JENSEITS VON GUT UND BOSE

We ponder the point of the UK markets, ignore clashing BRICs, set up for the slow fall in interest rates in 2024, yes, long lags are long.

There are two investor markets, one akin to gambling and speculation, one allocating capital efficiently to invest capital or fund governments. But like weeds in a nutrient rich field, spare liquidity attracts the rankest growth of useless vegetation. There’s no clear way of knowing which is which. Money famously does not smell, and clients don’t really care much about how they earn a return, whatever they may say.

A graph showing how often investment clients have asked about Environmentally friendly activities of the company in which they are about to invest

From: The FT Adviser Website

Fads and fashions in investing fuel some success at first - then they can no longer conquer new lands, and deflate, dragging down asset values as they go.

 

ARE INDIVIDUAL UK STOCKS WORTHWHILE?

 

I look back, as all investors should from time to time, at my successes and failures. Luckily out and out failures are pretty rare, and in some measure, so are successes, as I quickly milk the wins (usually from takeover bids), so they disappear from the record.

This leaves me a pretty solid mass of fairly dull UK equity holdings, I slightly favour value over growth. So, I know a simple snapshot won’t reveal the steady benefit of, at times, decades of good dividends.

But at the end of it all, for a UK investor, what remains is a mass of general mediocrity. Resource stocks have been good to me, still are, but the mass of industrials? Not really.

Or property companies?

Well big dividends from REITS, but again not really. Of financials? Again, long years of high dividends, but capital values stay scarred by the GFC. Chemicals, retailers, distributors, tech, utilities: well, all fascinating, with some good runs, often good yields. But in the end?

I could ignore such perennial plodders when their yields were far above base rate, but they are now surpassed, by a simple savings account.

So, I do wonder at times like this, why I hold them. Doubtless we will get rallies, but the tone feels a tad discouraging just now. And I sense the politicians of all hues, who seem to be eager to relieve me of anything that looks like a nominal gain, or enforce their often extreme views on my assets.

 

PERHAPS OTHERS DO IT BETTER

 

My long-term winners by and large stack up in investment companies, with specialist fund managers, and almost entirely overseas, or at the very least global. Not that is much of a surprise, we have mentioned before how the FTSE100 has not moved much in twenty, going on twenty-five years. Yet again it has flattered to deceive this year, yet again it has that slumping dinosaur feel to the graph.

The UK is not alone in that. Most of Western Europe shares that fate, and Eastern European investing has been a good way to create losses. Somehow Europe’s governments have done just enough to keep investing alive - and somehow the stock markets have had just enough liquidity to avoid collapse.

It is partly why so many investors love small companies, but they are savagely cyclical, as we are seeing just now.

I could blame management, and their apparently limitless greed, but while many quoted boards maybe have rogues or knaves, but nigh on all of them? No, I won’t accept that.

Globalization has freed capital to move easily and fast. Far faster than any real business can adjust, and in this world the ability to attract capital is vital. True many attract it, to waste it, like a meme stock, or Peloton, but it would be wrong to see that as a line of tricksters repeatedly finding ways to con the market (although many have) more about the power of liquidity to inflate prices, attract buyers, inflate prices once more, in an unending climb. That is until the last buyer has paid up, and the tipping point is reached.

 

Graph showing the price of the Peloton stock, over the last five years

Taken from this website

 

Then the whole thing unwinds downwards, down to a true value, or less.

WHERE NOW?

On the one hand, as interest rates fall, and they will do soon, even if that one last hike is much discussed and may well happen, the path looking forward is downwards.

FED rates in the last 5 years

This should benefit value stocks, as more and more dividends emerge once more above the high-water line of cash deposits. Rates won’t go all the way back to zero, that is gone, but should start on the way down.

On the other hand, the liquidity trade is here to stay, money attracts money until the thermal tops out and the vultures glide along to the next spiral, or indeed back to the last one.

And looking over decades, as fund managers must, that is all that happens in most markets globally, one or two have true secular growth that also gets returned to investors (a key caveat), most seem not to. Investors become either hobbyists in love with a stock or short-term traders. It is notable how many of the new breed of big company directors spurn the shares of their own companies, bar a token few thousand.

Markets seem to have progressively been made easier for momentum, versus ‘true’ investors, allocating capital to create real jobs. The capital allocation bit is worthy but dull, and arguably governments and regulators seem to have strangled it into stasis.

The endless, joyful, mindless dance of momentum, is simpler, prettier, easier to tax, cheaper to trade; quite wonderful really. But is it much else besides that, or is it substance without meaning?

It is odd how governments moan about the lack of growth and yet cripple capital allocation. In a market system, the best capital allocator wins. It is really quite simple.

 

Once the tightening stops, there should be more currency stability (of sorts) as all the Central Banks realign their rate patterns again. In (to us) an unresolved month, the dollar’s strength has been notable, when not a lot else was.


Reserve in Reverse

Fallen Emperor?

 

With almost two thirds of global equity markets represented by the US, the fall in the dollar so far this year is quite dramatic, and for many investments, more important than the underlying asset.

UK retail investors are especially exposed to this, as although Jeremy Hunt (UK Chancellor) may not notice it, the US is where most UK investors went, when his party’s policies ensured the twenty-year stagnation in UK equity prices.

While Sunak continues to pump up wage inflation, which he claims, “won’t cause inflation, raise taxes or increase borrowings” Has he ever sounded more transparently daft? Sterling, knowing bare faced lies well enough, then simply drifts higher. Markets know such folly in wage negotiation can only lead to inflation and higher interest rates.

We noted back in the spring, in our reference to “dollar danger” that this trade (sell dollar, buy sterling) had started to matter, and we began looking for those hedged options, and to reduce dollar exposure. To a  degree this turned out to be the right call, but in reality, the rate of climb of the NASDAQ, far exceeded the rate of the fall in the dollar.

While sadly the other way round, a lot of resource and energy positions fell because of weaker demand and the extra supply and stockpile drawdowns, which high prices will always produce. But that decline was then amplified by the falling dollar, as most commodities are priced in dollars. So, a lot of ‘safe’ havens (with high yields) turn out to have been unsafe again.

The impact of currency on inflation

Currency also has inflation impacts. Traditionally if the pound strengthens by 20%, then UK input prices fall 20%. The latest twelve-month range is from USD1.03 to USD1.31 now, a 28% rise in sterling.

In a lot of the inflation data, this is amplified by a similar 30% fall in energy, from $116 to $74 a barrel for crude over a year. In short, a massive reversal in the double price shock of last year. In fairness this is what Sunak had been banking on, and why the ‘greedflation’ meme is able to spread. But while that effect is indeed there, other policy errors clearly override and mask it.

 

A Barrier to the Fed.

In the US we expect the converse, rising inflation from the falling currency, maybe that is creeping through, but not identified as such, just yet, as price falls from supply chains clearing lead the way, but it is in there.

Finally, of course, this time, the dire performance of the FTSE is probably related to the same FX effect on overseas earnings assumptions. Plus, the odd mix of forecast data and historic numbers that we see increasingly and idiosyncratically used just in the UK. If the banks forecast a recession, regardless of that recession’s absence, they will raise loan loss reserves, and cut profits, even if the reserves never get used.

Meanwhile, UK property companies are now doing the same, valuing collapsing asset values on the basis of the expected recession, and not on actual trades. So, if you have an index with heavy exposures to stocks, that half look back, half reflect forward fears, it will usually be cheaper than the one based on reality.

 

Why so Insipid?

OK, so why is the dollar weak? Well, if we knew that, we would be FX traders. But funk and the Fed’s ‘front foot’ posture are the best answers we have, and both seem likely to be transient too.

If the world is saying don’t buy dollars, either from fear of the pandemic or Russian tank attacks or bank failures, that’s the funk. As confidence resumes and US equity valuations look more grotesque, the sheep venture further up the hill and out to sea. To buy in Europe or Japan, they must sell dollars.

The VIX, in case you were not watching, has Smaug like, resumed its long-tailed slumber, amidst a pile of lucre.

a graph showing market volatility

From Yahoo Finance CBOE Volatility Index

 

So as the four horsemen head back to the stables, the dollar suffers a loss.

The Fed was also into inflation fighting early; it revived the moribund bond markets, enticed European savers with positive nominal rates, (a pretty low-down trick, to grab market share) and announced the end of collective regal garment denial policies. But having started and then had muscular policies, it must end sooner, and perhaps at a lower level. So that too leads to a sell off in the dollar.

 

Where do we go instead?

So where do investors go instead?

In general, it is either to corporate debt, or other sovereigns. Japan is not playing, the Euro maybe fun, but not so much if Germany is getting back to normal sanity and balancing the books again. So, the cluster of highly indebted Western European issuers are next.

Sterling now ticks those boxes, plenty of debt, liquid market, no fear of rate cuts for a while, irresponsible borrowing, what is not to like?

 

For How Long

When does that end? Well, the funk has ended. You can see how the SVB failure caused a dip in the spring, but now the curve looks upward again. Although fear can come back at any time, as could some good news for the UK on inflation.  However even the sharp drop the energy/exchange rate effects will cause soon, leave UK base rates well south of UK inflation rates.

So, every bit of good news for the Fed, is bad news if you hold US stocks here.

How high and how fast does sterling go?

Well, it has a bit of a tailwind, moves like any other market in fits and starts, but could well go a bit more in our view. Oddly the FTSE would be a hedge (of sorts).

 

 


Photograph of a bleak landscape - near, Dungeness power station, UK

Pain delayed, pleasure denied

We look at the startling emergence of another US based tech bubble, the failure of value investing and offer some reflections on the UK market.

The Bones of World Financial Markets.

This has been a baffling half year in which, with few exceptions, we have ended up going sideways for most of it. The exceptions were in descending order, within equities, the NASDAQ (by a mile), Japan, Germany, the S&P and France. Although all, especially Japan, offset by a weakening local currency for UK investors. A quite unusual, largely unrelated, mix of old and new.

Overall, cyclicals in general, and energy in particular, as well as bonds, and China have been painful and financials at best so-so. It feels like a year to not hold what worked last year and vice versa.  Nor is it as simple as growth versus value; neither have worked consistently, except in the case of a small (but rotating) group of tech stocks.

Our view thus far, has been that until global growth starts to move, we stay out of the way. This has been wrong, because the overvalued US mega stocks, were almost the only game in town. Yet jumping in now, of course, also feels very dangerous.

However, a few of our growth markers have, even if flat on the year, started to shift, not the highly speculative micro stuff, which is still falling away, but the solid middle ground. The hot India tech sector, far more connected to Silicon Valley than we realise, has suddenly jumped.

Macro Skeleton

What about the underlying macro story? Well, the pain of the invisible recession, and the pleasure of resulting rate cuts, have been delayed and denied respectively.

Graph from OECD data showing the price increases in G7 countries between 2018 and 2023From the UK office of National Statistics – see this chart more clearly on this page.

Well, there it is, poorly controlled inflation persists, a longer rate squeeze may still be needed. The vanishing China post-lockdown boom means that there was no sudden stimulus to offset that. Our published data (from Andrew Hunt) was saying Chinese ports were remarkably empty three months ago, from soft export demand, a good lead indicator.

All of that was hidden by strong services demand, and in closed economies (as the UK is oddly becoming) there is no relief valve, and hence it suffers embedded high inflation. But clearly consumption is dropping in the US, recent retailer numbers are all over the place, confirming those China export stats.

While on commodities, the failure of sanctions to impact energy is ever more clear, and I doubt OPEC’s ability to stem the energy glut. As a final blow to value stocks, “higher for longer”, on interest rates, which we have been predicting for two years, hurts indebted companies, who increasingly have to refinance at high rates. It also makes their dividend yields less attractive.

When rate cuts do come, growth having survived the storm, may well soar; as we have noted before, the prevailing fashion in investing heavily favours so called “tech moats” and dislikes debt. That markets keep seeking out new moats, real or imagined, is all part of that.

The speed at which digital currency and virtual reality have become old jokes, but generative AI will save us all, is remarkable.

Bond Dilemmas

In bonds we have seen no point in our lending to governments at rates that are below inflation; in most of the world as inflation falls, bonds still remain unattractive, as yields then start to drop too. So, the bond trade has been messy to say the least.

With greater certainty about a consumption recession, the fear of defaults also rises, and the longer rates are high, the more that refinance risk looms. Jumping a spike is possible, vaulting a table, without spilling your drinks, rather less so.

There is also still a ton of money parked up in fixed interest, just waiting for the equity ‘all clear’.

Lost London?

The UK market (yet again) simply flattered to deceive; I struggle to see much hope for it. While we can hope the likely change of government will be an enhancement, it really will just entrench welfare dependency and producer capture of state services, albeit in a rather more disciplined way.

The risk of Brexit always was that we would use our new freedom to rebuild old prisons. Can a new flag on an old workhouse change much? As for where our stunningly high inflation comes from, again, it must be our own creation, the Ukraine energy peak is now a dip, so it is not imported.

While no one wants to say it, tax rises, especially of such magnitude of corporation tax, in particular, are inflationary, but so is the cheap theft of frozen income tax thresholds. Trade unions employ good economists too, they negotiate for higher take home pay. Rate rises also cause extra inflation, especially with our persistent high national and consumer debt levels.

Sterling strength (it is now moving up against the Euro too) is a sign of markets seeing the UK as the best bet for avoiding rate cuts (and for getting more rate rises). That is not a good sign domestically.

 


this is an illustration for a blog post by charles gillams called small earthquake - image photographed by Charles Gillams

Small Earthquake

Full year corporate accounts have now all been published, in several cases even read, so it is time to look at the raw data beneath all those clever funds and derivatives, at the underlying companies.

There are two themes emerging: one is the extraordinary scale of movements last year in defined benefit pension assets and liabilities, and the other is how we should evaluate the size of the Scottish discount.

 

Pension Asteroids Collide

Enormous numbers are shifting on defined benefit pension schemes, nearly all the big ones seeing asset losses of several billion, but with matched declines in liabilities of the same scale, leaving almost no apparent change, all stitched back together. This impacts in particular the big banks, utilities, resource majors and of course life companies.

It is a source of some nervousness, when large numbers crash about the balance sheet, dwarfing the trivial numbers in the profit and loss account. But they are also quite different items, the asset declines (from long dated gilts) are real money, stuff you could have woken up at the start of the year, picked up a phone and sold.

Yet the liabilities in terms of actual money to retirees hardly shifted, it was just discounted differently. While nearly all (91%) of the 5,000 odd UK schemes are either Closed To new members (CTNM) or to future accruals (CTFA). So, of little current relevance to operations.

 

Pie chart

From: This page on the UK Regulator’s website – the key to the abbreviations is also there.

What is relevant is the sudden loss of tens of billions of pounds ny these pension funds. But that is ignored, because of the liability offset, but it was lost and is gone. This came along with dramatic changes in the value of the gilts they hold, in cases by more than the unit value decline, as gilts were actually being sold quite hard too - a big chunk of assets that no longer exists.

 

Scottish Exceptionalism

So, to the Scottish discount. What is it? In our valuation models we discount earnings for political and operational risks, including for governance, including the location of the auditors. It is an internal assessment, so matters not a jot, unless others do the same.

We know the discount exists, the reversing tide of “swimmers” or companies raising money outside their domestic market, tells you the entire UK is already at a fair old discount to the US, even for companies with mainly US earnings. Should the same apply to Scotland? And by how much more? 20%? Whatever it is, it is getting bigger for us.

In my view if you are a FTSE100 Company, you have big four auditors, London office. Regional offices and smaller firms will be more dependent on a single big client and in enough cases to matter, that disproportionate power will swing it, for the Board, against the investors. Not that London based Big 4 is perfect (we know they are not).

So, to Scotland, there is a long-standing assumption they will use Scottish audit offices, and a drift to using Scottish firms too. This used to mean high quality, but I now sense they lack experience. Boards have also increasingly become reliant on a smaller pool of candidates, and two recent high-profile cases leave me wondering about their governance.

1.   Scottish Mortgage Investment Trust

We sounded the alarm on the peculiarities of this popular fund two years or so ago, in their glory days. Like some other troubled funds, they took on more and more unquoted holdings. All disclosed and approved, but in the end clearly linking private and public markets, indeed boasting of how many of their quoted holdings started out as private ones. Well, a closed IPO market knocks that bet pretty hard. When a lot of them are also Chinese, that renders that pipeline even more suspect.

While disclosed, yes, but adequately disclosed? In one case they hold G, I, H, A, C, B Prefs and A Common Stock, with greatly varying valuations by class. We were nervous, when the share price failed to discount these holdings, at a time when other equity trusts, indeed private equity specialists, were facing growing discounts on their holdings.

That has now corrected, the Board has finally stood up to the manager and questioned the existence of the in-house skills to back up these valuations. But in the process our Scottish discount opened up.

From a three year high of over £14 per share, SMIT has fallen hard to just over £6, wiping out half the value or the thick end of £10bn, from presumably mainly UK retail holders. It has kept falling. I think it will need to list those unquoteds separately, and give holders a share in each asset pool, to regain its once illustrious crown.

2.  John Wood Group

The John Wood Group, which operates in natural resource consulting and contracting, has been a disastrous investment. A well-respected consulting firm, its Board decided to merge with another well-respected quoted consulting firm, Amec: outcome? Hugely negative. Five years ago, its shares were over £5 and even quite recently shareholders were hoping a private equity bid would rescue them after only a 50% loss.

But having overseen that catastrophe, the Board seemed not to be listening. They only very reluctantly agreed to bid talks, and somewhere in those talks something persuaded the bidder to back off. From the bid inspired high of £2.55, it has now virtually halved again. The Board feels old style, out of date, insular. I particularly enjoyed (it is one of the few pleasures of reading so much verbiage) their illustration for the diversity report, (see below).

a pile of brightly coloured fabrics

Extracted via screenshot from the Annual Report and Accounts of the John Wood Group

This reminded me of sitting on a School Curriculum Committee (see the fun I have). We had to cover multiculturism, and the teacher (in the high pale Cotswolds) chose India; intrigued I asked why? The answer was that allowed the topic to be covered for our forthcoming Ofsted inspection, by having a takeaway meal in class. That was it. No map, no history, no people, just an affiliated consumable.

But nice money for the executives, look at last year’s bonus structure. That odd picture served them well. For an original business that is now itself worth nothing and half of what it paid for Amec !

Extracted - clipped and pasted from the accounts

Now, but for that Board, or that history, Wood looks a nice business, cleaned up, $5 billion of apparently profitable sales, with a market cap of £1 billion, not a lot of debt, all three divisions profitable at least at the EBITDA line. Heavily exposed to renewables, including in North America, it even reports in dollars. You could argue the bid was low - no doubt the Board did - but if the price then halves, after the bid vanishes, how credible are they?

So, in comes the Scottish discount – because this pattern of behaviour speaks of a particular culture and leaves me feeling the need for a bigger safety margin, to buy a business from that region.


A winter picture - there is snow on the ground and some trees with orange leaves, in a wood, in Luxembourg

Wood for the trees

We have all been obsessed with rates and inflation, but we seem to be in danger of missing what looks like a widespread bull market running broadly from last October. This is widely applicable outside the main US markets, including in gold. There is a similar and at times masking trend of dollar weakness.

What are the implications of this?

We also look at the unending tragedy of the various remnants of the Tory party.

Still Rising?

With markets still fixated on the next crash, we can sometimes overlook the long momentum swings. Although the US banking crisis matters, it is of little relevance to the far more concentrated and tightly controlled Basel III banks in Europe. Many would say to excess, but they are clearly tighter rules. The few assets not marked to market are a footnote in Europe; in the Wild West of US regionals, they can be the whole story.

On a one-year basis, the France CAC 40 is up 14%, the German DAX by 12%, with both the UK large cap and Japan’s Nikkei also positive, so equity markets have been strong, almost regardless of rate rises. The US is the main home of negative twelve month returns, but the gap between the S&P and the NASDAQ declines over that period, is now quite small, after the spring bounce back in the latter.

What does that mean?

For all the media love of the disaffected trashing their own communes, doing the right thing on pensions (they were very out of step) apparently helps France.

While the splitting of power in the US Congress and the meanderings of a senile President, has perhaps hurt the US, with everything from banking regulation to the debt ceiling made into a political game.

Brazil is down too, but India and Russia are up.

Well perhaps I go too far, but maybe there is a pattern? Markets like stability.

Relative values

While comparisons are complex where accounting systems diverge, the UK still looks like the lowest rated with the highest yield, and conversely the NASDAQ still has (by some way) the highest rating and lowest yield. US earnings are it seems still much more valuable.

The savagely anti-business stance of the UK, including a brutal rise in corporation tax maybe part of it, it will create a fall in earnings (and likely dividends) next year.

While the less visible, but still onerous onslaught in the US, including  a minimum tax take, won’t be good.

So, does inflation matter?

The UK perhaps is also seen as the one major European market that looks to have dithered too long on controlling inflation (which could explain sterling strength). However, I see no real appetite for more austerity in the UK, so I find that assumption slightly puzzling. Having the FX market convinced UK rates are going a lot higher (because of policy failures) is hardly comfortable, but feels a little like re-living last year now.

Oddly too, controlling inflation the US way, has hurt equity markets more, it seems, than letting it burn out in the European style. Heresy to many of us, but that’s what the numbers imply.

All the theory, all the historic data says we now must get a sharp recession, but then grandpa, pray where is your beloved recession? Still looking, since mid February. It seems we must appease the inverted yield curve and believe base rates matter, but a bit more evidence would certainly help.

And rate cuts will be a powerful tonic, when they come. The bears are now reliant on widespread recessions, and soon.

Perhaps the best of this little bull market has gone, but there is a lot of liquidity still about and being out of the market with high inflation, is not great.

A multitude of sins – local elections coming up

And what of the UK Tory “Party”, if such a mess can be called that. The assumption for a while has been that the imminent local elections will be bad for them. However, they are a curious mix of voting locations this time, not London, not all of the Home Counties, none of the Celtic fringe, but a good chunk (but again not all) of the Red Wall seats. See map below.

This is a map showing all the political parties in a regional map of the UK just prior to local elections in 2023

Map from Wikipedia page on 2023 local elections

But really it is heavily biased to the Tory heartland, vast swathes of Labour free wards, where they are not even bothering with candidates, so it will not tell us that much. The Lib Dems will do well, but significant conquests in many areas will now require quite substantial swings.

The assumption is also that Dominic Raab was cut down by Sunak, who has yet to learn that throwing competent colleagues under the bus may feel good, but it thins the ranks of effective ministers, and builds up the malcontents. He has handled these badly, and forgets the real target is not his ministers, but his own position.

Tory strategy

Seemingly the Tory party has run just one electoral strategy for years, based on old victories; just trash the opponent. In a two-party state, voters must then decide who they dislike least. And both Labour (and the SNP) have reliably offered something so vile, that a simple victory follows.

But no longer, Labour (despite their recent rather crude posters) still seem innocuous.

The Lib Dems are sticking to their amateur politics, which can also look strangely alluring, if the other two parties look mysterious or inept. The Tories (like the SNP) are now in danger of being judged by results, not by fear or hatred of the alternative.

The score card on that basis looks pretty bad, and Sunak’s pledges are so far, going the wrong way.