MARKET INSIGHTS: 24/07/2017
After recent downside surprises in US and UK inflation data markets are expecting a similar trend this week from Europe and Japan. Bond yields fell marginally last week but this may prove to be premature given that central banks are unlikely to retreat from their moves to normalise monetary policy through balance sheet reduction and – in some cases – by raising interest rates. There was no new news from the ECB last week and we expect a similar outcome from the US Federal Open Markets Committee meeting on Wednesday but markets will remain focused on the September meeting which is most likely to shape the ‘dot-plot’ interest rate outlook. In the US there is wage data, durable goods and Q2 GDP. We also get GDP data in the UK – likely weaker at 0.2% for the quarter – and in Europe. After a run of soft data market expectations are low so there is scope for upside surprise. The modest synchronised global recovery continues and economics are likely to take a back seat to the corporate results season and even politics ahead of the summer recesses.
DIARY OF A FUND MANAGER: 24/07/2017
The numbers matter when it comes to making investment decisions, but which ones can we rely on? Market and inflation indices are the subject of endless analysis, as are GDP and employment statistics, whilst companies provide weighty tomes describing their activities and results on a regular basis. The answer is a curate’s egg of good and bad, which is the main theme of this week’s Diary.Those trying to judge the direction of markets from 50,000ft are finding it hard to identify consistent patterns from statistics designed to capture what is going on in economies around the world. For the record, last week saw bond markets move higher, along with US and UK equities. The dollar and sterling were down against a strong euro. The good news is that economic growth in the first six months of this year was better than anticipated in the US, Europe and China. As a result, investors have continued to add to both bonds and equities in order to get away from zero return cash.In the short term, markets are in ‘show me’ mode as we work through the company results season and as attention shifts from screen to beach. Only Washington seems to be immune to seasonal influences as attempts to create a legislative agenda for 2017/18 struggle for presidential attention. A visit to a UK company that relies on long-term contracts from the US government was reassuring, because all around the table, including me, agreed that the Republicans had to make use of their majority position before the mid-term elections at the end of next year. However, I must admit that it’s getting harder to maintain the courage of my convictions, as US short-term money markets start sending out distress flares ahead of debt ceiling legislation which Congress will need to pass by October.Back in March 2000, the technology-heavy NASDAQ index passed 5000 for the first time before collapsing to an intra-day low of 1108 in October 2002. It was a long wait, but in April this year it finally made it to 6000 and now is a few hundred points higher. So much has changed in the intervening years. Back in 2000, the average PE multiple was at 73, whilst now it is similar to the US market as a whole at 19 times. The market value of the top five companies has increased from $1.9 trillion to $2.7 trillion, which is interesting, but not remarkable. What is notable is that only Microsoft has retained its top five ranking. Cisco, Intel, IBM and Oracle have been relegated in favour of Apple, Alphabet (Google), Facebook and Visa. Passive investors beware: valuation and stock selection drive returns.Making judgements about which companies will win and which will lose is hard enough, but at least the numbers can be analysed and the management teams held to account. Economies are much harder to get right, because the statistics are never more than best guess estimates and there is no one to fire when things go wrong. For example, the US non-farm payroll report is analysed to death each month by those trying to gauge the temperature of the economy. Almost every time, the numbers from previous months have to be revised because the sample taken is small relative to the total working population and so, rather like opinion polls, is subject to error. There are other measures of employment which provide contrast and so this unreliability is not a major problem, but it doesn’t stop the commentators fitting stories to numbers which, with the benefit of hindsight, are shown to be misleading. More seriously, it seems as if since 2010 the UK retail price index (RPI) has been overstating inflation by about 0.5% per annum. According to the FT, this has cost tax payers £15 billion so far.The size of an economy and whether it is growing or contracting is the foundation of many investment decisions. The Irish economy has been on a roll in recent years, as it recovered from the dark days of the credit crunch which destroyed banks and property speculators alike. Strong GDP growth has helped restore confidence both domestically and internationally. Unfortunately, it seems that some of this ‘growth’ is related to the restructuring of multinational companies taking advantage of Ireland’s low rate of corporation tax, and is unrelated to what is happening in the domestic economy. An alternative statistical model of the economy which measures Gross National Income describes a domestic economy that is about a third smaller than the one portrayed by GDP. The point of all of this is that although we use these centrally generated statistics, it’s the detail that matters when it comes to making the right investment decisions.Although some of my best friends are economists, I’m glad that long ago I studied natural sciences. Softening the hard edges of rational empiricism is so much easier than the other way around. If he hadn’t been a physicist, Heisenberg (not the lead character in Breaking Bad), would have made a good investment manager. His Uncertainty Principle, which in summary states that the more precisely the position of a particle is known, the less precisely its speed and direction can be measured, applies to financial markets and, come to think of it, everything else.Investors should remember that the value of investments, and the income from them, can go down as well as up. You may not recover what you invest. This commentary has been produced for information purposes only and isn’t intended to constitute financial advice; investments referred to may not be suitable for all recipients.
MARKET INSIGHTS: 18/07/2017
Blockchain, or distributed ledger technology, is an idea that has found its time, and is now engaging the minds and the budgets of almost all the most influential players in the financial sector. In the briefest terms, it is a decentralised network of databases that are updated by network members, and uses cryptography to ensure the integrity of the ledger and authenticity of transactions. The technology was first developed for the digital currency, bitcoin, to record transactions. Since then, however, the financial services industry has recognised the potential for a much broader application, from fund management companies, clearing houses and custodians to central banks.To judge by the resources being dedicated to it, blockchain is a game changer. The World Economic Forum last year estimated that $1.4bn had been invested in blockchain projects in more than 25 countries, generating more than 2,500 patents. The WEF concluded the technology will “fundamentally alter the way financial institutions do business around the world”, offering the potential to drive simplicity and efficiency. The expectation is that it will become as normal a part of the financial services industry as mainframes, messaging and electronic trading are today.Perhaps the most important application of blockchain in financial services is that it will enable the sharing of information. Traditionally, when making a trade, data is siloed within companies, and exchanged. But with blockchain, data can be shared instantly across the relevant network, from investment managers, trading platforms, clearers and custodians. Members involved in the trade have a ‘golden copy’, which is an immutable record of all data and transactions. Any amendments to the golden copy is viewed and approved by other members of the network.Already, Blockchain has been used to buy and sell mutual funds under test conditions. Calastone, a technology company, replicated the equivalent of a full day’s trades involving its 1,200 fund manager and fund distribution clients in 34 countries. According to Calastone, the test proves that blockchain can be used to create a one-stop marketplace for trading and settling investment funds. This would benefit the fund industry because the fund processing would be moved online, saving on staff, cutting costs and improving efficiency. Their next step is to apply the technology to real live trading. If successful, this could transform the asset management industry. This may not be surprising, as some firms still rely on manual entry systems, faxes and paper forms.CollaborationAlliances and working groups are springing up all over the financial sector to develop blockchain applications. Axa Investment Managers, a group with $747bn in assets under management, is working with BNP Paribas Securities Services, the custodian bank, on a blockchain project. The Royal Mint, part of the UK’s HM Treasury, is working with the Chicago Mercantile Exchange (CME) to start issuing Royal Mint Gold (RMG), a blockchain-based digital record of ownership for gold stored at its bullion vault.Currently in live testing, RMG is designed to be a complete eco-system for trading gold in the Royal Mint’s vaults, operating 24/7 like Bitcoin. RMGs give ownership of the underlying gold, without storage costs, and give buyers the option to take deliveries of physical gold. As the Royal Mint says on its website: “The RMG solution will provide an easier, cost-effective and cryptographically secure alternative to buying, holding and trading spot gold.”Another important development is the announcement by the Depositary Trust & Clearing Corporation, one of the largest providers of post-trade processing services, to work with R3, a New York-based blockchain consortium. R3 is fundraising for a blockchain platform from the consortium membership, which includes ING Groep, Barclays, Intesa and HSBC. Morgan Stanley, Goldman Sachs and JP Morgan, early participants, have opted out of the fundraising, and are looking instead at other blockchain projects, including Axoni and Digital Asset Holdings. R3 is also currently testing a blockchain prototype for derivatives with four Japanese banks (Mizuho, Sumitomo Mitsui, Daiwa and Nomura), while Northern Trust, the US financial services group, is developing a blockchain platform for the private equity market.Early daysFor all the development dollars being ploughed into blockchain projects, a number of problems remain before the technology can become mainstream. Inevitably, among all the different systems being developed, the security/cost trade-off means a cheap version will be more risky, meaning that systems have to be in place to guarantee the integrity of the data. The other danger is that where there are many members in a system, there is also the danger of hacking, as in any digital technology system. In June last year, hackers stole $50 million of ‘ether’, the Ethereum digital currency, from one of the Ethereum community members. But to make good the breach, agreement had to be reached with the whole Ethereum community, highlighting the need for consensus before any solution is implemented.Other outstanding issues include data privacy, which is not wholly compatible with blockchain’s unique transparency on transactions. For financial services companies, such data may also be market sensitive and be of interest to competitors. On the legal side, the UK’s Financial Conduct Authority has noted a raft of issues that remain to resolved, for example around decentralised autonomous organisations, online digital entities that operate through the implementation of pre-coded rules with almost zero input to execute ‘smart contracts’, and recording the activity on a blockchain.Potential impactAt Quilter Cheviot, we continue to explore the potential impact on the stocks and industries we cover as a result of the development of blockchain. Naturally, there will be winners and losers from such a transformative technology although the overarching role of regulation in financial markets may slow its adoption. We highlight the high forecasting risk in such a nascent technology but, with that caveat, we believe that market infrastructure is an area which is likely to benefit.The use of blockchain should increase efficiencies in post-trade settlement and clearing by reducing costs as a result of removing the need for reconciliations between market participants. The time to settle trades can also be reduced, which frees up collateral. Improved capital efficiency and reduced costs should lead to increased trading volumes. Among the stocks we cover, we believe NEX Group has a strong record of technological innovation. NEX’s Infinity platform is due to move into user testing with clients for spot FX and cash equities on the distributed ledger from July 2017.In contrast, we believe the risks to the banks from new technology are likely to be on the downside. On the one hand, distributed technology offers scope for significant cost savings in back office functions. Accenture and McLagan highlighted potential cost reductions of $8-12 bn (c. 30% of the existing cost base) from eight of the world’s top 10 banks, in a report entitled ‘Banking on Blockchain’. However, we see relatively limited pricing power in the banking sector and as a result, we believe potential cost savings are likely to be largely passed on to customers.Further, any cost cuts will only transpire when banks and regulators are confident that new technologies are robust, which may be many years into the future. Until this point, banks will need to run legacy IT systems, as well as bearing the cost of developing blockchain. However, we believe the collaborative nature demanded from blockchain, coupled with the role of regulation, limits the risk of a disruptive entrant fundamentally altering the market structure, as we have seen with other industries (e.g. Uber, Airbnb). While regulatory pressures may be abating, we see pressure from technology more generally as fintechs cherry-pick more profitable and less capital intensive areas of banking, such as payments and wealth management.The FCA is awaiting feedback from the industry on the future development of blockchain in the markets it regulates. Blockchain is still in its development phase, one that is expected to continue for the next five to 10 years. By then, expect the financial services industry to look very different.Any comment on specific securities should not be interpreted as investment research or advice, solicitation or recommendations to buy or sell a particular security. Investors should remember that the value of investments, and the income from them, can go down as well as up. Investors may not recover what they invest.