It is Not a Pipe
A long view this time : Has the price of capital changed for good? How bad is the UK position? Oh, and the unusual universality of colonialism.
A Far Off Galaxy
Letās start with colonialism. I have been reading about the benighted past of Bulgaria (R.J. Crampton, 2nd Ed, CUP). A Bulgarian I know said that the country āhas a knack for picking the wrong sideā - a little harsh, I thought. However, it has always existed as a colony, aside from a brief imperial phase around the last millennium but one, and before that when it equated to Thrace, almost as far back again.
Given the option, Bulgaria recently opted to join the Western European empiresā current formulation as the EU and NATO - the latter being the armed wing of Western thought. Bulgaria had suffered horribly under the Soviets, with a steady and ruthless coercion of an existing multiparty democracy, at a speed just enough to keep outsiders ignorant, or if not, passive.
That history gives me a whole new viewpoint, on the string of broadly similar states. The Balkans and The Middle East all appear in a new light, and indeed I start to comprehend the bitter sideshows (as they seem now) in both World Wars, over that same terrain.
The collapsing empires (Russian, Ottoman, Roman,) seem more influential than the current rulers in so many former colonial states. They are really not, as we think now, a series of nations fighting for āindependenceā. In most cases that independence is fragile to the point of being mythical, while the internal fissures are enduring. The cracks of nations within empires, not of states within a world.
Now You See It
One passage in Cramptonās work stood out āby mid-summer social and industrial unrest were widespread with strikes by civil servants. On transport networks, and despite the provisions of the law, in the ports and medical services. The government was forced to grant a 26% wage increase to all state employees, an action which weakened its attempts to control the budget deficit and inflation and which did little to impress the international financial organisations.ā
Written about conditions just before another wrenching Balkan realignment last century, this rather made me stop and reflect.
A parallel with the UK?
Just how close are we in the UK to that edge? Lost in a warm feeling for individual strikers and their causes, and a very British willingness just to plough on, there still seems to be a real danger.
I am well aware of our great national strengths, in the arts, our language, higher education, science, heritage, even logistics and retailing - they are enduring causes for optimism. But long-term investors need to weigh up the recent damage, especially the loss of political capital by the āresponsibleā right, the high levels of debt and taxation, which coupled with low productivity, could also spell trouble, the certainty of ongoing nationalism and the unhealed rift of Brexit.
There is danger too in the probability of a Labour government, which however centrist the leader is, will have left wing factions to assuage. It is equally dangerous to continue our recent experience of minimal ministerial experience. I hope the change wonāt be as bad as I fear, but it will probably be worse than I hope.
This remains a reason for the FTSE to be anchored to late 20th Century levels, despite almost every stock I research looking cheap. The fear of being still cheaper tomorrow rules.
Do Markets Care?
On the other hand, re-pricing capitalism after the decade of populist nonsense by central bankers does feel pretty good. If you have no cost of money and no reward for savers, financial gambling prevails.
All of this raises a key issue: is the apparent resurgence of speculation (the greater fool theory of investing) permanent? In which case investors should probably just watch momentum. Or is this most recent re-run of the last decadeās speculative phase, really transient?
For a better view, see this page on Statista
As long as inflation exceeds the cost of money, assets will likely rise; the widespread return of real interest rates (a point we are almost at) should slow that down.
After that point what matters is cash flow, and whereas gambling will favour growth stocks, real returns come about when interest rates are high, but inflation is also falling. The gap matters and we are not there yet.
This is probably the crux of the next two years, and we doubt that having had a serene and slow drift towards recession, there is any reason either to expect a suddenly faster descent now, or really to expect the corollary, a sudden fall in interest rates, to offset a deep recession.
If rates stay high, but have indeed peaked and inflation declines, value investors should be in a better place. If they get it wrong, they are at least paid to wait.
As we have seen in the last twelve months, growth investors fuelled by borrowed money really do need a rising market, they get hit twice if it falls: both through a loss of capital and then the need to fund loss-making assets at real rates.
The Monogram View
Overall, our position has been that fundamentals should win, but we suspect momentum will win. Spotting the next momentum shift early, therefore remains a powerful driver of returns.
One narrative of 2023 (so far) is that the SVB crisis and stronger growth combined led to far more liquidity than markets expected. This fed into the gambling stocks, giving them momentum.
So, although the first half was not what we expected, the second half might still be. But it is just one narrative, and it may still be the wrong one.
Note : Further reading, for those interested in Bulgaria :
See also, The Bogomils: A Study in Balkan Neo-Manichaeism, Obolensky, Dmitri.
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.Ā 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.
From the UK office of National Statistics ā 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 OPECās ability to stem the energy glut. As a final blow to value stocks, āhigher for longerā, 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 ātech moatsā 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 āall clearā.
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.
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.
From: This page on the UK Regulatorās website ā 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 āswimmersā 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.Ā Ā 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 Ā£14 per share, SMIT has fallen hard to just over Ā£6, wiping out half the value or the thick end of Ā£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.Ā 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 Ā£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 Ā£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).
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 yearās 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 !
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 Ā£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 ā 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.
The Scottish Play: Luck or judgement?
Three topics this week: has Sunakās luck changed? Has Indiaās bull run ended, and where is this much-discussed recession?
PICTURES OF MATCHSTICK MEN
I noted at the end of our last bulletin, that markets are feeling strangely bullish, for a few reasons, which I share. Although only in some places. I still find little attractive in most debt markets. They are cheap, but given losses this year, are they good value?
And UK politics is becoming boring, which is no bad thing.
So, were we right to predict that interest rates alone cannot tame inflation?
Our original thesis for this year, that interest rates could not tame inflation alone, maybe is right. The level needed would cause too much damage. But that is applicable (we now see) to the UK, but not as yet to the US. And oddly perhaps not as yet to the EU either, although Lagarde midweek, perhaps had the same tilt. But German profligacy may wreck that.
The logic is the same for them all. You canāt tame this beast by rate rises alone, as double figure inflation needs double figure interest rates and that is just not happening.
The UK is certainly not prepared for that level of rates and fiscal restraint is therefore now required. Fiscal drag will do some of the heavy lifting, and energy price declines a fair bit more.
Some commodity market statistics were released by the World Bank, this quarter. The above graph is extracted from their statistical report
But tax rises and government spending cuts will still be needed to cool the UK labour market. In particular the public sector must be reined in, or service cuts made.
Earnings will fall, taxes rise, growth stall, discontent rise. But still no collapse in housing (secondary) markets or in employment.
Nor do I therefore see much rise in loan defaults. This makes the recent round of forward-looking bank provisions unusually daft. You canāt audit the future, so how can you include it in historic accounts? A weird hybrid. Best to ignore all that and focus on now, and now is still not terrible. With a pretty hefty valuation discount in situ.
(Data downloaded from the Office of National Statistics for this in house graph).
The US political situation
In the US, The Federal Reserve have effectively said if there is no fiscal restraint, they will ramp up rates till there is, or inflation falls. That is scary, but it looks as if the Mid Terms will hobble Biden and stop some of his fiscally reckless measures. He thought the wave that toppled Kwasi missed him, but it was the same ocean, and likely will give him a rough ride too.
Bidenās approach felt good, overindulgence often does, but the pain of the untethered dollar is now starting to hurt US earnings, and in time US jobs, however much they dream of legislating against that. The impact of rate rises is also probably less than it sounds in the media, partly because most reporters are likely to have mortgages, whereas a growing number of investors donāt.
Overall US government policy remains to force up inflation and challenge the Fed to sort it out. Hence all the Fed threats are directed not at the market (which cares) but at The White House (that does not). Mid Terms (on the current path) will therefore be a big boost to US markets, as it means Congress at least, will start to work with, not against the Fed. As with Kwasi, a reckless budget will not pass unchallenged again this time. Those extremes belong to the COVID era, that is now over.
Comparison with the UK position ā and where Europe maybe is headed
With that battle already won in the UK, both sterling and to a degree UK rates are reverting to the status quo ante. And as sterling rises so the FTSE falls; that link also remains. If the UK is neither chasing interest rates up, nor letting the pound fall, it gives Europe some cover to do likewise.
In truth although sounding dramatic, in the real world it is inflation that really counts not (as yet) interest rates which are still absurdly low.
The Tory Party ā what can we discern?
Talking of status quo, thatās where the Tory party is now headed. Cameron drifted too far left, Boris dithered, Truss drifted right, and now the new government is a hybrid, although colloquial English perhaps has a stronger word for it.
I sense that spending decisions may correctly be back with a powerful Chancellor. There is a seeming party truce till the next election, when half the current Cabinet seats will vanish anyway, and then who knows?
Or if this coup and enforced hybridisation fails, we really will know the party is split, and a General Election could follow. Unlikely, though.
Why bullish then?
US earnings except for highly indebted outfits, will probably stay surprisingly strong for a while yet. And likewise, the dollar pivot point is being pushed further out, as no one else in the developed world is going for rates quite that high (or that fast).
There are also two market forces to look out for, rising rates and slowing growth is one, but the simultaneous loss of liquidity is another. The former will cause a patchwork of changes, both good and bad, but the latter the ending of a multi-year bubble.
It all remains cyclical ā a transition, not a bounce
The difference is key, rates are possibly a two-year cycle, a bubble a ten-year one. The bubble in non-revenue companies, and in absurd multiples for even profitable tech, will take longer to deflate, be slower to re-inflate and be muddied further by all that spare capital accelerating technological change. This is still not an area we either feel confident in, or trust their valuations.
If we really are back to the status quo in the UK, about to be in the US, why would markets be going down, down, deeper and down?