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2016 Outlook: US and China at a critical juncture

5 January 2016

  • China’s command economy will support its transition period
  • US economic cycle remains uncertain, but it isn’t over yet
  • Equity markets remain reasonably valued, with opportunity in UK mid-caps


Peter Elston, CIO, Seneca Investment Managers, says:

“We believe on balance that the world will continue to grow in 2016. Equity market valuations by and large are low enough to make positive returns this year and western government bonds remain overvalued.

“The world’s two largest economies, the US and China, contributed 82 per cent of global nominal growth over 2014 – 2015. Both nations are at critical junctures. While the US is arguably much closer to the end of its business cycle than the beginning, as evidenced by unemployment that has been falling for six years and that has just recently hit 5%, China is undergoing a pronounced and persistent structural slowdown, as evidenced by plummeting industrial metals, iron ore and bulk shipping prices.

“Yet there remain signs of progress in China’s services sector with PMIs remaining well above 50, while the collapse of Macau casino revenues is an indication that President Xi’s anti-corruption drive is biting, and reforms of China’s welfare system are ongoing. Overall, our view is that China is in a transition phase and will benefit from shift it is making from an economy reliant on manufacturing to more services- and consumption-driven growth.

“With the process of modest rate rises now underway and likely to continue – albeit haltingly and only to what will remain historically low levels – the future shape of the economic cycle in the US has become more difficult to determine. There is no doubt that some parts of the US economy are struggling. The strong dollar has put pressure on manufacturers while the sharp decline in the oil price has led to a contraction in the oil and gas sector.

“However, we believe America’s economy is big enough, deep enough and strong enough to absorb the pain. The services sector accounts for 80% of the US economy. Contractions in manufacturing and energy sectors should be considered part of the process of creative destruction, with freed up labour being employed in other, higher value-added areas of the economy.

“This optimism is supported by the US yield curve data, which does not suggest that a recession is on the horizon.  Additionally, the US economy has room to improve without putting upward pressure on wages, as supply of labour is boosted by people re-joining the workforce. This means that inflationary pressures should remain benign for some time, allowing the Fed to maintain an accommodative monetary policy – interest rates may rise but they will remain low. We therefore don’t believe the cycle is at an end yet.

“In terms of valuations, we see no value in developed sovereign bonds: at some stage we believe yields will rise significantly and government bonds will bite the hand that bought them. High yield bond spreads have moved out, which given our expectation of future growth means this is an attractive area for us, though we continue to avoid the oil and gas industry, which is suffering from the Saudi squeeze on margins.

“With regard to equities, these appear reasonably valued especially on price to book and yield metrics and the apparent lack of any imminent end to the global cycle from yield curves and labour markets. In addition to Europe, the value in UK mid-caps can be highlighted, where we expect continued good performance, and which are free from the excessive dividend concentration and low dividend covers so apparent in the large cap universe.”.

 

Important information

Past performance is not a guide to future returns. The information in this document is as at 30.11.2015 unless otherwise stated.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/01.

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The Yellen and Carney Show

24 August 2015

I’m angry with Fed chair Janet Yellen and Bank of England Governor Mark Carney. Why did they have to be so eager to raise interest rates, talking them up in the way they did? Yellen’s trigger happiness has caused the Dollar to rise, oil prices to fall, China to devalue its currency, other emerging markets to devalue theirs, inflation pressures (to the extent there were any) to subside and, guess what, the case for raising rates to be booted into touch.

Actually, it’s worse than that. By calling for rates to be raised too soon, Yellen has lost a lot of credibility. Central banks have been virtually single-handedly propping up the global financial system, so their credibility is paramount. I remember five years ago wondering which would come first; a global economy returning to “normal” or loss of faith in central banks. The last few days and weeks have seen me shifting my views firmly in favour of the latter.

My main bone of contention is that the end of QE in both the UK and the US constituted an effective tightening of monetary policy. As I noted in my last investment letter, it is estimated that the tapering of asset purchases in the US was the equivalent of an interest rate rise of 4 percentage points. This is the same as the entire tightening cycle of 2003 to 2006, which saw the Fed Funds rate go from 1% to 5%, and which arguably triggered the financial crisis. Why oh why couldn’t Yellen or Carney communicate the message that having had a substantial effective tightening, they would leave interest rates where they were for at least 2 years in order to gauge its effects? It’s not as if we were coming out of a normal recession in which inflation pressures were going to rebound quickly. Far from it. Inflation still needs propping up not suppressing.

I’m not an economist – thankfully! – but it seems to me that the world is prone to deflation not inflation. We humans seem to be able to find cheaper ways each year of making something or providing a service. Furthermore, while credit creation is inflationary, the reverse is deflationary. Throw in other sources of deflation like the internet or China and you have a world in need of central bankers not competing to be the first out of the blocks.

Fortunately, our Funds are neutrally positioned at the moment with respect to equities. This means our income fund has 40% in equities and growth fund and investment trust have 60%. While in these sorts of markets one always wishes one was more defensively positioned, I think neutral was right. While equity market valuations weren’t cheap, nor were they expensive. Furthermore, despite what Carney and Yellen say they would like to do, the reality is that monetary policy is likely to remain loose and thus supportive – at some point – of markets.

As for China, its one dimensional economy that relies on building more and more “stuff” has always been vulnerable to a nasty slowdown. China needs to break away from a model that has seen its consumption of cement and steel break all global records towards one that is more balanced. The good news is that in a command economy, the state is in a position to direct such a shift.

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Income & Growth Trust
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

LF Seneca Investment Funds
Before investing you should read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the Fund.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/107.

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Response to: Multi-asset pledge ‘should set off alarm bells’

10 August 2015

My attention this morning was drawn to an article in FT Adviser, Multi-asset pledge ‘should set off alarm bells. “Investors should be wary of multi-asset funds promising 5 per cent income that could be taking a “gamble” with capital, experts warn” says the piece.

I can’t speak for all funds seeking to deliver a 5% yield but I can speak for ours. We have done extensive modelling on our LF Seneca Diversified Income Fund and we believe we can deliver this yield without putting real capital at risk over the longer term (I would agree that one cannot seek to protect capital over the short term, markets don’t work that way).

In order to achieve our investment performance objective, we need to deliver a gross total real return of just shy of 7% per annum over the longer term. After costs, this would come down to closer to 5%, which would be split between income of 5% and real capital of 0%.

So, the question then becomes, how do we deliver a gross total real return of 7%? The answer is that it comes from a combination of strategic asset allocation plus value added from tactical asset allocation and security/fund selection.

We think we will get around 4.5% from strategic asset allocation without taking undue risk. Our strategic asset allocation to equities is fairly low at 42.5% (our fund sits in the IA 20-60% Shares sector) and we think equities will deliver us around 6% real, in line with long-term historic averages.

Adding in bonds and specialists, which we think will provide 2% and 5% real over the long term, and you get to a total of around 4.5% (our strategic asset allocations to bonds and specialists are 32.5% and 25% respectively).

As for value added, we are looking to add 2.5 percentage points per annum from tactical asset allocation and security/fund selection. Whether we can do this depends on two things.

First, is the ex ante tracking error of our fund in relation to its strategic asset allocation giving it the potential to produce 2.5 percentage points of value added? Our risk models tell us that the answer to this question is ‘yes’.

Second, do we have an investment process that is able to deliver this potential? Again, the work we have done tells us that the answer to this question too is ‘yes’. Our tactical asset allocation process draws on well-regarded academic work that finds strong links between yields of equities and bonds and future returns.

Within UK equities, where we invest directly, we focus on mid-caps where there are higher systematic returns as well as greater stock picking opportunities that exist because of thinner broker research coverage. We also think that we’re able to spot third party managers of overseas equities funds who have strong, value oriented approaches that produce good returns over time.

So, while we would agree there may be funds out there promising 5% that don’t know what they’re doing, ours does.

Important Information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Estimates of yields and long-term real returns are Seneca Investment Managers’ estimates. These estimates are derived from various third party sources, as well as the knowledge and experience of Seneca’s investment team. They are intended to be conservative, representing what Seneca hopes to achieve from each asset class in the way of income and capital return. Importantly, there is no guarantee that actual yields and real returns realised will be similar to or exceed these estimates.

Before investing in the LF Seneca Diversified Income Fund you should read the key investor information document (KIID) as it contains important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment.

The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the Fund (0345 608 1497). Seneca Investment Managers Limited, the Investment Manager of the Fund (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at 10th Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. . FP15/102.

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The Impact of a ‘Personal View’

6 August 2015

In my recent Investment Letter that was published last week, I questioned the need for an interest rate rise and also Bank of England governor Mark Carney’s apparently knee-jerk comment during a speech last month at Lincoln Cathedral about raising rates around the turn of the year, in sharp contrast to more vague comments he had made two days earlier.

Sure enough, today, following an inflation report that showed price pressures remained very subdued, he admitted that his speech had reflected only his “personal view”. I’m all for greater transparency, but not if it means greater confusion.

The timing of the first interest rate rise is hugely important for so many people both inside and outside the financial industry.

Perhaps Mr Carney should keep his personal views to himself.

Important Information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/101.

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The Summer Budget

9 July 2015

It’s worth considering yesterday’s summer budget in the context of what actual government expenditures and receipts have been doing over the last few decades. Looking at the chart below one can very clearly see the austerity of recent years in the flattening out of the orange line since 2010, and the fact that revenues have been recovering well since the GFC. In fact, excluding interest payments on the national debt, the public sector is now in surplus, also known as a primary budget surplus. Looking at the chart one can also see a couple of periods in which expenditures very closely tracked revenues, one in the first half of the eighties and the other in the years leading up to the GFC, with both growing at a reasonable pace. While it is not always easy to achieve, this balance is what the current government should be aiming for.

So-called ‘supply siders’ would argue that the reason for the recovery in government revenues was that there was no crowding out by the public sector. In other words, the austerity allowed the private sector to mend, unencumbered by higher interest rates that would have resulted from excessive government expenditure (the Greeks and residents of other Mediterranean countries would not have sympathy with this argument).

So, what of yesterday’s budget? The increase in the minimum wage is probably the decision that has caused the most debate in terms of its likely impact. Ordinarily I would be against price fixing on the grounds that market-driven economies are generally the more efficient. But the reality is that the UK has a productivity problem, as low wages have reduced the incentive for companies to invest. The increase in the minimum wage may well give companies the nudge they need, as well as help to weed out the weaker companies that have been propped up in recent years, in the process allowing capital to flow to the more deserving.

Public Sector Spending & Revenues

Graph 1

Source: Bloomberg as at 31.03.2015

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/90.

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When ‘Negative’ is Positive

9 July 2015

I am dismayed by how often the term ‘negative feedback loop’ is used incorrectly. The latest offender is Jeff Currie at Goldman Sachs who writes in a note to clients:

“The negative feedback loop is significant. The deflationary impulse created by lower commodity prices reinforces a stronger US Dollar, as witnessed by recent moves in FX markets that resulted in weaker commodity currencies. This decreases the cost of producing commodities in these countries through lower wage costs that are priced in the weaker local currencies. Further, this deflationary impulse reinforces a stronger US economy and higher rates. The higher rates in turn raise the cost of funding for emerging markets, which reinforces the need for emerging markets such as China to deleverage and deal with significant macro imbalances developed over the past decade. This ultimately reduces the demand for commodities, particularly those that are tied to investment such as copper and iron ore.”

The forces that Jeff writes about constitute a positive feedback loop, not a negative one. When one event (“deflationary impulse”) triggers other forces in the same direction (“raise the cost of funding for emerging markets” which “reduces the demand for commodities”), this is a known as a positive feedback loop, even if it relates to a “negative” event such as falling prices. A negative feedback loop is one in which one force triggers a force in the opposite (negative) direction. An example, to continue with the energy theme, would be falling oil prices that trigger an increase in demand for petrol and in turn higher oil prices.

Phew! Glad to get that off my chest….

Important Information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/91.

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Rejecting Calls for an Early Interest Rate Rise

30 June 2015

It is reassuring to see in today’s Financial Times that Andy Haldane, the Bank of England’s chief economist, is rejecting calls for an early interest rate rise.

I have argued previously that a premature rate rise would risk a repeat of what happened in the US in 1936, when the Fed increased rates slightly following a few years of moderate growth. The result was a severe economic contraction and a halving of the stock market.

According to the FT, Haldane notes that an early rate rise “would risk generating the very recession today it was seeking to insure against tomorrow.”

Haldane is not worried about wage growth, saying that his talks with businesses leave him “confident wages are not going to embark on a rocket-propelled ascent.” He also notes that Sterling’s rise will be more important in keeping inflation below the 2% target.

This should all be positive for Equities, which like low but not negative inflation and loose monetary policy.

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/85.

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Greece Imposes Capital Controls

29 June 2015

At 3am local time this morning, the Greek government announced the suspension of overseas banks transfers and that daily cash withdrawals would be limited to 60 Euros. This was in response to the failure over the weekend to reach an agreement between Greece and its creditors that could be put in place before the current agreement expires tomorrow and the withdrawal of ECB emergency liquidity funding. In Monday trading, the Euro has slipped by around 1.5% against the US Dollar and Asian markets have fallen on average by around 3%. At the time of writing, European Equity markets are also down by around 3%.

Looking at the facts, it seemed inevitable that that this point would be reached. Greece’s debt of 322 billion Euros is shared among 3.5 million workers, meaning 92,000 Euros of debt per worker. There is no way Greece would be able to pay this back within a hundred years, even if it had an extremely competitive exchange rate which it doesn’t. At the same time, the so-called troika has been demanding austerity in order for Greece to be able to achieve a primary budget surplus. This pushed Greece further into recession, as it could not rely on a competitive exchange rate to revive its private sector (indeed Greece’s actual economic output last year was around 20% below that originally forecast by the IMF). Syreza, the current governing party, was elected because it was anti-austerity. For it to have accepted the troika’s demands would have been political suicide. Greece and its creditors were on a collision path.

What happens next is hard to say. The Greek people will vote in a referendum on Sunday as to whether to accede to the demands of the troika. If they vote ‘no’, the stage would be set for Greece to exit the Euro. If they vote ‘yes’, Prime Minister Alexi Tsipras would step down and an interim government would be put in place pending a new election. But even with a vote in favour of austerity and the possibility of an agreement being reached with creditors, Greece is still left with an unsustainably high level of debt.

The good news is that a relatively small amount of Greece’s debt is now held in private hands, so the repercussions for financial markets outside Greece are not what they would have been back in 2010. 83% of Greece’s debt is in now in public hands, such as the ECB, the IMF and euro-area governments. A Greek default and exit from Euro would be a rather unfortunate balance sheet issue for them but beyond that the European financial system is well ring fenced. For Greece, a more competitive exchange rate would eventually be a blessing, though in the meantime a severe contraction should be expected as a result of the payment system grinding to a halt.

As for the implications for Europe’s financial markets, there has clearly been a nasty reaction, though equity markets are well off their lows. The reality is that if developments in Greece do not impact Europe’s financial system, then equity markets should recover. The economic recovery across the Eurozone had been underway since 2013 and this should be expected to continue, particularly since on a trade weighted basis the Euro is more competitive than it was back in December. Equity market valuations remain reasonable, with the Euro Stoxx 50 index on an attractive trailing dividend yield of 3.5%.

We recently increased our target weight to European Equities and we will be using the current weakness to move to these new targets.

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/84.

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European Equity Conviction

24 June 2015

Last week we increased our European Equity exposure to a 4 percentage point overweight position relative to our core allocations. We had felt that there had been a reasonable correction over the prior two months, with the Euro Stoxx 50 index falling by around 10% from its April highs.

Furthermore, we remain optimistic that an economic recovery is underway in Europe but that it is still in its early stages. Unlike in the US, where unemployment started to fall more than five years ago, in the Eurozone the employment situation only began to improve in mid-2013. Thus while the unemployment rate has fallen, it is still high at 11.2%, meaning that monetary policy will remain likely very loose for at least the next couple of years.

We feel that this, combined with profit margins that provide scope for improvement and dividend yields that are reasonable, bodes well for European Equities.

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/82.

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