Quarterly Investment Comment: Q3 2013


The leadership of the two deepest markets in the world, the USA and Japan, continued mostly at the expense of other regional equity markets in Q2 ’13. Fixed income featured a reversal of fortune and downside in commodities accelerated. In Sterling terms, Japanese equities rose despite a big fall in the Yen, and the S&P 500 rose 2.4%. Continental Europe was up marginally (+1.9%). Almost everything else was essentially weak. Developed equity markets with exposure to China were all down: Australia -15%, Canada -8%, Hong Kong -6.5%, even the UK was held back by its global-facing cyclicals, in particular mining shares. Emerging Markets, having already fallen earlier in the year, fell -7.5% paced by Brazil -23%, China down over -10%, Russia -12.6% and India -5.9%.

Globally, defensive sectors such as healthcare, media, insurance and telecom rose, while mining, machinery, energy and shares with interest-rate sensitivity underperformed – US REITs fell -3.5%, though UK REITs bucked the trend, +3.7%.

With bonds, downside volatility was worse in fixed income markets, at least relative to expectations. Developed market sovereign yields generally rose 50-100bp, while emerging market sovereign yields rose 100-200bp, with Emerging US dollar debt faring the worst. In the US, long-term bonds (iShares Barclays 20+ Year Treasury ETF) fell -5.6% and are now down -8.9% year-to-date. Municipal bonds fell -5%. Brent Crude fell -6% and Gold -23%. Summing up the period, our January ’13 call on Japanese stocks and April ’13 observation that, “…the risk-reward in fixed interest at current yields to maturity just does not inspire confidence” both proved correct.

The Policy-Driven Market

“When investors perceive a change in policy it will be a shot heard round the world”

Warren Buffett, Berkshire Hathaway Shareholders meeting, May 2013

We may look back at the past quarter as the moment when central bankers lost control of markets.

As we have described in Comments in the past year, central bank policy, as opposed to fundamentals, held complete sway over markets.

It looks as though the Federal Reserve may just have been lulled into overconfidence in its ability to exert policy influence over markets. Investors’ reaction to Chairman Bernanke’s news conference where he outlined the conditions for eventual tapering of QE (the now infamous “taper-tantrum”) was clearly not what the central bank expected, with US mortgage rates skyrocketing over 100bp in a matter of days.

Clearly, it is much easier for the Federal Reserve to buy than sell. In fact, reversing QE and shrinking the central bank balance sheet, as opposed to merely hinting about slowing the rate of purchases, is frankly out of the question. More optimistic pundits described the Fed’s guidance as signalling a strong economy that was ready to weather tighter monetary policy, i.e. a traditional tightening cycle.

Alas, nothing about this recovery is traditional: US median real household income in the US is down year-on-year; purchasing managers indices are flirting with contraction; and real GDP growth is barely above 1%. Judging by the backpedalling from various regional governors in the days following Bernanke’s testimony, the Fed is now desperately attempting to undo the damage in fixed income markets which threatens the robust recovery in housing.

Will the Fed’s increasingly muddled message be enough? Our sense is that the genie may be out of the bottle, that the Fed is now on the defensive trying to stem a further tightening of financial conditions brought on by the popping of a bubble in financial assets for which it is largely to blame. Investors pulled a record $60bn from bond mutual funds in June alone. Viewed in this context, far from indicating a strong economy, the back up in interest rates has nothing to do with the real economy and simply reflects deleveraging by investors who, to paraphrase Jim Grant, gorged themselves on “return-free risk”.

Nor should we automatically assume that the mighty US stockmarket can keep powering ahead in the face of slowing growth in emerging markets, as it did in the first half of 1987, 1994 and 1997. US corporations today are far more exposed to emerging market growth, especially China, than they were 15-25 years ago. This could quickly feed into corporate results—and already has judging by the brisk flow of negative “preannouncements” ahead of the Q2 ’13 earnings season. If you look closely, market behaviour such as the new trend of end-of-day weakness in the US stockmarket suggests distribution, that is, shares moving from strong hands to weak.


The main risk, as we see it, is that the US economy is weaker than reflected in the stockmarket. Where the US goes, some say, everywhere else follows.

We would refrain from bottom-fishing in emerging markets. We remain positive on Japan with the proviso that volatility after the elections cannot be ruled out, though the outcome is all but assured.

We are more cautious on the outlook for the wider Asian markets with slower Chinese growth in prospect.

We prefer stocks geared into a domestic recovery in Europe and the UK and, selectively, commercial property benefitting from such recovery. The same goes for fixed income though it must be said that given the unstable backdrop, risk-free returns of 2-3% suddenly seem attractive.

As always, we recommend diversification in order to spread risk and prudent investment in the wealth creating sectors of the world economies.

Risk warnings
This document has been prepared based on our understanding of current UK law and HM Revenue and Customs practice, both of which may be the subject of change in the future. The opinions expressed herein are those of Cantab Asset Management Ltd and should not be construed as investment advice. Cantab Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. As with all equity-based and bond-based investments, the value and the income therefrom can fall as well as rise and you may not get back all the money that you invested. The value of overseas securities will be influenced by the exchange rate used to convert these to sterling. Investments in stocks and shares should therefore be viewed as a medium to long-term investment. Past performance is not a guide to the future. It is important to note that in selecting ESG investments, a screening out process has taken place which eliminates many investments potentially providing good financial returns. By reducing the universe of possible investments, the investment performance of ESG portfolios might be less than that potentially produced by selecting from the larger unscreened universe.