Reflections & Predictions
This year wonât be last year, that much we know. Nor indeed will it be the inverse, which is inconvenient. So, starting this year as last year, but simply turned face down on the desk, is a trap.Read more
All Clear? REITs and Private Equity
When do we go back to property (REITs) and private equity (PE)? We look closely at these two areas, as there appears to be nothing new to see or say on interest rates or inflation.
Macro is dull just now
Neither the Fed nor the Bank of England, nor indeed the ECB meet this month. So, the default is to assume a half point rise all round. Which should mean Western central banks are broadly aligned for a while, so by implication are currencies.
Clipped from this site â downloadable from source.
Recessions lag rate rises, so are not due yet either, although clearly one is coming.
Inflation will probably drift lower, but the employment markets stay strong, as the shuddering readjustment out of COVID continues to keep churn elevated. In person service hires roughly balance stay-at-home sector losses for now.
Basic food commodities, which have driven much of the recent inflation surge, will stay elevated until the current crops/stock are harvested and replanted late in the spring. Energy is possibly oversupplied for this winter. So not that much change in those two inflation drivers yet.
REITs
So, when is it safe to go back into risky assets? We look at two contrasting stories, firstly REITS which are seen as bond proxies, so cannot properly bounce until rates top out. This seems to need a couple of months at âno changeâ from the Central Banks. We are less sure about quantitative tightening ending, but most of the market gets spooked by that too. We think it matters little, because masses of global liquidity make what US banks hold somewhat irrelevant.
Nor do we see why REIT assets held on 7â8-year leases with typical debt fixed for half that term, should oscillate so violently over a few months, but thatâs life, they just do.
Does property matter?
Institutional interest is not high, we know that, and most institutions need daily liquidity before all else, which lumpy property canât give. Plus, for boring old REITS a lot has changed for the worse.
Who knows where retail space settles? It remains over supplied (and overtaxed), likewise probably office space, with the added wrinkle of retrofitting for carbon neutrality. COVID created an excess of new storage and warehousing, which also needs to be worked through, so thatâs not safe either. While no institution wants the grief (or bad publicity) of dealing with individual tenants and homeowners, so we have long thought if you want to play the residential market, buy high street banks, as a kind of proxy. Mortgage lending is about all they do now.
It is private investors who still love property as a tangible asset; most are over invested in property and have been over rewarded for being so. Habit really. But if they had that habit before, they are still keen to know when to step back in, at bargain basement prices.
Private equity
Now PE, is a bit different. Yes, private investors like it (like hedge funds) but trust it about as much. Never sure why you would buy a car with just an accelerator pedal, and only forward gear, but most investors buy just that: no shorting, long only for ever. Must be nice to have a mind wedded to constantly rising prices (which long only implies).
PE is just that, so you are buying for management endlessly improving, but adding into the mix a belief in high gearing. You also believe that the managers will constantly be selling and buying investments at a profit. So, you must endlessly mark up your stock, to shift it too.
Can it really work like that?
Markets do not agree.
So, while there are many eye-wateringly deep discounts in PE, markets expect debt to blow a few things up and prices to sell stock to be cut back hard. With some reason, big banks have a shed-load of deal related debt stuck on their balance sheets, probably a fair bit of equity too, and no one is underwriting an IPO, if there is a scintilla of risk left involved. So, unless it is marked down, we have a stand-off, a buyersâ strike.
And in tech, the flaky stuff (AIM etc) is back down below pre-COVID levels, and possibly still falling, which is logical. The better stuff, but with an FX impact, bottomed out a while back, possibly in June? The big âportfolioâ quoted holders did so in October, when discounts maxed out around 50% and the FX (i.e., dollar) tailwind was keeping asset values rising.
NASDAQ - a proxy for private equity
However, the NASDAQ hit a new low on 28th December, and that looks much less like a clear bottom, more a long base from October. It is a tough call; NASDAQ multiples drive PE valuations, so that is not helping. Investments with three yearâs money a year ago, now have two yearâs cash and judging by the speed of layoffs, know that when that drops to one year, funding lines either dry up, or get super pricey. And I donât see FX helping much this year.
So yes, massive discounts, but also yes, huge lags and the normal discount implied for firms that mark their own homework on the valuation side. Audit firms may also be growing more supine (or getting sacked if they ask the real questions).
So, on a five-year view the sector is fine, even cheap, but on a five month or five-day view? The jury is still out.
While the PE sector is still looking better than REITS in terms of recent prices, it is still, in our view, the one that has yet to base out. If the reason for revival is a flourishing IPO market, that feels more like three years away; by contrast the stability in interest rates that REITs need will probably arrive this year.
So, we stay in touch with both areas, but by no means all in - not just yet anyway. But nor given the performance and yield they give, can they be ignored for ever.
Welcome to 2023.
Charles Gillams
Bonds and Bullwhips
What are bonds for? Not always what you think. And the whiplash of the economy, (the bullwhip effect on all markets) makes recession both inevitable and meaningless.
Corporate bonds vs government bonds
So, to compare bonds - a corporate bond is issued to fund a project to produce a return greater than the interest and principal, and then pay the lender back. Much of the value lies in the assessment of how reliable that redemption is. Some of it is also whether the bond is cheaper or more expensive than a similar one, some of it is who is allowed to hold that bond.
But value lies in redemption, especially at the shorter end.
So, on that basis, what are government bonds? Well, they are there to achieve other objectives, seldom involving either redemption or a cash positive lifetime. It is largely accepted that they are a funding device to load debt upon future taxpayers, who luckily canât vote. And the price of the bond is just what investors will pay for it.
Market rigging
Governments will therefore try to directly rig the market, to avoid paying too much interest, by for instance, mandating all investors and especially pension funds should hold gilts, their debts, on the gloriously fake grounds that they are âsafeâ. Well, just remember this yearâs disastrous collapse, down by a quarter at the long end, with plenty of volatility too, âsafeâ they are not. But the regulators and professional bodies still peddle versions of the old homily about the percentage of bonds in a portfolio should equal your age.
They can also apparently use the rate of bond interest to control inflation (so they say), so raising it (and devaluing bonds) if inflation rises, albeit the causes of inflation have little to do with the bonds (or bond investors). Then most marvellous of all, they can rig the price by easing and tightening their âquantitativesâ at will. Although no one is quite sure what a quantitative is, or indeed where it lives.
So, the government bond market turns out to be pretty much whatever you want it to be. To be contrasted with the weird and feckless equity, whose value can be, pretty much whatever you want it to be. Or indeed bitcoin, whose valueâŠ.
A difference of degree granted, but less clearly one of substance. Rigged markets in any asset, make us nervous, and all markets are increasingly manipulated, to some degree.
What of bullwhips and earthquakes?
Well, both show a declining sinusoidal wave, that ripples prettily along and disappears. Whether it is the globe scratching its toe itch in Tierra del Fuego, or an irritated ear in Reykjavik, it is very jumpy. Where you stand now can be higher or lower than yesterday; it is erratic, chock full of faults, and crucially, not smooth and cyclical.
So, measuring whether you are higher or lower than last weekâs datum matters little, if your fields have vanished into the sea, or indeed your sea has become a field.
So it is with recessions, after the shock we have had, being up or down two quarters in a row is trivial. Indeed, as that slick whipping wave races by, we will certainly be both.
Do changes in the Government bond markets matter?
And trying to decide whether the gyrations in the government bond market have any relevance to the level of the economy when the whole structure is bucking around, is slightly crazy. Nor are yesterdayâs maps going to be of any use.
That is even assuming that the price of bonds has any relationship to anything except how little governments want to pay for their exorbitant debts. While I have not even mentioned the wealthy autocracies involved in the same game.
And thatâs the market muddle we are in. The US Central Bank is playing old style economics, using the interest rate to control inflation - hang the cost of debt, thatâs a problem for Congress.
But the UK and European Central Banks are playing new style, because they fear that the usual medicine will be disastrous for their rather sickly patients.
And US stock markets are using that funny old, discredited, yield curve to predict a recession that is by their definition (two down quarters in a row) inevitable, but ignoring the COVID earthquake which has upended all our old data and assumptions, simply because we have never had one like that before. The curse of econometrics is that we can only predict the future if it resembles the past.
EU stock markets
Meanwhile European stock markets have understood rates are not going up much more, because the EU would prefer to rig the market, so investors think they must have avoided a recession, which is equally a delusion.
And underneath all that is the great big chunk of molten sludge at the core, the vast irredeemable mass of government debt, where real yields are apparently staying submerged everywhere.
So wise men can select from all of that to predict that markets in debt and equity are going to go up a lot or down a lot, really as you wish. And they may all be right, at least somewhere on the globe.
Our own choices
But we still see no point in holding state debt, nor much in holding cash for too long. Corporate debt and equities, especially equities with a real value that you can figure out, maybe. We look at ones without state interference rigging the price, and with an ability to raise prices to hold margins, and which have a dividend yield. Those, we think, may still be attractive.
And we are not alone, many markets and stock prices bottomed out in October and are steadily inching up. Our own MonograM momentum models (both in the USD and GBP versions, a rarity this year) have triggered a re-entry into equites, and for once in a while, not US ones.
Something is shifting under our feet. So next year at least, is very unlikely to be like this year.
When we next write the calendar will have changed and no doubt many rate rises will have happened. But we doubt if the big themes will change much.
In the meantime, Seasons Greetings and a prosperous New Year, to all our readers.
Tripod
We take a look at three things that move markets: macro, politics, and mood.
We have an inexplicable market rally to explain. On bonds we remain wary and we also take a look at the Keynesian attitude to inflation.
The obvious explanation for the market rally is Santa Claus, or perhaps in more mundane terms mood. The markets (in both bonds and equities) have had a beating, the shorts were satiated, the cash piles vast, and markets had simply had enough.
So, back up like a bungee it went, the heaviest fallers often bouncing back the highest.
Inflation (still)
We can talk endlessly about peaks and plateaus for interest rates, but we still donât see any measures likely to get inflation back to 2%, for several years. But it seems that doesnât matter now. The so-called base effects, the softness in commodity prices, the excess inventory (rather than prior shortages) all mean inflation will fall, and for most, for now, thatâs enough. Regardless of how far or how long it takes.
Indeed, there is some realisation that if prices are really rising at 10%, it is best to buy now, not wait for higher prices.
And for a lot of service-based firms, capacity is indeed short, and they feel free to ram through price rises, to open up their gross margins, assuming (rightly) that if everyone else is doing it, and no one really knows their true cost bases, they are winners. As they are.
And as we long predicted, the elimination of competitors, and monetary tightening, leaves big firms free to expand into a void. After all they have faced flat prices for a long time, so the chance to move prices up is most welcome.
Seeing it like Keynes
So, it is perhaps useful to remind ourselves of the Keynesian view that inflation is âa method of taxationâ which is used by the Government to âsecure the command over real resourcesâ in the same way as ordinary taxation. So, he was really not a fan.
How then do we explain the UK Treasury (all notional Keynesians) using abundant deficit financing to sustain already overheated demand?
Well in short, we donât, it is just politics. By raising pensions and welfare in line with inflation, the UK Government is acting as if they need to secure the economy against high unemployment and a recession. The classic ills Keynes addressed.
Although (so far) neither of those disasters is evident anywhere, except in their own predictions. Older hires are rising which is generally a sign of overheated labour markets, looking for marginal supply.
Which is quite neat, as if those evils donât arrive, the policy clearly worked and if they do, well our politicians tried their best. Given the shambolic recent failures of Treasury predictions, that they have any ongoing credibility is really quite remarkable.
But that process also embeds the long desired extra taxation, resulting from the inflation they are not quelling. There being no limit to how much Governments want to spend, there is equally no limit to their appetite for tax.
All of which nicely pings the pinball back to the Bank of England, which was so very unhelpful in the early autumn, so letâs see how they do now? Will they truly show the steel of the Americans or the Micawberism of the Europeans?
And interest rates (still)
The interest rate (beyond the short-term market rally) is therefore still the big decision. If inflation is here to stay, it all depends (once more) on the US, and on what reason the Federal Reserve has to stop tightening, even with high inflation. We canât see one. Albeit we are very reluctant to guess there is none, with such strong markets. And it maybe they just had an arbitrary target, which they have now reached.
From this page on the Vanguard website
However, that gives us a trio of reasons (apart from the roguesâ gallery above) to still avoid bonds.
- If inflation stays elevated, bonds are a rip off, as they have a negative real return.
- If the Fed stays strong, bonds are a rip off, because base rates are still rising.
- And if the Fed wins, but others fail, then bonds are a rip off, because the dollar keeps rising (and hence other currencies fall).
In summary the only bonds that look attractive to us are still short-dated US ones. Which is not really new, nor does it make long term sense, with strongly negative real rates still. Bonds by definition can only have a real return when rates exceed inflation, either due to falling inflation or rising rates. And we donât see that crossover for a while.
A THREE-LEGGED STOOL
So, we return to that trio: macro, politics, mood. Political uncertainty is much lower (for the next two years) in both the UK and US, and perhaps is not that unstable in Europe either, although the Ukraine war could still change that significantly.
Even China seems a little less keen on confrontation.
Macroeconomic factors really do not yet feel encouraging. It is way too early to declare victory over inflation.
Paradoxically when inflation is clearly beaten, earnings declines will then set in, as pricing power recedes. The failure to see that decline, will indicate inflation remains a threat.
And finally, mood - yes, the mood feels good, for now, although how long that remains is as much psychology as anything else. But if bonds do start to slip, donât expect the party to keep going for long. Nor will recent dollar weakness persist.
The overall view seems to be that the handbrake turn has been completed, we may slide a bit more, but we wonât spin again.
But that assumes we know a lot about the track and conditions - do we?
WHAT DO THEY KNOW OF ENGLAND?
Let us look at tech, private equity and this seeming market bounce, driven by those sectors. The NASDAQ is up almost 10% at 11,320 after a trio of twelve-month lows in the mid 10,300âs, the latest of those lows just this week. Meanwhile it looks like the US Elections have delivered both gridlock and a rebuff for Trump, which some see as a perfect mix.
Todayâs post title is derived from Rudyard Kipling at his most sanguine and reflective.
I HAVE FLUNG YOUR STOUTEST STEAMERS TO ROOST
The true horror of the tech wreck has also been concealed for UK investors, by the climb in the dollar, a move that seems to be going into reverse. In terms of closing prices sterling has rallied hard from 1.08 to 1.18 in a little over a month. This has left the NASDAQ collapse, from touching 16,000 - brutally exposed, now without much of the concealing currency appreciation.
Where is the Nasdaq headed?
We suspect that the NASDAQ is heading lower still, but accept that is a big call.
From this page on Tradingeconomics
It remains a crowded space for a lot of unprofitable companies to jostle, as they build market share. This disguises the possibility that in some spaces, even owning the entire market will still be loss making.
However, market sentiment has perhaps turned, the tech rubbish generally got chucked out early. The subsequent switching out of the tech majors probably had to be into Treasuries, where their recent price rises suggest some demand, or into cash.
It remains a crowded space for a lot of unprofitable companies to jostle, as they build market share. This disguises the possibility that in some spaces, even owning the entire market will still be loss making. Bumping up against that is the second phase of the market collapse, as the multiples on profitable tech giants returned to earth.
And cash (and oddly apparently the S&P) has also been seeing inflows from China and crypto, as those areas have sold down hard. There is also the unpleasant negative impact of holding cash, on returns. Put this together with sentiment, and this may well help the NASDAQ bounce into the year end. However, many fund managers cite the dotcom bust as meaning this is now starting a multi-year sideways recovery phase, not a quick bounce at all.
LONG BACKED BREAKERS CROON
A concurrent look at Private Equity is important. NASDAQ multiples drive much of their values and are falling, and with such a recent twelve-month low, Q3 valuations (private equity valuations are always lagged) have further losses built in. And a sprinkling of those will now also be based on a significantly higher dollar too. That wonât be pretty either.
Plus, as we know there are some spectacular blow ups lurking in there, the insolvent FTX was a big investor in, and investee company for, some well-known PE names. Overall, despite solid reports, I am still expecting some fair-sized holes in quoted private equity, as either the NASDAQ rises and the dollar falls, causing currency losses, or the NASDAQ falls and the dollar rises and the one again masks the other.
Access to distress financing, has it seems largely vanished, as it does at times like this, making the chance of highly damaging wipe outs, not just down rounds, much greater.
A possible dollar sterling parity?
But those talking of dollar sterling parity are surely way off now. So, regardless of future disasters, I want more information before seeing UK Quoted Private Equity Investment Trusts as a buy. About six months after the NASDAQ bottom, will be a good valuation point, and that likely means Q3 2023. At that point we will know what the current large discounts really refer to; I donât expect them to look anything like as generous.
THE UK - UNDER A SHRIEKING SKY
There is a lot of market optimism about the next UK budget, based on Hunt being really nasty. That may overstate his hand, as the Government has long abandoned reform, it can only support out of control spending by harsh tax rises, which will certainly kill jobs, but probably the wrong ones.
Nor can it do much to enhance investment and has foresworn labour market reforms, so both of those, with existing policies and more rate rises, must encourage the persistence of poor productivity.
Although of course the real budget numbers will be barely mentioned; energy, rate rises, and inflation are largely out of Huntâs hands. He is lucky all three do look a lot better than when he was installed. So, the need for harsh medicine is rather reduced, and may even disappoint.
But just as the rally helped US risk assets, so it helped others, like property, come off a deeply oversold floor. TR Property Investment Trust has jumped 30% in a month, for example, and still yields over 4%.
Post Mid-term elections for the US
And coming full circle, although slowing inflation took a lot of the credit, at least some of the post Mid Term bounce came from realising that the Federal Reserve now has an ally in the legislature. It can be less vigorous in steering the economy, just relying on the brake pedal, as Biden and Congress are no longer able to simultaneously hammer the accelerator.
Overall, however we still remain cautious, we expect this pre-Christmas rally to fade, rate rises to persist into at least Q2 2023 and rate cuts to be a 2024 feature. And peak gloom lies ahead as those rate rises conclude and then start to actually bite.
Looking ahead
In general markets have had a solid look at the worst case this year, from famine to invasion and nuclear war, to out-of-control Central Banks and deluded politicians, and nothing terribly dramatic has transpired. So even with bad things still happening, we donât see a repeat of this yearâs dramatic falls either.Â
Charles Gillams
- The Kipling Society meets on November 16th, at the Royal Overseas League.