THERE IS NO SANITY CLAUSE
Three big topics this week from three central banks, all of whom look to be in a muddle, with their knitting all jumbled up and highly implausible. Entirely predictable inflation meanwhile threatens to sweep them off their path, as they tinker with micro adjustments to interest rates.
Boris is diverting, but we doubt if it all matters; pre-Christmas entertainment. If he were logical or even vaguely numerate, he would change, but heâs not, and he wonât, but nor does he need to.
The Lib Dems win a by-election, that Labour fails to contest, but it makes no difference in Parliament, and it lets Boris look contrite mid-term. He will survive this with ease.
Which is not to say he should, or that heâs not making a hash of COVID, the sequel. In keeping the NHS in its current format, Boris fails to ask, as many have before him, whether it is still fit for purpose. This remains an urgent question. It canât simply collapse every year.
Bailey - Bank Governor and historian
But perhaps Andrew Bailey, Governor of the Bank of England, understands the extraordinary risks Boris poses to the economy, and has hiked rates to show that. A Cambridge (Queens) historian, with a doctorate on the impact of the Napoleonic Wars on the cotton industry of Lancashire, he will know full well the impact of a French orchestrated trade war backed up by a dodgy pan European monetary system.
A consummate insider, via the LSE, he moved on to the ascending ladder of the Bank, which did include a slightly unfortunate move into the FCA. This turned out to have rather more real villains than he was used to. Married to the head of the Department of Government at the LSE, he will be very well aware of the political game and the current mood in Whitehall.
Heâs seen enough inflation and has decided the Bank must pretend to act. Not only is the rate rise trivial, but it also coincides with a continuation of Government bond buying (QE), an odd call. That the last thing the economy needed was still more liquidity, has surely been obvious for eighteen months now.
Christine Lagarde and Jerome Powell
In Europe the same mishmash exists. We have been hearing Christine Lagarde explain why the ECB is now accelerating one asset buy back (APP) while ending another one (PEPP). She was winging it with the phrase âutterly clearâ in answer to a pertinent question, when it was clearly anything but. Still, she did seem to have her ear rather closer to the ground on wage inflation, at least compared to Jerome Powell.
He by contrast has been caught with his pants on fire, trying to weasel his way out of the Fed failing to spot inflation, by saying that most market commentators agreed. Remind me, which is the canine, and which the wagging appendage?
Basic economics - why inflation arises
We called it on inflation as soon as that stock market rally took off, and for the simplest of economic reasons: the pandemic had reduced global productive capacity, so absent a change in price levels, the economy was less productive, profits were therefore lower, competition would therefore be less (unless prices rose), and total production must fall. Less output, same demand will always mean inflation.
Forget the energy issue, forget supply chains, less capacity, more demand always means trouble. True based on that one schoolboy error, the dopey measures to reduce capacity further by more regulation, hiking the minimum wage, paying people not to work and so on, plus embarking on accelerated decarbonization and a few new trade wars, was not going to help much either. But please no more âsurpriseâ inflation, it was baked in. (See extract from my book, Smoke on the Water, blog dated July 2020, title re-appearing shortly on Amazon)
After the interest rate rise
However, we have also long felt that interest rates canât rise enough to stop inflation, but that as governments have to back off fiscal stimulus, as they are already overborrowed, the lower productive capacity will itself shrink demand, and in the end cause inflation to fall. But we see that as taking years, not months.
Why are interest rates not rising to combat inflation? No political will for a start, and any one country that gets too far out of line will find currency appreciation itself addresses the problem. So, do we believe the US âdot plotâ suggesting three rate rises in 2022, while the Euro zone does nothing? We struggle to.
Powell is still clinging to the lower workforce participation rate (which matters) as a signal to defer rate rises and not the unemployment rate (which is more closely related to vacancies) and hence of less fundamental relevance. While employment is great, it will still be unattractive if inflation (and fiscal drag) takes off, thereby holding the participation rate low.
This does still suggest dollar strength, while sterling like other smaller currencies always needs to be wary of getting too far out of line with US rates. But also, a need to fathom out the new look economy. To us, it does not seem service industries that rely on cheap labour are operating in the same world they grew up in. Certainly not if it is onshore.
There is a forced change in government consumption patterns (and hence employment), and this will also be telling. We are heading into quite a different market, when all this shakes down.
Sitting on high cash levels over Christmas, as we are, is pretty cowardly, but if you canât see the way ahead, slow speeds are usually safer.
We do also rather agree with Chico Marx, this year at least.
Charles Gillams
Monogram Capital Management Ltd
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
Thin ice skaters or savants?
Are we drifting out further from the shore of reason, confident we can slide gracefully back to safety, or do we have insight others lack? Perhaps rates just canât rise, whatever the inflation rate? If so, they are a paper tiger. While in a week others have pondered the failure of UK investing during this century, we look at why our biggest bank seems to hate the country.
Iâm talking about the economics prognostications from HSBC, our largest bank. Following an intellectually flawed change in accounting standards (yes, another one), on top of the insanity of âmark to marketâ comes the âpredicted loan loss modelâ.
Now professional bankers (unlike those in fintech) donât make loans to lose money.
So, the politicians have instead required them to assume that they do.
Do the regulators know the industry theyâre regulating?
Imagine portfolio management where you assume a certain portion of your buys always fail. Might be true, but how? And if you admit you have to buy a certain number of your holdings to instantly lose money, what do your investors feel?
But although banks advance money on the basis of their credit committee assessments, the hordes of regulators deem some of it is immediately lost. Being rational people on the whole, the banks, not great fans of predicting the future (given their record), hire economists to do this for them.
Economists, as we know, actually know little, but they do build nice econometric models. The regulators, who know even less, tweak the models, the bank Boards (see above) also tweak them. Soon every model is so tweaked that the economists wonder why they bothered.
UK shown as the riskiest of places to lend
Which leads us to page 62 of the HSBC Interim Report. We read it, so you donât have to. There on the excitingly named, but dull as ditch water section called âRiskâ it is set out.
Now HSBC lends globally: Mexico, India, Vietnam, Peoples Republic of China. So, guess where âThe highest degree of uncertainty in expected credit loss estimatesâ relates to? Apparently, the basket case to end all wicker weaving is . . . Yes, the UK.
How?
Well first up their âcentral scenarioâ model sees the short-term average UK interest rates for the next five years, as 0.6%. Which at least is positive (unlike France, as they hate Macron even more), France (i.e., the Euro) rates are assumed to stay negative till after 2026.
This gloomy central scenario has a 50% chance, although for France it is a tiny bit better at 45%.
Now these are central estimates, but their âdownside scenario worst case outcomeâ for the UK is heavily weighted, with a chunky 30% chance, and oops, France then gets a 35% chance of that disaster, neatly using up the slack just given to them, by the central scenario.
Oh, and thereâs worse: house prices crater, double figure unemployment is locked in etc.
And thatâs a combined 80% of outcomes sorted; for a bank, that is pretty near certain.
China compared to the UK and France
What about Mainland China, then, their biggest market, if you now include Hong Kong. Well like the US (75%), China is at a high (80%) central scenario certainty, with Hong Kong at 75%. The worst-case scenario for the PRC is ranked at just a measly 8%, the lowest of any of their major markets.
Call it impossible - a prediction that China canât fail.
Well, if thatâs what the economists believe, who are the dumb Board to argue? Well of course they can, to cover their well-appointed posteriors, they then chuck another couple of billion of extra reserves in on top of the doomsday forecasts.
So, you see the vortex, everyone, regulators, economists, non-executives are just adding to reserves, like the good old days.
Maybe they are right, but we are seeing very little sign of those incredibly low global interest rates for five years, negative in France, 0.6% in the UK, 1.1% in the US? Really? If they are right, the markets are wrong.
And it is not just technical, with a 35% chance of France hitting the worst-case scenario, no wonder the Board has shipped out their French operations to a fin tech start up, albeit one backed by private equity giants Cerberus. Not an outfit known for overpaying. With five-year rates at 1.1% the dash for cash in the US makes sense too, selling out of their retail side as well. While with a virtually nailed on, global leading, 5% five-year average GDP growth in the PRC included, surely time to expand there?
Their loan book does not bear out HSBCâs bullish estimates of Chinese infallibility
So it is with some trepidation that we look at their loan book, on Real Estate, in China. It must be massive? Certainly, markets apparently assumed so last week. But no, a paltry $6.336 billion, for HSBC thatâs a rounding error. Luckily too, all rock solid, just $28m of reserves needed, although given their certainty that almost feels excessive. The Board probably slipped that bit in.
I have great admiration for HSBC, and for me personally it is a long-term hold, but I have much less regard for regulators and âeconomistsâ models, about which only one thing is certain. They are wrong.
So, I try to just strip out the predicted loan loss nonsense, but it is still driving asset allocations, even when palpably false. It explains much of the last two yearâs volatility in bank share prices and reported profits, it also justified the highly damaging dividend ban.
Yet the HSBC share price is still not much above 50% of its pre-COVID peak. Great investor protection that was, it hammered HMRC receipts too, for what? Based on what?
Does anyone challenge those weird scenarios internally at HSBC?
Is there really a 35% chance of France virtually collapsing in the next five years?
Or is this just part of cozying up to China? In which case as the IMF has shown, bankers accused of fiddling data for China, are not always seen as professionals and can lack credibility.
Regulators should not impose those odd fictions on real investment decisions either.
If they do real economies and yes jobs, suffer.
Charles Gillams
Monogram Capital Management Ltd
EVERY DOG
Boris seems slowly to be turning into the opposition to his own party, which I suppose is not new for him. Meanwhile China also seems to be hitting an identity crisis. Neither bodes well for investors.
We apparently have a real budget due soon, but this vain Prime Minister seems bent on upstaging his own team, so we had a pile of tax rises and changes to tax law bundled out in a haphazard fashion in response to the endless (and insatiable) demands of one ministry.
A likely collision course with natural Tories
That pretty well defines bad governance, and these ad hoc excursions into major spending plans are a hallmark of waste and short termism. So, to me the investor headline should be about planning ahead for the Tory government to either fail in front of an exhausted electorate, or less plausibly given the large majority, to implode. But have no doubt that No 10 and the mass of the Tory party are now set on a collision course.
The extraordinary extravagance of the blunt furlough scheme has always been the fiscal problem, and it is hard to believe, as many bosses are clamouring for new migration to solve multiple labour problems, largely in some measure of their own making, that the government has still parked up a fair chunk of two million workers, on pretty close to full pay.
I struggle to comprehend that number in a hot summer labour market, nor do I see why employers would cling onto staff until October at which point, presumably they take a decision? Are these ghost workers? Already happily in new jobs, but having done a deal with their bosses to split the loot, their fake pay for not being? Are these people HR have forgotten or are too scared to fire? Will they really try to pick up work they put down eighteen months back, in a largely different world and probably for a now quite alien organisation?
Who knows, but the whole thing cost ÂŁ67 billion (so far) and thatâs what Boris needs back. I challenge anyone to give a lucid explanation of how his latest proposal âfixesâ social care for the elderly. Nor to explain how in parts of the country like this, with no state care home provision anyway, it can ever be called âfairâ. So, to me, it is just bunce for the ever-gaping maw of the state, and the idea, with Boris in charge, that it will ever be temporary or even accounted for, is somewhat risible.
What would âfixâ social care is transparent, autonomous, local provision, not bullied by a dozen state agencies, not run by money grubbing doctors, not harried by property developers and absurd land costs, nor daft HMRC grabs on stand-by staff pay, and it needs to be highly invested in simple technology, all IT integrated with the NHS; not this crippled, secretive, subscale mess.
It is not that there is no problem, but it is as much operational as financial. A recent Bank of England paper looking at wealth distribution highlights how in retirement property comes to both dominate assets and also shrinks far more slowly with age.
(Sourced from this speech given at the London School of Economics, by Gertjan Vlieghe, member of the Bank of Englandâs Monetary Policy Committee.)
Of course, the crux here is seeing a family home as both an asset and an essential for life. That is the distortion, and this fiddling with care rules attacks the symptom, not the cause.
Can you trust a word he says?
So, now tax on income rises, a broken promise, employer tax rises, broken promise, the âtriple lockâ on pensions is ditched, broken promise, and to top it off those working beyond normal retirement age (now 66) get a 25% tax penalty, via another broken promise. Oh, and if you are mug enough to save, then dividends will get hit too.
Again, there is a real problem but this is by no means a logical answer either: I guess the Treasury were applying heat on excess debt, and this is sand kicked back in their face, but it shows no sign of anyone solving anything. The UK has both high debt levels and no supportive currency block around it, sure France and Italy look bad, but they have Germany to help. The UK does not. Hence the anxiety.
So, Boris has had a fine Cameron-like bonfire of dozens of electoral promises; the worm turned on Cameron (and Clegg) when he couldnât keep his word, and so it will turn on Boris. This time he wonât have Corbyn as the pantomime bete noir to bail him out. Indeed, Kier Starmerâs response linking this problem to inflated property prices is remarkably prescient, even if his typically confiscational solution is not.
These tax levels (as a % of GDP) have not been seen in fifty years, for an economy with a noticeably less effective grasp on government expenditure and a rather less globally competitive commercial base.
While tax rises are emerging everywhere (see below), and public service reform has become a simple money equation, need more service, spend more money, a dangerous one-way road.
Source: from this primary report
While notably, âbuy to letâ is again left untouched. London house prices have doubled in this century, the FTSE 100 has moved from circa 6800 at its late 1999 peak to 7030 now and remains below pre-pandemic levels. So clearly this is not the time to hit the investors in jobs and business, who have had a 5% nominal gain (that is a 60% real loss) in twenty years and yet to leave the buy to let rentiers trading in second-hand hopes, with their 60% real gain in that time, untouched.
And donât give us the dividends argument; the buy to let plutocrats get plenty of rent and all their sticky little service charges. This measure simply hits the workers and investors in business and pampers the bureaucrats and the rentiers. It makes very little sense, unless you are a senior civil servant or a retired prime minister, like Blair, of course.
Chinese insularity - the new version
Meanwhile China I feel is now detaching itself from both the rule of international law (in so far as it ever bothered) and more interestingly the world financial system. It may indeed end up better off, but for now (and this is also a change from much of the last 50 years) it does not feel it needs to attract external capital.
So much of its trade and capital markets engagement has been predicated on securing capital; this is an odd and novel twist. Although perhaps a logical response to the West, who rather than conserving capital as a scare resource, are immersing the world in torrents of surplus cash and inflation.
Much of Chinaâs policy about their own global investment (so outside China) also used to have the same theme, driven by the desire for returns, influence and to hold their own export-based currency down.
But no more, it seems, and their inherent desire for autarchy, the hermit kingdom trope, has only been emphasized by Trump, WHO and the madness of the internet. It apparently wants to be the new Germany, (no longer the new USA), so it will be insular and conservative: cautious, not driven mad by debt and the baubles it procures.
Well, if true it will be different, whether it can really be done, without a wave of disruptive defaults is unclear, but donât doubt the length of vision, so unlike our own government. While a theme of this century has also been where China leads, the rest must reluctantly follow.
Even a dog has its day, but for investors both the UK and China now feel significantly more canine than at the start of the summer.