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Around the world with Bruce Stout

Bruce Stout shares his thoughts on the world’s major markets in a typically forthright fashion after a difficult year for his Murray International Trust.

In his latest letter to Murray International shareholders, Bruce Stout shared his thoughts on the world’s major markets in a typically forthright fashion.

It was not a vintage year for Murray International, however, as its net asset value return of 4.6% lagged the 21.2% gain in its composite FTSE World benchmark.

As a result, the trust clawed back £5.3 million of previously earned but unpaid performance fees from Aberdeen.

Stout nevertheless vowed to stick to his defensive approach. ‘Severely stretched valuations reflect belief that the developed world can successfully wean itself off its chronic dependency on printing money without threatening fragile economic recoveries: that savers continue subsidising the profligacy of governments and irresponsible bank-bailouts; that deflationary pressures abate enabling corporate profit margins to breathe again; and that earnings will be delivered in sufficient quantity to satisfy high expectations currently baked-in to equity prices.’

Stout concluded: ‘If the challenge 12 months ago was how to preserve capital in an environment of rising bond yields, the focus is now compounded by how to protect capital when earnings expectations remain too high. Protecting margins becomes of prime importance, so the portfolio will remain focused on those companies deemed well positioned to achieve this.’

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The US

‘Choosing to accentuate the positive has long been ingrained in the US psyche. In a year when politics and policy debate dominated the economic backdrop, a constant flow of positive rhetoric was required to counteract the reality of lacklustre fundamentals. In this respect the US did not disappoint.

The most prominent portrayals of such imaginative interpretations involved assessment of economic recovery and debt reduction. Desperate for evidence of economic stabilisation following five years of post-credit crunch disruption, policymakers championed falling unemployment, rising consumer confidence and expanding GDP as evidence the US economy had turned the corner.

In reality, underlying activity remained extremely fragile. In the presence of anaemic earnings growth eternal optimists extolled the virtues of stock buybacks, but at ever-increasing valuations this was hardly in the best interests of existing shareholders. Such financial engineering of reported profits masked the weakness of underlying earnings growth, so much so that over 75% of equity market returns over the period were due to pure price/earnings multiple expansion. In essence higher prices were constantly paid for virtually no improvement in profits.

Even the most myopic observer must surely have noticed the ever-expanding debt mountain that continued to haunt the outlook. With the drip feed of liquidity no longer favourable, corporate profits must now be delivered in the US if valuations are to be supported. Against this evolving backdrop of stuttering growth and deflationary debt dynamics there remains enormous scope for disappointment.’

So what has Stout done in the market? He has recently bought into Verizon and healthcare group Baxter International ‘to maintain the high quality, defensive positioning of total exposure’.

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The UK

‘With the country still experiencing its slowest recovery in a century, having recouped less than two-thirds of the output lost during the financial crisis, progress was solid but unspectacular. Thankfully persistent talk of economic normalisation and back-to-trend growth was absent from most informed comment.

The possibility of UK GDP growing around 2% increasingly became accepted as a realistic pace of economic recovery, given deleveraging and deflationary headwinds that persist for consumers and companies alike.

So far so good, but not all aspects of economic life succumbed to the evolving sense of realism. Policymakers continually paid lip-service to the dangers of boom-bust property cycles yet actively encouraged policy directives destined to ultimately distort prices. Lectures were preached on thrift, abstinence and austerity yet simultaneously the Bank of England kept printing bank notes causing further distress to the country’s sovereign balance sheet.

More worryingly, Britain’s desire to become an internationally competitive exporter remained thwarted by relentless appreciation of sterling. Consequently, the net trade deficit constrained growth whilst a ballooning current account deficit rekindled genuine fears over future financing.

On balance, prevailing economic fundamentals marginally improved but rising bond yields left the heavily indebted mortgage owning UK public suffering disproportionately and increasingly weakened in terms of spending power.

For an economy so dependent on consumption for growth this will pose a tough hurdle to negotiate in the coming year, especially once the stimulus of unsustainable monetary support is eventually withdrawn. Like most developed equity markets, UK equity returns proved excessive relative to evolving fundamentals so great caution is warranted.’

So what has Stout done in the market? He has bought into BHP Billiton, which trades on 11 times forecast earnings, ‘using capital recycled from more expensive investments elsewhere’.

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‘With the past four years of crisis witnessing financial bailouts of five European nations, policymakers continued to struggle with practical agendas as opposed to theoretical rhetoric. Economic dislocation remained rife throughout Europe as contagion between banks and sovereign debt periodically threatened to destabilise the financial system.

Progress towards establishing a banking union persistently stalled as demands for national discretion repeatedly hindered the banking reform process. Strict rules across 27 countries was always an ambitious target given the enormous range of balance sheet exposures, liabilities and capital ratios that prevail. Powerful self-interest and reluctance to yield power ultimately ground the process to an effective halt.

Less ambiguous and infinitely more transparent was the evolving state of the Eurozone economy. Regional growth flirted with recession throughout most of the year. The economics of austerity prevailed in most European countries, exerting further downward pressure on prices. Emphasising just how fearful the authorities became over potential outright deflation, interest rates were cut to record lows.

While the prospect of negative deposit rates were not welcomed by savers, the severity of Europe’s debt-ridden fundamentals arguably gave the European Central Bank little choice. Plagued by record unemployment and rising levels of debt defaults, policy options rapidly ran out for Europe’s decision makers.

Within such a difficult and distorted economic landscape, the only real bright spot was Germany. Invigorated by being pegged to the globally competitive euro, the German export sector went from strength to strength. As exports boomed the importance of the Eurozone to Germany was increasingly evident. Any threat to euro currency sustainability clearly threatens future German prosperity, suggesting vested interests will prevail in preserving the Eurozone as is.’

So what has Stout done in the market? He has maintained his holdings of conservative large-caps, such as Roche Holdings and Nordea, despite their relative underperformance while the market favours recovery plays. ‘Whilst disappointing from a relative short-term perspective, the emphasis on defensive high quality positions will be maintained,’ Stout said.

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Latin America

‘Hostage to constantly changing sentiment towards perceived risk assets, Latin American financial markets endured a torrid 12 months. Conventional logic decreed reduced monetary stimulus in the US must translate into higher borrowing costs for all capital dependent emerging market nations.

Twenty years ago such intellectual reasoning was unequivocally accurate with widespread evidence of value destruction to support it. Fearful history would repeat itself, investors were quick to withdraw funds from Latin America.

No one considered the enormous strides made by Mexico and Brazil over the intervening years to wean themselves off US dollar debt. Overall sovereign debt levels less than half the bloated average of developed nations counted for nothing. Nor did substantial domestic savings held in long duration domestic bonds, nor indeed significant foreign exchange reserves. As investors picked at the scab of the 1994 Tequila crisis, structural progress was ignored.

Mexico delivered stable policies, controlled inflation, responsible government finances, respectable corporate profit growth and commitment to embrace pro-market reforms. Despite market weakness, Mexican portfolio exposure returned over 10% in sterling terms with above-average dividend growth enhancing total income accrued.

In Brazil, the increasingly fractious presidential leadership of Dilma Rouseff undoubtedly aggravated economic pressures caused by rising interest rates and relatively weak growth. Domestic spending and credit growth stayed subdued in line with central bank objectives, but negative international sentiment arguably reflected rising political uncertainty rather than structural economic hardship. A 32% decline in the value of the real against sterling over the past two years quantifies the magnitude of concern currently discounted in Brazilian assets.’

So what has Stout done in the market? Deeming the sell-off ‘excessive’, he took the opportunity to add to stakes in Vale, Bradesco and Petrobras, ‘companies where long-term growth prospects remain attractive’.

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‘The financial and economic landscape in Japan changed markedly over the period but not necessary for the better. All areas of society were influenced by the Bank of Japan’s radical monetary stimulus. Headline statistics showed the largest yearly gain in Japanese equity prices in four decades with the yen declining to its lowest level against the US dollar in five years.

Whilst Japanese shares finally got the world’s attention, investors clinically examined the sustainability of the Great Reflation Plan. Dramatic currency depreciation immediately translated into rapid rises in food and energy costs. With prices escalating five times faster than wages, consumers’ purchasing power and confidence were severely constrained.

In the misguided pursuit of generating inflation the government appealed for companies to raise wages. Such calls, not surprisingly, fell on deaf ears. Faced with rising costs squeezing profitability there was no appetite within corporate Japan to stomach further competitive erosion through wage hikes.

Structural rigidity also prevailed in financing terms as the demographically aging nation faced the mammoth task of funding a sovereign debt burden now more than twice the size of the economy and a deteriorating trade deficit. Adding to the potentially growth retardant impacts from an imminent consumption tax hike there can be no doubt systemic risk to the Japanese bond market has risen significantly.’

So what has Stout done in the market? Steered clear. ‘The safest place to observe evolving economic events in Japan is from the side-lines so current low exposure will be maintained,’ he stated.

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‘Capital withdrawal and portfolio outflows constantly stoked demand for US dollars throughout the rest of Asia. Currency weakness was the dominant theme all year. As devaluations gathered momentum, inflationary pressures rose, with those countries particularly dependent on inelastic imports of food and energy worst affected.

India and Indonesia fell into this category, suffering a miserable year of rising consumer prices and deteriorating current account deficits. Fear and uncertainty restricted economic activity, causing widespread cyclical slowdowns in growth throughout the region. South Korea, Thailand and Taiwan could only manage around 3% growth rates, and Asian heavyweights India and China slowed to their lowest levels of growth for over a decade.

Consequently Asian equity markets underperformed developed markets by the widest margin since 1998, the year of the Asian crisis. Not only was this strange, and arguably excessive, fundamentals bore no resemblance to those prevailing 15 years ago.

Whilst history illustrates the folly of standing in the way of short term capital flows, it also illustrates longer-term pricing anomalies that present attractive investment opportunities when such practices persist. That point is rapidly approaching.’

So what has Stout done in the market? He has retained holdings in businesses with robust earnings and dividend prospects regardless of the prevailing macroeconomic backdrop, such as Unilever Indonesia and Taiwan Mobile, confirming that he would also look to increase exposure on further price and currency weakness.

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Bruce Stout
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