PHOTOGRAPH OF A BOAT CALLED RECOVERY ON THE RIVER THAMES, IN FRONT OF BIG BEN WHICH IS UNDER SCAFFOLD

AGAINST THE TIDE

The two massive current market questions are about liquidity and rates: maybe that’s just one question.

So, do we now question our long-held assumptions?

The storm in a teacup in a short trading week over UK Gilts is of little interest, we all know where it leads, I am sorry to say.

STILL ENOUGH LIQUIDITY?

Liquidity is the scary issue, and bond yields rising indicates a loss of liquidity, but is it serious?

I don’t think so; the usual sequence is a panic causes a loss of liquidity, so settlement starts to fail, causing technical defaults, and then the frightened regulators crash the system. None of that is visible.

There are real strains, no doubt, Russia is struggling to finance war, China is suffering a property bust, but notably rates there are falling. Saudi Arabia can’t fund expansion on less than 90$ oil, and both France and the wider EU are in very deep. But none of that is causing disastrous rate rises. Indeed, currencies, as intended, are taking some of the strain.

Gold and bitcoin are building vast, useless, liquid supplies of wealth. While a strong tech market is luring funds away from bonds, and of course the US Federal debt is vast.

Nor does anyone want to be in the market, when the inevitable happens, liquidity crises are a persistent feature of the system.

But for all that I see Central Banks still holding the line reasonably well. No one state has seen a dramatic failure, even the UK, always the weakest, is not yet really offering an enticing rate on ten-year money, given its failure to stop inflation.

So, the current liquidity action still looks, on balance, like bets for and against rate cuts, not distress.

And Trump has profoundly disrupted global markets, by offering a genuine, large-scale alternative to secular decline.

BACK TO RATE CUTS

What about rate cuts then? And inflation.

Inflation is clearly a problem, Biden has been running the US economy hot, to try to win the election, and now Trump optimism is doing the same.

US NON FARM PAYROLL - DECEMBER 2024

A GRAPH OF THE USA PAYROLL - NON FARM EMPLOYEES

From this website

 

 

And the Fed rate cuts now look ahead of the curve. Indeed, the pre-election 50-basis point one always was.

We felt it was politically motivated, so a sharp kick through a reversal and a rate rise is indeed possible, but with real US rates still positive, it would also feel gratuitous.

The rest of the world has the opposite problem. True it will now import US dollar inflation, especially on energy, and its exports pre-tariffs will look more competitive, but I doubt if either matters, when austerity looms once more.

They just serve to disguise the underlying issues. Although it is possible Germany gets a Trumpian boost, post-election.

However, it will still be really hard for the European old guard to resist rate cuts, let alone allow rate rises. Taking down an already non-functioning banking system, would be reckless.

The UK is very vulnerable; that’s why avoiding the Euro made so little sense, if we were set on swallowing the other nonsense.

I have never seen other outcomes, given Labour election promises and the need for some attempt to steady the ship before implementing real reforms. But nor have I ever seen other exits bar Truss II. If Reeves and her team let up on real service cuts, they have signed their own resignations. Spending money and raising taxes is instant, so never the hard part. Cutting bloated budgets is also easy, but does need nerve, time and skill. The jury is still out on if Labour has those.

WINTER BLUES

All the market turbulence relates to the holiday period, which in the US now spills over into late January with Martin Luther King Day, and the added impact of various Presidential comings and goings, so I think it can still be ignored.

Thin trading encourages stunts. While Q1 data is usually terrible, the most adjusted season of the year.

The first “live” Fed meeting therefore looks to be on March 19th. Which is well after earnings season.

So yes, volatility and reasons to be fearful, but overall, I fail to see this derails the Trump boom. Also, at some point the UK mood will change, if only for shares with high dollar earnings.

Adequate liquidity and on-going rate cuts therefore remain supportive narratives, but both are currently on a winter break.

Assuming no disasters on their return, the year ahead looks fine.

OTHER PLACES

India

I have had a longer look at the Indian economy.

In aggregate  India remains impressive, with plenty of money being made and invested. However, it can in the end go no faster than the average voter, and for some of those, life remains tough.

Modernisation and urbanisation look great on the IMF charts, but always come with a cost, in particular for the urban poor. To be clear, there is no old-style deprivation, no lack of food or clean water, no loss of civil order, there is some basic healthcare, but for all that a lot of surplus marginal labour still. Navigating those strains, while building a modern state, is no small feat. So, India looks great, but only if it can hold a basic policy line through and beyond the retirement of Narendra Modi. Here is a summary of India’s 2025 issues, as taught to its civil servants.

Pakistan, Argentina, Poland, Hungary

Of the true frontier markets, which is the tier below emerging, the best Asian performer last year was Pakistan at +83%, but even they failed to match Argentina at + 91%. While closer to home the expected ending of the disaster that is the Ukraine War, let Poland achieve +46% and Hungary +36%.

None of these have much depth, all feel like recoveries from oversold positions.

Yet at some point Europe needs a single functioning capital market, not a string of small historic ones. Within that, the great advantages of New Europe, low state debt, plentiful land, skilled labour and big EU spend, could be attractive in the multi-year boom that will follow the end of hostilities.

 

 


Good intentions

Two quite technical topics this week, hinged on the persistence of old viewpoints on current markets: pricing in UK stock markets, and China, and how we might look into emerging market funds. Plenty of good regulatory intentions, but rather less than welcome outcomes.

 

FIXED ODDS

Little in the debate on UK markets has looked at the major role played by an increasingly poorly performing small UK bank, Close Bros. Even when it was doing well, it felt odd to have a vital market role being undertaken in a backwater, but as its capitalisation dwindles, the core task of equity market maker, which it provides, seems oddly misplaced.

In smaller UK stocks, we therefore still have a ring holder who, it is said aligns buyers and sellers’ interests. Not mine.

Given the fortunes at the disposal of state banks or indeed the London Stock Exchange, why is Winterflood (a part of Close Brothers) still trying to provide this vital service in the style of an old-fashioned bookie?

It matters greatly, because in many UK stocks and investment trusts, the wide bid offer spreads make dealing almost impossible. If you are eking out a high single figure return, and in these markets not doing badly to do so, Close Brothers scooping 10% off a single trade, in the bid offer spread, is pretty lethal.

With them restricting trade, liquidity disappears, without liquidity so does price discovery, and it is not a stock market any more.

Close has itself also suffered a number of hits lately. It is a hotch potch of old merchant banking activities, along with an expensively acquired asset management business, plus a shocking venture into litigation funding that might ultimately (it is itself a matter for litigation) cost almost as much as they paid for it.

While just lately the FCA has been asking (dear CEO
) about insurance premium finance, oh, and Close has a lot of motor finance too, an area of recent expansion, but also another hot spot for the FCA, after issues on commission. The latter Close has known about for a while, it was a disclosed risk in their last accounts.

All places where margins are quite high, perhaps in the view of the FCA too high.

 

A screenshot of a section of Close Brother's website

From: Close brothers website – section on ‘who we are’ - their business model.

Given the lack of any announcements, the 40% share price decline in Close (CBG) over six months, to levels seen just after the GFC, is remarkable. Perhaps this benign graphic is not quite the whole picture?

Premium financing is ironically a good business, because the FCA’s wide and unpredictable view of its own remit makes financial services insurance premiums rather high, but that’s another story.

And market making is run as a bookie, not as a market utility. Winterflood itself can be taking a long or short position. So, investors must fathom both the share price, and which way their market maker is facing. In big stocks with lots of choices that’s all fine and pretty transparent. But in small ones, they can look (and behave) like the only game in town.

And it looks as if last year, they possibly went too short in the autumn. So, when the market turned on a dime in November, a fair bit of short covering took place, prices leapt, in places by over 20% and spreads opened out. And market size dwindled to penny packets.

It matters how? Well, you can get ripped off to deal in smaller UK stocks, where smaller is up to about £300m, and the price can be “wrong”, volatility increases, and liquidity goes. Do companies or investors like any of that? Nope.

It is notable that their trading profits in this area seem to far exceed both their gross (long and short) and net (long less short) positions.

Every big company was small once, and if you choke off the supply you get an ossified market, like the current moribund main FTSE index.

Perhaps the FCA could start to look more at best execution and market depth, and less at arcane ways to double count costs, or ‘protect’ those trying to enter the primary market from strict rules. This interview with Witan makes a reasonable case for looking after the secondary market first, not just the big IPO’s, with their juicy listing fees.

Investor protection is about investors making money, not about them losing it as cheaply as possible.

CHINESE BURNS

After our piece last time, we have been looking at Emerging Market funds ex China, because far from being the great hope of EM investors, China (and not just the PRC, but also Hong Kong) has become the rock that shatters fragile performance.

The role of benchmarking

There are several structural problems in EM funds, one is the role of benchmarking. A good idea at one time, it allows investors to compare performance to something specific. But it has become quite expensive (guess who pays?), as benchmarks don’t come cheap, if you now have to have them.

It also rather neatly points out to investors, when an index fund might do a better job than active managers, and worst of all, especially with the oddly amateur directors of most UK investment companies, leaves them ‘hugging’ or enslaved, to the benchmark. For good reasons in one sense (you don’t get fired for just about beating the benchmark) but for bad in others (all the funds are boringly similar). They just make the same mistakes together. And a beaten benchmark, that is itself falling, means the investor still suffers losses. I have yet to meet an investor that liked those.

The impact is both direct, so you can’t find India funds without Reliance Industries (the biggest stock), for example, and indirectly so as to “generate alpha” funds take bigger risks within a market, rather than have a below benchmark position in that market, even if all their analysis says they should just quit that particular town. Which is why funds find reasons to linger in bad neighbourhoods.

Another bias that hits the EM sector (which for a decade now has flattered to deceive) is that their stock analysis is focused on stocks they have held, while the investor wants to hear about stocks they should hold.

So, a fund manager typically gives a detailed list of analysts and companies followed by their firm, and it is full of what looked sensible when all those analysts were hired. So, in EM, there are stacks of China analysts, of organisations based in Singapore (the preferred offshore China centre, after Hong Kong got too hot), hundreds (if not thousands) of Chinese stocks covered, but all the buying is now into India. With quite nominal stock coverage; and hardly anyone based in the country.

Just as to a hammer, every problem is a nail, so to those EM analysts every opportunity is in China. Until outfits like Janus Henderson and Templeton stop having toolkits full of hammers, they won’t be able to stop breaking investors’ hearts with China. Nor will investors realise quite how much this infects their performance.

This will slowly correct, but small funds that can exit China totally in a week, and have a global remit, with no equity benchmark, dare I say it, have quite an edge.

It is a vast and nuanced space, Lazards provides a good overview.

And it is not just EM specialists, we looked at Ruffer of late, it has got broken China littered amongst its portfolios.

So, we worry that the Christmas rally looked broad based, because of a bear squeeze over a range of stocks, that then reversed with early January selling, based rather more on fundamentals. In which case 2024, so far, is in danger of looking more like 2023, less like the cyclical turning point many hope for. We do see earnings falling, of course and then ultimately rate cuts rescuing valuations. But ultimately may be quite a while.