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
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?
The Turn of the Screw
So, we have Truss now. The continuity candidate, not the dull man who would take away our sweeties. But also, the same old Fed, keen to do just that. And its time we took a look at Starmer, the other continuity candidate and an excellent book on him; required reading for serious investors.
Otherwise, it is always a good summer when nothing changes. Markets swoop and soar vainly trying to catch our attention, but the reality remains that rates have to rise enough to destroy the excess demand that causes inflation. And they have to rise to equal or surpass that level, eye-watering as that prospect is. It will not be over until the US jobs report goes negative, and stays negative; anything less is prolonging the pain. Â
Presentation over substance
But this is a time of intensely political Central Banks, headed up by people without a grounding in economics, but a lot of âpresentation skillsâ. They will be dragged kicking and screaming and smiling to do what they should have done last year, hoping vainly for some supply side reform or windfall to help out. But largely still facing the exact opposite, populists who think subsidies âcureâ or ameliorate inflation.
Markets are oddly buoyant; they get like this at times, but we see that as a mix of delusion, the self-reinforcing strength of the dollar (be very careful of that one, it is a new bubble) and the spluttering remnants of buying on the dip.
But be under no illusion, Central Banks trying to guess where the economy is going is like fly fishing with a jar of marmite. Entertaining, but highly unlikely to catch anything.
Truss: Issues and options
Truss meanwhile looks like a re-run of Boris; it wonât be quite that simple, but it looks like more style over substance, a different set of lobbyists, but nothing really changing. The idea either she or the EU can afford a bust up with the UK, just shows how silly markets can get.
Some of her programme may make sense, both the NI (tax) rises, and the corporation tax increases were badly timed and should be reversed, given inflation is doing the hard work already through fiscal drag (or frozen tax thresholds).
The rises were proposed when we were exiting the COVID crisis, but before we understood the energy one. We said so the last time we wrote to you.
Ditching a few Treasury backed white elephants (HS2, Freeports, the crazy fiddling fetish on capital allowances) would do no harm either, but overall, the marketâs verdict is clear: fiscal responsibility is still a long way out. We can all see how sterling has collapsed against the dollar; it is less clear why it has fallen against the Indian Rupee or the Chinese Yuan.
Source: See this website for all the daily data.
A book to read for all investors
So to Starmer, the likely next UK prime minister, where we need to pay more attention. Both on his mindset and on why the Labour Party hates him so much. Which in turn explains why (and with the Tories fatal ideological split heading them into Opposition), he is so fixated on party control.
Oliver Eagleton writes very well. His recent book The Starmer Project looks at four episodes, his left wing legal start, his transformation into a Tory enforcer with a penchant for exporting judicial expertise to the colonies (donât laugh), his alleged machinations to back the Peopleâs Vote nonsense to bring Corbyn down (pretty dense stuff, even now) and his use as the Blairite stalking horse to put a stop to Corbynâs chiliastic tendencies, (which also gives you a trigger warning about a light dusting of Marxist ideological claptrap).
So Starmer is all about what works, which would make a nice change.
Weâre looking at a very global mindset, apparently quite a strong Atlanticist outlook, keen to work with European authorities, but aware that the Brexit boat has sailed. An interest in devolving power down, but keenly alert to the risk of anarchy that entails. Indecisive, a Labour Party outsider (on his first election in 2015, apparently his nomination had to be held back to ensure he had the minimum length of prior party membership). Starmer is not exactly collegiate, but he has run a Whitehall department (as Director of Public Prosecutions) so not a loose cannon.
Very London too, Southwark, Reigate, Guildhall School of Music (sic), Oxford for post grad law, Leeds as an undergraduate. So should at least know where the Red Wall was. But lest you relax too much, a total ignorance of economics or business, let alone how to create growth. It wonât be easy.
And what about Markets?
Well for a UK (or non US) investor you only had one question this year. If you ditched the local currency you made money, and if you held onto sterling you got hit. Our GBP MonograM model is doing fine, it got that one big call right: kind of all you need. If you are a dollar investor, outside of energy your best place was cash. And our USD model took longer to spot that shift. As for active investing, sadly pretty much the same, the dollar is the story, or dollar assets. All of which perhaps makes dollar earners in the UK look cheap still.
But for now we see the story as a currency one, and at heart that is just about the timing of tightening interest rate spreads. The widening of those spreads has caused the recent havoc.
So when (finally) the European and UK Central Banks abandon futile incrementalism and get the big stick out, that will call the turning point.
Charles Gillams
The Times They are A Changinâ
Rishi or Truss, can either be worse than Boris?
Also, we do seem to be decisively leaving the decade of low rates and by implication the experiment of quantitative easing. On a twelve-month basis, bar the FTSE 100, all major markets are down, although that is only just true for Europe and Japan. The Nasdaq and Aim are the big losers, and their recent recovery looks like a head fake to us.
We look at the global economy, and investment options.
So, what does the race for the next UK prime minister now look like?
It is not that important anyway, if as I assume, the next election is lost already.
These are stand in candidates, with no real grip on the party and likely to be loathed by the surviving group of Tory MP after that 2025 contest. Like a relegated football manager, they will have shaky job prospects.
Is there much to choose between them? Again, I am not sure, they have established that the party to its core hates higher taxation, whatever fantasies Boris had, and some at least understand that a smaller government or higher debt, is what the hard choices of governing are about.
I rather expect much of the âdifficultâ stuff attempted by the last Cabinet will get ditched by new ministers. It still would be wrong to say the new team canât achieve much, the governing majority is solid, and further bloodletting inconceivable. I would anticipate that they will still have two and a half years to run.
The two candidates compared
Sunak is admired for his high-profile experience as Chancellor, disliked for his willingness to raise taxes, loathed for wielding the knife on Boris. Truss is thought to be opportunistic, and rather unfairly for being dim and not substantial.
But I donât expect much of a change, more fiscal conservatism, less besotted greenery, perhaps less socially liberal, but only to the extent of holding the line, not really rowing back. Short term stability, long term decline.
Preparing for another European killing field?
But you do feel Sunak would be less of a cold war warrior.
The report that the Chief of the British General Staff had called this âour 1937 momentâ and launched âOperation MOBILISEâ suggests the bloodlust is well and truly up, all adding to the hefty training programme. We are already deep into a proxy war ourselves.
I hear it is just as insane in the Pentagon. There is even high level gossip about this being the final great âkilling fieldâ in our centuriesâ old hostility to Russia.
Economy : two questions affecting interest rates and inflation
As for the global economy, we had two great questions for the year, how long could the Fed âextend and pretendâ over inflation, and how quickly everyone else would then play catch up.
Well pretty well the day Powell was re-confirmed earlier this year, he binned the Jackson Hole pretence that high employment did not have to mean high inflation.
I suspect (and so do markets) that he wonât really go after inflation, if he did so, we would have interest rates in double figures by Christmas.
Bread, job, and a roof, these three a politician must provide, and just one without the others, is a vote destroyer.
The current modest level of rate rises will let inflation creep lower, but will not control it, and we donât see interest rates topping out for quite a while, not helped by the very low starting point. Although overall, it looks like the currency markets are forcing the rest of the world to follow in raising rates quite fast and in the end, to the same levels. Nevertheless, in Europe the response to double digit inflation, has so far only extended to ending negative rates.
As if that will matter, as the Euro collapses; they will have to move faster. Lagarde confidently delivering total guff and mysterious lawyerly threats wonât save Italy.
The economic models everyone is relying on to forecast otherwise, seem to assume no incremental rise in energy prices next year, and indeed a sizable fall. That maybe so, but there will still be a lag as this yearâs rises have not been fully absorbed and will echo and bounce around the economy for a while to come. Not least through a still very tight labour market, which has several years of lost capacity due to COVID and indeed the familiar demographic time bomb.
A slackening in wage inflation needs US and Northern European unemployment to at least double; no sign of that yet. It is a muddled employment market with spatial and skill deficits, so increasing capacity where it matters, will take time. Not least because of persistent high surplus labour levels to the South and West in Europe.
So, if the Fed (and Wall Street) insists (as it does) on calling this transitory inflation, or now the new phrase, âpeak inflationâ, they are simply using dud econometric models (again).
What next?
Cash flow will again be king, capital will be well rewarded in the bond markets, dividends will have competition, non-dividend payers face a long winter. Experience of the dot com bust, and then the banking crisis, suggests it takes three or four years to retool models based on prior poor capital allocation (and boy have we had that). Not the three or four months which is being assumed.
Granted we were oversold at 3666 on the S&P 500, perhaps an auspicious low. Yields meanwhile had shot out beyond reason, but reluctantly we consider this pleasant bounce canât survive. We accept too that earnings are OK, but they are in most cases a poor indicator of economic forces that take years to establish themselves. The extinction of even capitalist dinosaurs takes time.
And then there is the great concertina of rates: ignore what each Central Bank says, in the end they must march to one beat, that of the dollar.
Monogram performance, compared to others in the Absolute Return sector
It is striking that our USD MonograM model now holds no equities or bonds, our GBP MonograM model is fully invested in both. While the list of storied Absolute Return managers who fail to beat our model remains embarrassing.
Download the newsletter of which this table is a section, for the full data.
There is no availability of this model, except through ourselves; perhaps it is time to talk to us about using it?
Do get in touch, an exploratory discussion is never wasted.
We wish you a pleasant summer: as good Europeans, we will fall silent for August.
I hope it all looks clearer when we return. Â
Charles A R Gillams
Boris finally quits, and 'Quality Growth'
Boris finally quits: the loss of his Chancellor clearly made this inevitable. We also reflect on the London Quality Growth Conference, held in Westminster last month. It implies a very US bias, driven by two US universities, that seem to dominate much of UK investing and indeed public policy.
First as tragedy, then as farce
So, it is over. The absurd repetition of the same error and the same apology passed from tragedy to farce.
Clearly the belief that you fight inflation and unpopularity, by bankrupting the country with printing money, had also simply become too much for Sunak. That was the fatal blow. Let us hope the next leader is less of a deranged populist. In the real world what is popular seldom overlaps with what is right.
We will skip the look backward, over his flawed career, skip the look forward over the seven dwarves, and fervently hope for a different set of economic policies by his successor. It sounds as if there is plenty of time for a long summer of speculation. The likely candidates are less than attractive, let us say.
How might the UK market respond?
Nor can I fathom a market response to a change of leader in London: bullish that it is over? Or could it be bearish as we donât know what comes next, or indeed bearish in that it surely strengthens the opposition?
While we felt the Old Lady moved far earlier than others (late in 2021) because of UK fiscal laxity, we see no reason yet for them to back off their August rate hike. Politically it is hard to stop and start interest rate moves, while just repeating a previous measure in mid-summer will look innocuous. I suspect thatâs true for September too, but that feels a long way off. And I do note, that as we predicted, the great spike in corn and wheat prices has taken just one growing season to unravel, as farmers react quickly, by adjusting cropping patterns, knocking out another justification for any more price rises.
A weak pound is also importing inflation, and the Bank has to make a stand somewhere, but 1.19 to the dollar feels too early, 1.09? Pressure will start.
Alchemy Unchained?
We turn now to âQuality Growthâ, an excellent conference and well presented with a dozen first rate managers from the US, UK, Europe presenting.
But it led me to ask about the underlying assumptions of the âQuality Growthâ model.
Firstly, there is the Santa Fe school, which speaks of the ultimate failure of nearly all quoted companies. This is the old â99% of the S&P 500 stocks contribute nothing to returnsâ case. Allied to that is the Columbia (New York) mantra that some companies can beat the pack for ever, so the theory is find those âcompoundersâ with their âdeep moatsâ and your investors will win for ever.
It was surprising how much of current fund management practice is wedded to those two assumptions. They look remarkably shaky to me, but if believed by enough of the industry, are likely to become self-fulfilling.
Which adds to another oddity: we know active managers seldom beat index investing. But this year should be showing the exact opposite. Passive long only funds are destroying wealth at a terrifying speed. So true active managers should do well too, but oddly (and absurdly) perhaps because of this âa few chosen winnersâ theory, they too seem to willingly forget about valuation.
True Believers
You see these few companies are (after exhaustive analysis) the nailed-on winners, so if the market halves, they will still outperform - just hold on and they will come good, the fundamental long-term analysis says so. You will recognise Cathie Wood, Scottish Mortgage are, in some measure, exponents of this too.
What is not to like? Well, self-reinforcing buying propelling valuation is dangerous; ask the Woodward investors about that one. But we also get odd clusters (identified as the winners, or the winning group, or amongst which will be winners; choose your terminology, like Tesla or Palantir or Netflix), which cut loose from sane valuations, becoming for a while mere intellectual Ponzi schemes, moving only upward, fed by endless new money.
Until they donât.
And every time âbuying the dipâ gets burnt, there is less fuel for the next attempt, and less appetite to try.
Too narrow a view?
I am not wholly convinced by the âonly a few stocks matterâ theory; for a start, you have to be very lucky with your baseline, even if you can spot the gems.
But even less do I believe that you can really thread the needle to identify the great companies, and secretly buy them, without shifting their prices and then hold them, in public portfolios. If you are right (and success requires you to be right) then everyone else piles in, and valuations simply become a function of overall liquidity.
The belief that having found them, you can leave them in your portfolio for decades, feels somewhat quaint. There are some giants that do perform year on year, but we all know of plenty of giants that rise and stumble (see above), and many that have multi-year slumbers (most oil and bank stocks).
Fashion or Momentum?
So, at the conference, we had a hall of great fund managers, but also the odd IFA pleading to be told about current performance, which was simply shrugged off. Our clients are always keen to be told about our recent performance, I am sure in truth so are theirs.
Given the structure of the market, now may be the perfect time to buy Quality Growth, but that bigger question about rates and inflation trumps all. And investing, we know, is about fashion, thatâs why momentum (usually) works.
I do like some of these funds, and respect their hard-working managers, but feel investing needs a hybrid approach, quality, yes, growth yes, but critically valuation and momentum too.
It seems like public policy has also increasingly drifted in the direction of this âpicking winnersâ theory and backing what are believed to be high yield, clean, desirable industries, rather irrespective of their viability.
Public Policy implications
Once you accept fund managers can spot these, you perhaps accept governments can also nurture them and scatter tax breaks around them. This will, at the same time, destroy the rest of the commercial ecosystem, in part, oddly to fund the hoped for predictable and desirable elite. Look at what Tesla (again) has done, extensively subsidised by exchequers round the world.
Does real life work like that? I doubt it - but investing theory has clearly now tainted public policy too.
 Â
Charles Gillams
Monogram Capital Management Ltd