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.
From the UK office of National Statistics â 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 OPECâs ability to stem the energy glut. As a final blow to value stocks, âhigher for longerâ, 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 âtech moatsâ 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 âall clearâ.
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 Regulatorâs website â 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 âswimmersâ 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 ÂŁ14 per share, SMIT has fallen hard to just over ÂŁ6, wiping out half the value or the thick end of ÂŁ10bn, 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 ÂŁ5 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 ÂŁ2.55, 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 yearâs 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 ÂŁ1 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 â 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 Sunakâs luck changed? Has Indiaâs 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 canât 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 canât 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.
Bidenâs 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 donât.
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 â 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 â what can we discern?
Talking of status quo, thatâs 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 â 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?
Lend me your fears
I come not to praise Kwasi, but to bury him. This is an explainable, predictable but probably futile coup in the UK Tory Party, along with more King Canute from Bailey of the Bank.
But in markets there is abundant good value, but with few clues on how, or at what cost, inflation is to be tamed. Or indeed what may escape this time.
Political Manoeuvres
We have long noticed the Tory partyâs splits and factions, broadly between the left and the right wing. This was a chasm Boris was uniquely able to bridge, by talking right, and acting left. The puzzle, as we noted, was why the left would bring him down to replace him with a right talking right acting Prime Minister. The preference was for a Blairite Conservative, low tax, high spending, but a steady reformer, with a lethal penchant for foreign wars and illogical hatred of the Euro. After Kwartengâs departure, the Tories now have the doomed high tax big state faction back in charge again.
Hence the need for a pretext to overrule the party members and threaten Truss with the ever-gleaming sword of Damocles, held by the 1922 committee - we are back where the plotters wanted to be after Cameron â with the neutral Hunt playing the safe stooge to hold the fort.
Unlikely to win the next election
It foretells the inevitable party split â but we had never seen another Tory term as possible, regardless of the leader. Nor have we ever seen Keir Starmer as needing to do anything but sit tight and keep a grip on his party. If he is also spared the crippling cost of a really tight General Election, he can now face down the Trade Union money men as well.
As for Kwasi, if he stays the course, his troops will yet triumph at Philippi, he is by far the best the Tories have just now and looks to be the future. He has understood that if you fail to free the supply side, in a new productivity revolution, the current national decay will just go on, as it has for twenty years or more. But he has also not torched his future, Miliband style, in the wrong leadership move.
Will any of this stem the attacks by market traders? I doubt it. Will any of this forestall the inevitable sharp rise in interest rates, I doubt it. Or indeed stop ongoing sterling losses. To quell inflation requires interest rates above inflation, you canât bear down from below. It remains daft to think UK interest rates can be effective whilst remaining underneath US ones either, as we said in our previous post.Â
Both clipped from this site, and set out side by side. The core data as is cited below are from the Federal Reserve and the Bank of England respectively.
So, what is the shape of this next recession?
I think we are now starting to see it. Not that much unemployment, the current tight labour market, without addressing increased workforce participation, is going nowhere. Nor is a secondary residential property crash certain. That is so last century, both areas are now far more heavily fortified sectors than they were last time. And both are now designed (and legislated) to be fiercely inflexible downwards. That is what the current labour market (and our dire productivity performance) is telling us.
House prices are propped up by a very generous market backdrop, ongoing vice like planning, high land taxation, tons of liquidity and a deep political fear of the consequences of a collapse. For all the moaning, borrowers are still able to load up at negative real rates, with a highly competitive mortgage market and generous fixed term offers.
But do expect a general slaughter of small businesses (or rather the current collapse will go on despite the various support packages). Expect weak margins for UK based firms, ever more exposed to competition, from far more generous and protectionist states.Â
WTO rules really are in tatters now and routinely ignored by powerful countries like the US and Germany. Expect a resulting fall in quality both in goods and services, again a continuation of current trends, as globalisation retreats.
But remember too, that so far, we do have inflation, but not a recession. The current dislocation is caused by a resource switch towards savers, who at all levels have had slim returns for a while, and we will now instead punish borrowers, who have had an absurdly easy, subsidised, inflationary decade.
The big picture, overall
Meanwhile in the energy world, a resource transfer is taking place from energy users to energy producers, who have likewise had a thin time of it. That those energy producers are places like the US, Russia, Saudi Arabia, Iran, Nigeria, Brazil, is a remarkable own goal for Europe.
But it is neutral for the world.
Indeed, much of those surplus funds will now be collected as various direct and indirect tax revenues, or to pay down debt, or as new investable funds, or distributed as dividend payments, but very little of that vast energy price transfer leaves the known universe.
For Europe, however the decline happens with the slow loss of productivity, plus the demographic torque. Meanwhile borrowing our way out, is suddenly becoming far more painful.
The political turmoil is ultimately from this change, and the longer states borrow more and pretend nothing has changed, the less effective will be their remedies. And indeed, the more the big efficient producers, like China, the US and Saudi Arabia will thrive. Neither more debt, nor protectionism will solve this, nor indeed will more global military adventurism.
Confidence is understandably damaged
Given that backdrop the mood music is damaged just now. Markets are trying to spark rallies, but with no real confidence yet.
Investors sense there is value, but with too little data to know where.
But whisper it quietly, Santa Claus is due, and the market mood is not quite as bleak as events suggest it should be.