities over the next ten years. Running a quick analysis of the S&P 500 (weekly data), suggests that the only times equities returned less than 1.8% pa for a 10-year period are the 70’s until 1982 (a dismal period for the global economy), and the 2008 Global Financial Crisis. So unless someone is expecting runaway inflation ruining the global economy or another Lehman-like event, that pessimism may be misplaced.

The latter case, going for capital gains, is more probable. As buyers see the Fed extending its maturity reinvestment programme and the ECB restarting QE they feel a strong buyer will be present for bonds, so they would pile into, without expecting to hold the debenture until maturity. In essence, it’s ‘riding the bandwagon’ or ‘the greater fool theory’, a situation possibly exacerbated by momentum related algo-trading.

Does this mean that recent bond movements are a bubble? The rally certainly could last longer. Momentum is still positive for bonds, central bank dovishness isn’t going away anytime soon and global growth is set slow down further, hurting company earnings.

However, longer term investors should be warned. There’s a solid case to be made that bonds might be in bubble territory. At any rate they are much more expensive that equities or their own historic valuations.

An average return expansion



12

What does this all mean for investors?

Under an enormous debt burden, growth is forecasted to be tepid- and certainly below the pre -2008 trend. Interest rates and inflation are also set to remain low, in an environment that can be described as “secular stagnation”.

The immediate effect of such and environment is the need to be thorough in terms of risk and reward.

Equity investors must actively look for growth where they can. Should they pay for it? Yes, but one needs to be critical in the search. The higher the multiples, the more one pays for future earnings, so looking at the track record of delivery on promises is much more important than looking at earnings trends. Thus, before pouring in money in IPOs of companies that have never turned a profit is ill-advised, less an investor has specific insight on the product and the market for it.

Secular stagnation is the natural habitat for bonds, which up to a point, in confluence with aggressive financial repression accounts for the very bullish bond market.

Bond investors need to be thorough and make sure they are rewarded for the risks they are taking. No matter how many flows the market drives into a particular asset class, even if many of those flows are institutional, valuations are what they are and risks of default are irrelevant. This is especially true for high yield bond markets, which see yields that in the previous decade were reserved for investment grade debentures. So thorough risk/reward analysis is also required here.

Long term, it is good to shy away from chasing yields all the way to the bottom. The normal investing rules don’t apply to large parts of the fixed income space nowadays. Rather than a “safe haven” asset class, the sovereign bond market is turning into a high-stakes poker game of central bankers and bond traders. Anyone sitting at that table should better have a lot of capital and be prepared to take profits rather than wait for long term pay-outs.


GEORGE LAGARIAS Chief Economist

13

Global economic data suggests that the slowdown in global manufacturing (especially capital goods) is accelerating, and the services sector is now following this trend. The US has joined the cohort of large countries which now see their economy slow. Inflation remains at bay and unemployment in developed markets is near all-time lows, however we could see some pressures ahead as companies eat into their backlogs. Consumption is dented and capital expenditure is suffering as a result of weaker trade. The trend favours countries with strong internal demand vs those more dependent on asset-heavy exports.

Risks for global growth are increasing: Trade wars, Brexit uncertainty and the Chinese slowdown, along with the fact that the cycle is well into its 10th year, may unnerve investors. On the back of this feeling, central bank accommodation is increasing, and the Fed’s persistent assuaging of investor anxieties certainly helps those investors willing to buy on a dip. This has helped risk assets remain at high levels, contributing to a dichotomy between the economic and market signals.

Our latest investment committee in September felt that uncertainty has increased. Markets and economies seem at odds with each other and the question we faced with is “when and how will that gap close”. Additionally, probabilities of a disorderly Brexit have climbed. Therefore, we decided against changes in the asset allocation, as we feel the portfolios are positioned exactly for this sort of environment. We don’t maintain strong geographical preferences at this point, awaiting for more visible catalysts going forward. We still believe that the cycle, for the time being, remains intact but it is showing increasing signs of maturity.

Chart source: Mazars Calculations

03 Asset Allocation

14

03 Asset Allocation – Risks

Risk Monitor

Global economic growth is slowing. Markets are mostly focused on risks stemming from protectionism, the European and Chinese economic slowdown and global debt levels. There are two main global risks: a precipitous climb in bond yields, which are at historic lows –with $17tn bonds yielding negative- and economic nationalism. As last year’s US fiscal policy initiatives petered out, central banks once again picked up the growth baton and became more accommodative. Meanwhile, political pressure on central banks to keep currencies cheap is undermining their independence. The risk is that markets become too dovish about central bank intentions and are eventually disillusioned if policy doesn’t follow through.

In the US the main risk is a further economic slowdown, especially after Q2 2019 by which point the effects of the tax-cut stimulus had diminished. Additionally, investors have yet to discover the true depth of recent tax reforms, which could put additional strains on the budget.

In the UK we have seen some of the impact of Brexit uncertainty in the form of slower growth, dented consumption, a slowdown in house prices and companies considering new venues. Brexit angst is at its highest levels, affecting domestic investment.

In Europe, fears have shifted from Italy to the ailing German economy. Investors are also worried about the fate of Deutsche Bank and non-performing loans across the Eurozone. In China the slowdown persists, but some evidence suggests a possible rebound going forward.

We feel that short-term systemic risks are mostly manageable as liquidity is still ample. While a recession is drawing nearer, a “crisis” is not in the horizon. We are closely monitoring the increasing number of headwinds, the confluence of which could upend the economic and financial cycle.

• Protectionism

• Trade Wars

• Bond Bubble

• Chinese and Global Slowdown

• Policy Error by Central Banks

1515 Chart source: Mazars Calculations, Bloomberg, OECD

Currency Q3 2019 Q2 2019 Q1 2018 Q4 2018 YTD

Equities local GBP

UK GBP 1.23% 3.21% 9.42% -10.22% 11.08% 11.08%

US USD 5.05% 6.75% 11.49% -11.52% 19.07% 22.43%

Europe EUR 2.25% 7.94% -10.59% -10.59% 20.34% 19.4%

Japan JPY 6.42% 5.00% -13.04% -13.4% 8.22% 13.44%

Emerging Markets USD -1.00% 7.85% -5.23% -5.23% 5.73% 8.71%

Fixed Income

UK Gilts GBP 6.20% 1.31% 3.38% 1.92% 10.29% 10.29%

UK Corporates GBP 3.68% 1.98% 4.06% 0.14% 9.33% 9.33%

Global Bonds USD 4.49% 5.88% 0.39% 3.71% 7.23% 10.25%

Other Assets

Gold USD 7.91% 11.63% -1.15% 10.4% 16.50% 19.79%

Hedge Funds USD 4.95% 4.75% 2.01% -2.07% 7.05% 12.16%

Asset Class Performance in Q3 2019

04 Economies and Markets

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5.00%

0.00%

-5.00%

-10.00%

Equities Fixed Income Commodities Currencies

Source: Mazars Calculations, from 30/6/2019 to 30/9/2019 = Local = GBP,

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Non

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GB

P /

EU

R

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US

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JP

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UK

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16

04 Economies and MarketsGLOBAL

Chart source: Mazars Calculations, Bloomberg, OECD

Global equities rose 3.8% in Q3, despite news on slowing growth and earnings, led by defensive sectors such as Consumer Staples and Utilities. Materials and Energy were the laggards. Meanwhile global bond yields fell, as traders bought more aggressively in light of central bank easing. Global stocks are trading at 16.4x P/E, 8% above their 10 year average of 15.2.

Global growth continues to be tepid with all major economic regions slowing, exacerbated by a crunch in global capital goods orders and increasing fears over trade wars. As a result, global trade, especially in capital goods, continues to slow down. Countries with a strong export sector have been suffering more than countries with strong internal demand. Manufacturing is contracting across the board, dragging the service sector along, suggesting conditions are tepid across the board. Inflation, naturally, remains at bay, as demand is weak. Unemployment is still near all-time lows, especially in developed nations, but as backlogs of work and inventories are reduced, probabilities for higher unemployment are rising. In this environment, the central banks remain very accommodative, with the Fed now projected to cut one more (a total of three) time in the year, a significant departure from a previously projected 2 rate hikes.

Outlook

The cyclical rebound for the global economy is now past due, which would make us more apprehensive about the prospects for trend growth. Having said that, risk assets overall are well supported by central banks, however we feel that it may be difficult for the Fed to positively surprise markets, where half of participants now believe that it will deliver two rate cuts before the end of December.

Global GDP - Mazars PMI model

Global PMIs

Stocks correlated this year

17

04 Economies and MarketsUK

UK stocks rose 1% in Q3, led by Telecoms and Utilities, while Energy and IT lagged. The UK 10y Gilt ended the quarter at 0.49%, down roughly 34 basis points. UK stocks trade at 12.73x earnings, 4% below their long term average of 13.24% and at a 23% discount versus the MSCI World.

The British economy, long sensitive to the global economic cycle, continues to face headwinds from weaker growth, especially in Europe, as well as Brexit uncertainties which have delayed investment spending and policy decisions. The country’s output gap is widening. Manufacturing conditions have slowed sharply, partly reflecting weak external conditions and partly because of inventories built to address a Brexit contingency but not reflecting broad demand conditions. The service sector was reported to have contracted for the second time in the year in September. Overall employment conditions remain strong, with unemployment near all-time lows and wages near cycle highs. Consumers, however, are still very cautious, deferring big decisions until the Brexit uncertainty is removed. Despite the softer Pound, inflation remained benign. Meanwhile house prices have barely moved, while overall construction is now a detractor for output growth. The central bank remains accommodative and alert, as policy decisions will probably be dictated by the shape of Brexit.

Outlook

Brexit continues to hamstring growth in the UK, adding to the strengthening headwinds in overall global output growth. Spending decisions are being deferred, parts of the financial sector have quietly relocated to the EU and anecdotal evidence suggests that British businesses remain unprepared, especially for a disorderly Brexit. Non UK-economy related risk assets should continue to have a negative correlation to the Pound.


UK economy slowing

UK construction slowing

UK large caps cheap

18

04 Economies and MarketsUS

US equities rose 5% (1.9% in USD), mostly due to dollar appreciation. The rise was led by Homebuilders and Utilities, whereas Healthcare and Energy lagged. The US 10 year fell by 34 bps, to 1.66% during the period. US stocks trade at 17.88x forward P/E, 12% above their 10 year average and at a 9% premium over the MSCI World.

The US economy is slowing, along with the rest of the world, as the effects of Mr. Trump’s 2018 pro-cyclical stimulus –and the period that preceded them- have petered out. Despite a good amount of Dollar repatriation, output growth, which peaked in mid-2018 at 3.2% now stands at 2.3%. S&P 500 earnings are expected to fall in Q3, marking the third straight decline in the year. Consumer sentiment is still high by historical standards, and consumption patterns are not too worrying, but overall consumers are worried over the effect of trade wars and have been reserved about their purchases. Manufacturing has slowed, along with the rest of the world, despite companies building inventories and eating into their backlogs. The services sector is faring somewhat better. Employment levels are high, with both unemployment and underemployment falling by multi-year lows. Due to the confluence of internal and external pressures in the economy, the Federal Reserve has increased its dovishness, with investors now expecting one or even two rate cuts by the end of December (a total of 3-4 for the year).

Outlook

The US economy is slowing at a rate commensurate to that of the rest of the world, as the benefits from last year’s stimulus failed to improve trend growth. However, as the Fed remains dovish, the outlook for US assets, which also feature very high ROE companies continues to remain upbeat, at least relative to the rest of the world.


US GDP slowing

Manufacturing slows

Relative valuation

19

04 Economies and MarketsEU

European equities continued to climb last month and were up +2% in Sterling terms, led by utilities and telecoms, while autos and materials lagged. EU stocks trade at 15.13x forward earnings, 8% above their average and at an 8% discount versus the MSCI World.

Growth conditions in the Eurozone have continued to deteriorate with the weakness in manufacturing starting to spill over to services. France, which is less reliant on exports for its economic output than other European countries, saw its Services PMI decline with the pace of new business slowing and firms increasing their staff numbers at the softest pace since April. However, growth was recorded in all sectors but Hotels & Restaurants; arguably one of the most cyclical sectors. In Italy, services continue to expand, however there has been a further decline in output charges which has added further to deflationary pressures. On the other hand, input cost inflation has risen to a 10 month high, resulting in a mixed inflation outlook going forward.

A challenging economic environment characterised by ongoing global trade tensions and political uncertainties has resulted in Europe’s largest manufacturer, Germany, falling deeper into contraction territory. The seasonally adjusted Manufacturing PMI came in at 41.7. With growth prospects weak and Brexit uncertainty looming, the industry is facing significant challenges. Additionally, Trump has gained the permissions to apply tariffs to some EU goods, in particular, whiskey, wines and cheeses to name a few, in response to the Airbus funding case; adding to fears of a US-EU trade war.

Inflation in Europe surprised to the downside in September, with a figure of 0.9%, still significantly below the ECB’s target. The ECB has cut interest rates and re-started QE in response. The unemployment rate for the Euro Area ticked down to 7.4%.

Outlook

The Eurozone still remains unclear as external uncertainties persist; this includes geopolitical risks, including Brexit uncertainty and trade disputes with the US, which have now materialised with the new tariffs. Overall we are neutral on EU risk assets.


Eurozone services PMI

German manufacturing PMI

Relative valuations

20

04 Economies and MarketsEM AND JAPAN

Japanese equities rose 6.5% while EM equities fell 1.1%. Japanese equities trade at 13.11x their forward earnings (at a 14% discount versus average and 20% discount versus the MSCI World) and Emerging Markets equities trade at 12.95x earnings, 8% above their average and at a 21% discount versus the MSCI World.

Japan saw mixed economic data releases in September. Exports fell by -8.2% (YoY) for the ninth month in a row, partly due to the global slowdown and trade tensions. One reason for weakness in export growth was also a stronger yen during the month, which makes Japanese goods more expensive for foreign buyers.

Japanese services sector marked 3 years of continued expansion with a value of 52.8 in September, down from 53.3 last month. Manufacturing activity on the other hand, remained under pressure and fell to 48.9 in September, down from 49.3 last month. Donald Trump signed a partial trade deal with Shinzo Abe, easing tensions between the two countries as Tokyo made agricultural concessions in exchange for a reduction in some US industrial tariffs. The Bank of Japan kept monetary policy on hold but hinted at possible action in October as it frets about a slowdown in the global economy.

As trade tensions between the US and China continue to pose a threat on the Chinese economy, the PBOC cut its reserve requirement ratio for the third time this year, with an aim to increase the supply of credit to the economy, days after the US hit China with a fresh round of tariffs of 15% on $112bn in manufactured goods.

China’s manufacturing sector rose unexpectedly to 51.4 in September, up from 50.4 in August. The latest reading pointed to the strongest pace of expansion in the manufacturing sector since February 2018, as output and new orders increased at a fast paceg.

Outlook

We are neutral on both Japan and the Emerging Markets. Japanese risks assets continue to suffer from tepid growth and long standing structural deficiencies. Emerging markets seem more attractive, based on performance, but high valuations versus their averages continue to put a cap in investor expectations.

Chart source: Bloomberg

Valuations

GEORGE LAGARIAS Chief Economist

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More reading...REFLECTIONS IN INFLECTIONS: DID THE FED KILL ECONOMIC CYCLES?ECONOMIC OUTLOOK Q3 2019

Leading economic indicators, particularly in the manufacturing sector, gave no reason for optimism with the evidence suggesting that companies were completing backlogs with lower expectations of new business.”

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MAZARS WEALTH MANAGEMENT INVESTMENT NEWSLETTERAutumn 2019

Equity markets across the world ended the quarter broadly where they began having recovered from a slight loss of confidence during August. This stability came despite no improvement in economic data, and a further fall in government

bond yields signalling a cautious economic outlook. In a similar vein Gold continued to rally as other safe haven assets became prohibitively expensive. Leading economic indicators, particularly in the manufacturing sector, gave no reason for optimism with the evidence suggesting that companies were completing backlogs with lower expectations of new business. This is particularly the case for export led economies, notably Germany, with trade figures still depressed as the dispute between the US and China shows no signs of being resolved, in addition to the Chinese economy being in a structural slowdown.

Supportive of equity markets was the continued loose monetary policy with both the European Central Bank and the US Federal Reserve cutting interest rates as expected. There is though now a general acceptance that such moves whilst benefitting financial markets are ineffective at driving a revival in the real economy. Years of cheap credit have not ignited capital investment, so why should a further small cut do the trick now? Attention therefore has turned to fiscal policy, and

whether a more direct injection of stimulus in economies might be more catalytic for growth. New Chancellor Sajid Javid announced a spending package which is expected to breach fiscal rules, although this could be seen as more of an electioneering move than an economic policy. More significantly the German finance minister hinted at Berlin being willing to loosen its purse strings in the face of an expected technical recession in Germany.

For Sterling based investors the possible path of the Pound continues to be the largest short term determinant of returns as markets struggle to divine the likely path of Brexit. Constitutional crises might make for good news headlines, but they do little to shed light on whether the UK will leave the EU with or without a deal.

Our Investment Committee agreed to maintain our cautious stance reflected by our neutral position in equities and overweight position in gold and cash. Given the many possible outcomes in the Brexit debacle and the corresponding volatility in Sterling we decided to maintain our partial currency hedging position in our overseas equity holdings.

I hope you find this newsletter interesting and relevant to you, and I would very much welcome any feedback you may have. Please do feel free to get in touch with your thoughts either by phone on 020 7063 4259, or by email on [email protected].

Outlook 2019 Quarterly newsletter

The information contained in this document/presentation/factsheet does not constitute individual advice. Mazars Financial Planning Ltd will not accept any responsibility for decisions taken or not taken on the basis of the information presented. Always obtain independent, professional advice relevant to your own circumstances.

Any reference to legislation and tax is based on Mazars Financial Planning’s understanding of United Kingdom law and HM Revenue & Customs practice at the date of production. These may be subject to change in the future. Tax rates and reliefs may be altered. The value of tax reliefs to the investor depends on their financial circumstances. No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of these comments.

Mazars Financial Planning Ltd is a wholly owned subsidiary of Mazars LLP, the UK firm of Mazars, an integrated international advisory and accountancy organisation. Mazars Financial Planning Ltd is registered in England and Wales No 3172233 with its registered office at Tower Bridge House, St Katharine’s Way, London E1W 1DD. Mazars Financial Planning Ltd is authorised and regulated by the Financial Conduct Authority.

© Mazars LLP 2019-10 37881

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