River Deep, Mountain High
Welcome back Mr. Powell - so what is a good response to impending inflation?
After nine months or more the newly reappointed Fed Chair conceded the blindingly obvious: we have an inflation issue, along with the equally transparent need to tighten monetary conditions to quell it. At least heâs fronted up to that, unlike the position in Europe.
What diverts us is what the right response is. Some things are perhaps obvious: gold at least in sterling terms now has positive momentum again. But there is a tremendous volume of liquidity to soak up still, while stimulus will keep being pumped in for a long time. But fixed interest just looks hopeless, credit quality is plummeting, rates are rising, and returns are poor, even in high yield.
Are we clear of COVID effects?
Nor are we really clear of COVID effects. We are yet to pass beyond all the âemergency measuresâ. So here in the UK, VAT is still reduced, commercial evictions banned, and government departments are still showing that odd mix of budget destroying costs and below normal productivity. So, spending pressure will stay elevated for a good while. Tax rises on corporate profits and on labour through National Insurance hikes, will therefore start to bite, well before the last variant has caused another pfennigabsatze-panik. (spike/trough related panic)
Markets have also been jittery. In general, the buying opportunities just after Thanksgiving have held, which is a good sign. The subsequent gyrations have (so far) indicated a good weight of money ready to buy the dips. But there is little doubt cash is fleeing the overhyped stocks, which are far more prevalent in the US, than in the UK. The shift out of basic commodities is also apparent. So, I would still expect enormous cash balances to build up into the year end in the banking sector, albeit maybe not always in the right places. Any Santa Claus rally will be strictly retail elf driven; the old man is self-isolating this year.
Characteristics of this inflation
Our view remains that the expected high inflation is systemic, simply because of the structural damage and inefficiency inflicted by COVID. So, it maybe transient, but multi-year transient. In this case while the seasonal moves down in energy prices will be a welcome relief, assuming Northern Hemisphere temperatures stay around seasonal norms (and thatâs what mid-range forecasts are indicating) - it is not a solution to the inflationary pressures.
Nor do we see the any unwinding of the inventory super cycle caused by the holiday season and the ending of lockdowns, all at once, as having much beneficial impact on price levels.
Businesses all want inventory and will keep rebuilding it across their full ranges for a while. After all, right now holding stock has little financial cost attached.
See this article published by Markit.
Most corporates are at heart squirrels; it wonât be easy to break a new habit.
So how should we play this?
The bigger issue is how to play this - the received wisdom is pile into the US, probably the NASDAQ, while having a side bet on bitcoin or some less disreputable alternatives.
Thatâs where most investors knowingly or otherwise have their funds.
NASDAQ may churn as dealers try to create some volatility, but the overall (and in our view inflated) levels will most likely remain.
This Omicron variant episode at least has halted the IPO madness, and the whole SPAC nonsense is washed up. Sadly, not a big surprise to see portly old London has just tried to catch a train that left the station last year.
The longer view
But it is a bubble we think - our icf economics monthly looks in more depth at how these played out the last couple of times. Not pleasant, but oddly familiar.
NASDAQ and Bitcoin may yet scale new peaks, but the river below is very deep. Perhaps that old affection for base gold is not just nostalgia?
Time for some year end reflection.
Charles Gillams
Monogram Capital Management
Which is the Leviathan?
This is a week to ponder the role of private equity in portfolios, in what may be an early phase of a great investment and technological explosion. There seems to be no sign of higher interest rates and a stubborn refusal by Central Banks to care much about inflation. The talk of a UK raise always looked to us like a head fake which we ignored.
Spotting good and bad private equity
So first to private equity, a beast that comes in many guises, not all benign from an investor viewpoint. All liquidity fueled equity explosions come with a heavy loading of chancers; Bonnie and Clydeâs rationale for bank robbery remains valid.
Good private equity relies on management being superior to that of their targets. This can be in their analysis, their execution, their swiftness of foot or their innovation. All of this generally flourishes away from the hidebound inertia of many listed companies and their professional Boards of tame box tickers.
Bad private equity uses accounting tricks, the malleable fiction that the last price is the right price in particular, and the terrible phrase âdiscounted revenue multipleâ which is a nice conceit for ânever made a profitâ. All of these share the same vice of management marking their own work.
So, we struggle with the likes of Scottish Mortgage and its little array of unquoted Chinese firms, the alphabet soup of non-voting share classes and love affair with management. Maybe they are that skilled, but nothing that looks like a real two-way market is evident to us, in many of these valuations. We have by contrast long admired Melrose Industries for their quite ruthless devotion to turning over their investments, good or bad and stapling executive pay to actual cash realizations paid to investors.
Where we stand â given our strategy
For an Absolute Return specialist there are added constraints: we want to hold under twenty positions altogether and all in ones we can sell tomorrow afternoon. And we like holdings where valuations are transparent, there is no gearing (there is usually quite enough in the private equity deals already), and you can pick them up for a fat double digit discount: oh, and we do like a yield too.
So, we are looking for big, listed options with hundreds of high-quality funds bundled together and for any yield, a bias towards management buy outs. We are certainly not at the venture capital end, with silly pricing, high fail rates, unrealistic managers, and not a decent accountant in sight and aspirations to change the world. Met those, invested in too many, and donated more shirts off my back than I care to enumerate to their serial failures and inexhaustible funding rounds.
But there are good things about Private Equity, one is that in a rising market, it can be like clipping a coupon. The accounting rules require them to be backward looking, so coming out of a trough they are typically reporting on valuations that are three or four months old, which in turn reflects business activity up to six months old. As they trade at a discount of typically 25% or so, you can buy today at a 25% discount to the value of the business they were doing in the spring. There are no guarantees, but for most, that was a lot worse than current conditions, so todayâs price is simply wrong. This is a time machine that lets you buy now but pay at old prices.
Watch for built in volatility in private equity
These lags are complex, the reference points are often public market valuations, and so there is volatility built into them. While in an Absolute Return fund, not only are choices limited but the overall exposure must be too. However, in those rare purple patches of fast recovery and expansion they are excellent for performance.
What kills these bonanzas off is tight credit. In part they need debt for trade, but also their realizations rely heavily on it. A closed IPO market does them no good (just as they enjoy an exuberant one). That is a risk, as liquidity starts to tighten, that this will hurt, but as Powell and the Bank of England both showed, there is no political appetite for that just yet.
The UK and US on taming the leviathan
Indeed, Sunakâs UK budget yet again feels reckless, devoid of any discipline and with every department cashing in. Government spending is predicted to rise to 42% of GDP by 2026, a fifty year high. Healthcare alone is predicted to have grown by 40% in real terms since 2009 (both estimates from the oddly named Office for Budget Responsibility). At that level of loading, it is inching closer to hollowing out the entire budget and causing it to implode. (Leviathan was just such a creature âbecause by his bigness he seemes not one single creature, but a coupling of divers together; or because his scales are closed, or straitly compacted togetherâ feels an apt description of this new giant state apparatus.)
But that gamble means there is no room to pay higher interest rates, or the economy will be reduced to a double-sided monster. The one face devoted to raising debt and levying taxes and paying interest, the other to feeding out of control public spending, with nothing left in between.
Thanks in a slightly odd way to a Democrat Senator, America has avoided throwing itself under that same bus, but with no effective political opposition the UK is now powerless to resist. Sterlingâs relentless decline from the summer high and a FTSE 100 index still below its pre-COVID peak signify what markets feel about all this.
From the London Stock Exchange graph
So, while we were more bearish than we have been all year, in terms of asset allocation, at the end of October, we have yet to call time on the Private Equity cycle, that has provided such a powerful boost this year. It still feels good value to us.
Of course, we recognize too, that the populist fear is of the wealth creators and an opposing adoration for wealth consumption. Unlike politicians, however, we are tasked with producing real results not vapid dreams.
I guess we can each choose which to regard as the leviathan â the burgeoning state, or private equity.
Charles Gillams
Monogram Capital Management Ltd
Caution: Bumpy Road ahead
Puzzle: World markets have whipsawed in the last few weeks, from high anxiety to an almost beatific calm. The VIX volatility index has dropped to pretty well a post-pandemic low. Which should mean we all agree, but on what exactly? Rising inflation, yes, but how durable, and caused by what?
And that, we all accept, will make interest rates rise, yes, but how high for how long? Markets we feel are, to say the least, fragile.
At the turn, we know that moves can be dramatic both ways, for markets. Â
Are we really seeing a labour shortage? The UK truck driversâ situation
What we see now is not a labour shortage, and hence political talk of stemming migration and higher wages is well off target. What it is, in part at least, is a failure of the routine operations of an incompetent government, something politicians typically donât want to discuss.
The government has insinuated itself into so many areas, with its complex regulations, that the market economy now lies ensnared in myriad interlocking regulations, backed up by a deeply entrenched blame culture (and its friend the compensation economy).
To take one example, there is no shortage of truck drivers, but there is a shortage of qualified, approved, signed off and regulated truck drivers, because as part of the destructive lockdown, the government just halted the conveyor belt of required testing and approvals.
Truckersâ wages have for long been too low, of course, especially for the owner drivers in the spot market. What we have is not a labour shortage, itâs a paperwork shortage. The difference is vital for how enduring inflation is. A new driver will take a couple of decades to grow, but clearing a paperwork jam, a few months. One is enduring, the other transient.
Withdrawal of older workers from the labour market
Work after all is something of a habit: once it is lost, it can be hard to understand why it existed. So, we see a marked increase in older workers in the UK who have just withdrawn from the market (Some thirty million fewer hours worked - see figure below). That too is not a labour shortage as such, they all still exist.
But if work was of marginal benefit to the worker, and the costs to resume work (actual or psychological) are high, disruption will cause the fringe or marginal job to be unfilled. Yet again more in the transient column than permanent.
Someone will waive the rules, or the government will notice, well before all drivers get paid high enough wages to cause embedded inflation. In any event articulated fuel tanker drivers tend to work for big employers, with good conditions, and are well organized. They have to be, after all they drive mobile bombs. The spot operator on a rigid rig is in a different market.
Inflation will most likely be transient
So, if it is not an actual labour shortage, it wonât cause wage inflation, and will be transient. Some other areas reliant on highly skilled older workers will continue to see standards fall, but generally younger workers will over time fill those slots and gradually acquire those skills. And it wonât be a long time.
Our view from way back was of 5% plus inflation and labour markets that struggle to clear this year. We were wrong to not foresee the failure of regulatory processes to keep up. However we still do see a permanently higher post COVID cost base and therefore in certain sectors, a large amount of marginal productive capacity are likely to be withdrawn from the market.
With a banking system that still struggles to offer commercial finance to the SME sector, because of excessive regulatory caution, there are swathes of jobs that have simply gone. So that labour will in time be redeployed. The current concern is that many of these workers show no desire, or ability under current conditions, to return to the market. But when they do, the capacity that has been destroyed will slowly return, and once more drive down prices.
Nor should we forget just how much the Exchequer loves inflation, as fiscal drag, their beloved tax on higher prices, smooths away so many budgetary blemishes. They will let it go, if they possibly can.
Commodity prices
On the input side we do still see commodity price rises as transitory, at least within the energy market. As others have noted much of that too is regulatory failure on a grand scale, not a true shortage. Price fixing by the state is a notoriously foolish concept, as we learnt in the 1970âs.
There are a number of other supply factors at play too, but while some will recur, most are temporary. Â Â
How long do we think the inflation spike will last?
So yes, inflation will spike, and yes it will stay elevated for much of next year, but no, we donât see it as necessarily durable, once COVID restrictions and related behavioural changes vanish.
We are still pretty certain that the political costs of aggressive interest rate rises will outweigh any perceived price control benefit. As long as some Central Banks hold off rises, it will be very hard for others to do so, without sharp currency moves or bringing in formal exchange controls. That would in turn spook markets far more than rate rises. Â
The next phase of markets
All of this says to us that a major market dislocation, despite the benign signals, lies ahead in the next six months.
Markets shifting rapidly are more a sign of uncertainty than of a new degree of confidence, and we simply donât trust it. We see inflation as apparently out of control, but no significant interest rate rise response is feasible. That can feel like stock nirvana, but also like investor purgatory, as you have no idea what is or is not a sustainable profit.
Charles Gillams
Monogram Capital Management Ltd
Inflation: The elephant in the room?
Inflation and how persistent it is, now fascinates us although we will skip how that relates to US bond yields, as that currently makes no sense. Weâre also pondering the recent high performance from non-US markets.
We signaled inflation as a forthcoming problem well over a year ago, and slightly oddly not for either of the two reasons now cited so often. The received wisdom, that it is all about freight rates and used car prices, identifies specific issues we had not spotted.
Freight and used cars â really?
The freight issue seems to be a jumble of factors, dominated by having the âwrongâ demand structure, so in any movement of goods (or people), one way traffic is also the worst, if you can get the return route paid for by someone else, you will always halve the cost. Hence the obsession on most mass transport with return tickets. Sudden demand shifts destroy that balanced economy. But clearly there is more to it, so poor port capacity, extra flows created (or existing flows destroyed) by COVID all matter, all that PPE displaced other goods, while grounding airlines eliminated vast amounts of high value hold space.
But all of that, the natural creation of new capacity (that is making more containers), or simply activating more shipping from lay ups, will create new supply, and we therefore recognize that whole process as a fairly short-term spike.
As for used cars, well, I can see from the congested roads that no one is using public transport, but with global over capacity, how long will that surge in demand for cars last? In general shutting car plants due to excess capacity still remains the trend. While flaws in the too tight âjust in timeâ schedules have been apparent for a while, not helped by almost bespoke production, but that too is all probably transient.
After all, a hire car can be any colour, as long as it is black.
So, what did worry us about inflation? Capacity and competition remain the two drivers.
It was capacity, as either the number of viable business units has to decrease, if the costs per unit increase, or the price per unit sale must rise, hence inflation. This is obvious to most, although it seems not to many Central Banks. For a while any business will, it is true, keep going, even if only generating a marginal contribution, but soon it must either cease trading or lift prices. Companies just donât sit about making losses, in the real economy.
The other part is competition, as the number of operators in a market decrease, the survivors gain greater pricing power to raise prices, while no one builds any new capacity simply to suffer losses. You can easily see these two dynamics play out in the coffee shop sector (or indeed with wine bars and public houses). COVID eliminates 50% of the capacity, by enforced social distancing. Takings must then also fall by 50%. You can prop that business up by furlough, or tax cuts, or eviction bans, but sooner or later the owner will conclude that in a fixed physical space, a 50% revenue cut just canât work.
With operators in both those sectors and indeed many others deciding they have had enough and donât want to face mounting debts, the capacity is then lost and the incentive to replace it is weak, so competition inevitably drops.
Looking back at the hire car sector for a moment
We are told it is price inflation caused by a temporary shortage of cars, but that sector famously is full of border line survivors, the margins are wafer thin and often come down to the residual fleet value. Several big firms have also dropped out through insolvency; of the rest many only ever survived on the twin props of residual fleet value and extended manufacturer credit.
Do you think high secondhand values are making them expand their fleets? Not that plausible. More likely they are cashing in. Nor do auto makers need to restock them on vastly extended credit terms, just to keep their own production lines running. New car sales to the sector are always at low margin to bulk buyers. So thatâs not likely either.
We think it is quite possibly inflation from capacity cuts and weak competition, and that is nothing like as transitory. That is far more durable, not a brief supply side spike. Turnover is vanity, profit is sanity, as industrialists say.
In short Powell et al want to see no inflation, want to tell their political masters it is all fine, that they can keep running the engine hot, but having skimped on the engine oil, it seems rather more likely that running hot will simply seize the engine. At which point they must either coast to the hard shoulder or apply the handbrake of interest rate rises, before the economy blows a gasket.
Currency and the momentum model.
The other note of interest to us is that non-US markets are starting to flash up on momentum boards as exceeding US returns over some time periods, in particular in GBP comparatives.
In dollar terms the momentum is in the S&P 500 and NASDAQ. However, in sterling terms it is moving. We have noticed Europe shifting ahead for a while, but we were surprised to see our GBP momentum model now drawing our attention to Latin America.
Now a lot of these models (ours included) are very sensitive to the recent past (that is the momentum we care about, after all) and that means there are big moves to fall in or out of the sequence, so care is needed. But despite the headline turbulence and distress in the Latin American continent, it has forces in its favour; the index is dominated by big mining operations, closely followed by oil companies, then banks, which are seeing rates rise sooner than in the rest of the world, and then (often Mexican) consumer goods.
They will find the weaker US dollar helpful in some sectors too, but will especially enjoy the vast demand surge (and short supply line to) the US. So, all in an index with some good reasons for outperformance, despite the political noise.
Is Sajid now a factor to note? Rapid reopening will probably also continue.
Talking of politics, I donât see the renewed ban on French holidays (or rather the absurd elongated quarantine on return, regardless of vaccine status), as anything to do with COVID. Rather it is a shock coming from the always unstable Tory politics, where the return of Sajid has created the first node of a genuine ânot Borisâ grouping, as a minister now too valuable to be left out in the cold.
Boris canât bully him twice, without a major loss of face, so some of the other pretenders to the leadership want to take him down, by sabotage to his policy of an overdue full and proper re-opening.
Shapps, who dreamt up the absurd new ban, it seems wants to usurp the health portfolio, and apparently feels put out at being left in a dull and dangerous ministry, hence his attempt to claim territory and undermine a cabinet foe. However, I think his manoeuvre makes little difference to the overall thrust of government policy on rapid reopening.
We also note, that at long last the destructive and stupid attack on UK banks, by enforcing a dividend ban, when they were awash with cash, simply out of political spite, has been ditched. I suspect it is too late to reverse long term damage to the sector, but even if a year late, common sense is welcome, as is evidence that the colossal 2020 state seizure of power, is at last being pushed back, at a few points.
Last April/May I was writing about these kinds of issues, now sitting in this book, if the more regular amongst my readers would like to take a look â one of the measures has to be consistency of approach, after all. The second volume is under preparation.
Finally, we too will take a summer break, returning to this just before the August Bank Holiday, as summer draws to a close.
We wish you an enjoyable break and a well-earned rest from what has been a crazy year.
Charles Gillams
Monogram Capital Management Ltd
18.07.21
ALL QUIET: Covid and UK Property
A brief glance at an excellent first half for investors: thoroughly ârisk onâ for the first quarter, but a slower but still an upward grind thereafter. Not that such arbitrary dates matter. What does count is what can make it kick on from here?
Covid patterns
So, first a glance at COVID, or rather our reaction to it. The disease itself is now less important in most OECD economies, they have the capacity to deal with it, vile though it is, and the vaccine numbers are rising steadily, faster than we expected in the UK.
This is a screenshot from this website at Johns Hopkins University : https://coronavirus.jhu.edu/map.html
In raw demographic terms, in most places it is barely a flicker on the remorseless upward march of global population growth, but the extraordinary evasive action being taken mattered much more, and I see little sign of that abating.
Watch a dynamic map of all births and deaths at this site: https://srv1.worldometers.info/world-population/ (these figures include all deaths, not just from Covid 19.)
One of the key issues is that, for whatever reason, it is prone to sudden spikes, the only defence to which is almost complete (90%?) vaccine coverage. Indeed, the spikes can clearly ride quite widespread vaccination, higher than originally thought. But the spikes last weeks, perhaps a month, and for most of the year, most places are not experiencing them.
The trouble, especially in the UK, is our muddled policy response is to take down the economy on a semi-permanent basis, almost as a fetish against the lurking evil. To put in place colossal support measures for spikes that are transient is both cripplingly expensive and turns emergency response into embedded base cost. We are on a constant war footing, even when the enemy has seeped away to regroup.
So, despite Mr. Javidâs optimism, we do expect the bureaucracy to cling onto extensive controls, that limit capacity in public services and many consumer sectors. I had hoped that the ridiculous restrictions would bear down on the eliteâs summer holidays, but I now understand they donât care, as they clearly donât obey them anyway.
HOW MUCH MORE DELAY CAN THIS 'REOPENING TRADE' TAKE?
Which brings us to two thoughts, firstly the re-opening trade is shrugging off some mighty setbacks, and very little of the run up from last November was based on controls extending into 2022.
At some point balance sheets will start to crack, and values will then retreat.
Commercial property sector
The other is a more sector specific concern, but also a straw in the wind, in the extension of the UK commercial eviction ban well into 2022. I donât follow the logic of that, it is a significant ongoing seizure of private property rights, it is not clear to what end. It is not protecting jobs, unless furlough is also to be extended. It appears to assume businesses can occupy premises rent free for an extended time period, although the Government also suggests (slightly oddly) that much of their business support package (mainly loans, with government backing) can be used to pay rent.
Not that I care much for commercial landlords, who have long been over protected in the UK and exploitative, but it is to me, an odd move. We looked at real estate earlier in the year and expressed support for the TR Property Investment Trust in particular, in February, after which it has been on a run. But reading a quartet of March year end REIT annual accounts, I feel rather less sanguine: those are British Land, Land Securities, Helical and NewRiver.
The trouble here is they got hammered last year, with their March rent collections a mess, and double figure valuation drops on the retail side, they have been hammered again this year, with similar double figure write downs, and now it looks like they could be hammered for the current year too. Thatâs a lot of damage for the sector.
Office rents are holding up, collections are better, surrenders fewer, but they are running hard to stand still, with typical average lease lengths in single figures; this brings a lot of renewals too close for comfort. Time off debt maturities is also becoming significant.
Some Specifics on British Land, Land Securities, New River.
Equally clearly a lot of London occupiers, in particular, will have spare space, probably well into 2024 and maybe forever. Successive asset write downs, keep eating into the debt cushion, rates are low, so debt service is not an issue, but covenants are tightening, cash flow for development is getting squeezed and banks are not sitting back, just because the tenants have a state license not to pay.
They do differ of course, British Land is fairly serene, based on London offices. Land Securities having been boring for so long has appointed a new team, from the student accommodation and logistics worlds. Granted both were good performers in the last decade, but they are talking of ditching much of the existing portfolio, to chase development schemes. Brave if nothing else, one might say. Helical is smaller but goes for ultra-high quality office refurbishments and expansions, with tenants who can pay for quality, but each of their complex inner-city projects can take years to get through planning and their growth depends on a steady stream of them. After current ones complete, there will be a hiatus.
While NewRiver, always an aggressive high (and at times uncovered) yield stock, also looks strange. Debt is substantial, and another double figure fall in values could be harsh. Granted that would take more of its yields into double figure territory, in areas where demand (and alternative uses) should really provide a floor. But it also flirted with a badly timed foray into pubs, and their valuers are (to no great surprise) saying valuations for those are in the âwho knows?â realm. Meanwhile the finance man is apparently jumping ship to lead a spin-off of the licensed premises, which sends some quite odd signals, although maybe holders have tired of his complex skills.
This leaves a more bifurcated market than ever, but with the risk of overvaluations both in the good stuff (last mile logistics in particular) and storage in general, and in residential.
By contrast UK retail is looking ever more wounded. It has been a great reopening trade, but unless the runway is really getting cleared, take off may now be too late for some.
Meanwhile Boris canât seem to let go, having gained control, freedom is clearly an unattractive option to those in power. If that stays the same, we can see a perfect real estate storm brewing, if and when liquidity dries up a little.
The umbrella organisation, RICS, has in the mean time this summary to offer as its full market survey results.
Politics in the constituency of a murdered labour politician
Finally, the odd thing about Batley and Spen, was the idea that the Tories could win. I looked up the odds on Labour last week, at 4: 1 against, I found them most attractive. And that was based on my wrongly writing off Gorgeous George, who mercifully is one of a kind.
Without his strange allure it was and is very solidly Labour. Another non-story, I fear.
Charles Gillams
Monogram Capital Management Ltd