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
All kinds of everything
We move towards the end of the year with a great deal of challenging uncertainty and big calls to make, on inflation, China, US Politics, whether interest rates are pegged, and a few political issues. The temptation to sit it out and come back after Burns Night, is intense.
A lot of things will be clear then: the severity of the winter, and hence fuel prices, also of the EU COVID spike, the nerve of some Central Banks and who leads the largest one, and how the Beijing Olympics will go. All are potentially significant matters for investors.
Few of these issues are surprises, which is good, indeed we see advanced economies as being in fairly stable shape, but badly damaged by populist politicians, who canât face telling voters that ânothing comes from nothing, nothing ever couldâ.
Inflation
So, on inflation, we took some flak back in the Spring for talking about 5% inflation, but we regard that as pretty conservative now.
From the OECD data here.
We see it as structural too, not related solely to excess demand, supply chains or energy prices. All of these matter, but the last two are indeed transient, and excess demand is within the power of the fiscal and monetary authorities to affect. The real trouble is both the lingering and severe harm COVID is causing to productivity, especially in the service sector and in a public sector still too reliant on overmanning and allied with that, the curse of politicians trying to exploit the pandemic to pay off their chums.
Our conclusion is that we will have higher prices at least for the next two quarters and possibly all of next year. Critically Central Banks will most likely be powerless to prevent or reduce that, without bringing the house down.
Broken China?
One cannot but be envious of the performance turned in, yet again, by Scottish Mortgage. The half year gains are massively from one stock, Moderna, and then a broad raft of e-commerce and big data plays. So, really, they just continue to surf the NASDAQ run. By contrast their big cap China positions generally damaged performance but have not yet been visibly trimmed. Although China does drop from 24% to 17% of their NAV, which is significant, with North America rising from 50% to 57%. (I should also mention we donât hold a position in this stock and have not had one this year.)
So, NASDAQ strength allows them to survive what for most fund managers has been the poison of owning anything in China this year. A decision we took, guided by our momentum models, very early.
We also note the managerâs viewpoint, which broadly aligns with a view that what Beijing is doing, is what the West should do as well, in attacking and controlling big tech platforms and their associated excesses. Telling the biggest companies to also do more to reduce inequality and cure social problems hurts profits; but they still see both as not unreasonable requests and they claim big Chinese companies are already willingly complying.
Yet for all the apparently cold rationality of the Scottish Mortgage viewpoint, we do understand it, and do see China trashing their participation in areas of global commerce and capital markets as an odd piece of self-harm, if it is really their aim, not just an ill-thought-out consequence of domestic actions.
So, we see the set back so far in China stock prices, as based on the possibility of the area being uninvestable, like Russia, but not yet on that certainty - see the how strong the trade figures are even with India, a so-called political antagonist. But tipping over to uninvestable would be a market shock and again we inch closer to that, with each diplomatic spat.
United States - and the Fed Chairman
The big US call, and again we signaled this as critical a while back, and actually well before the US Presidential Election, is about Powell. My sense is removing a competent Fed Chair for purely partisan reasons would be damaging to markets and the dollar. But the pressure on the ailing Biden to do just that feels intense, and I am struggling to see who in the White House will have the maturity to stop it, if Biden caves in.
Would a new Chair do things differently? Might markets push harder still for a rate rise and the dollar, short term at least, suffer? For now, re-appointment is still expected, but the odds on a shock are shortening.
Interest rates
The Bank of England is also, quietly in the midst of a storm, it is not actually independent however hard it claims otherwise, it relies too much on Whitehall just to survive, and, in a way, canât do anything meaningful on inflation anyway. Still a rate rise, even a notional one, would show it is still awake. It makes little sense just now, but as a symbol might yet happen. To us it simply adds emphasis to the political chaos overtaking Johnson and the ongoing shift towards an institutional alignment with a Starmer government.
Material interest rate rises (so returning us to positive real rates) during 2022 therefore still feel impossible. Indeed, German rates have once more flirted with changing the nominal sign, only to collapse back into negative territory.
To sum up - where does that leave us?
Well curiously, mildly bullish. We may not much like the position, but who cares about that, our task is to make money for investors. We also have had a think about what rescued investors from the COVID slump, on the basis that a future sharp inflexion in interest rates could look much the same.
What we see is the power of real growth, not the flotsam of cash hungry concept companies that can never pay a dividend, but fast-growing, broad-based technology â following that has been the winner for a decade. We do want to call time on that, partly for the nonsense and scams it tugs along behind it, but we still struggle to see the turn.
Charles Gillams
Monogram Capital Management Ltd
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
Caution: Bumpy Road ahead
Puzzle: World markets have whipsawed in the last few weeks, from high anxiety to an almost beatific calm. The VIX volatility index has dropped to pretty well a post-pandemic low. Which should mean we all agree, but on what exactly? Rising inflation, yes, but how durable, and caused by what?
And that, we all accept, will make interest rates rise, yes, but how high for how long? Markets we feel are, to say the least, fragile.
At the turn, we know that moves can be dramatic both ways, for markets. Â
Are we really seeing a labour shortage? The UK truck driversâ situation
What we see now is not a labour shortage, and hence political talk of stemming migration and higher wages is well off target. What it is, in part at least, is a failure of the routine operations of an incompetent government, something politicians typically donât want to discuss.
The government has insinuated itself into so many areas, with its complex regulations, that the market economy now lies ensnared in myriad interlocking regulations, backed up by a deeply entrenched blame culture (and its friend the compensation economy).
To take one example, there is no shortage of truck drivers, but there is a shortage of qualified, approved, signed off and regulated truck drivers, because as part of the destructive lockdown, the government just halted the conveyor belt of required testing and approvals.
Truckersâ wages have for long been too low, of course, especially for the owner drivers in the spot market. What we have is not a labour shortage, itâs a paperwork shortage. The difference is vital for how enduring inflation is. A new driver will take a couple of decades to grow, but clearing a paperwork jam, a few months. One is enduring, the other transient.
Withdrawal of older workers from the labour market
Work after all is something of a habit: once it is lost, it can be hard to understand why it existed. So, we see a marked increase in older workers in the UK who have just withdrawn from the market (Some thirty million fewer hours worked - see figure below). That too is not a labour shortage as such, they all still exist.
But if work was of marginal benefit to the worker, and the costs to resume work (actual or psychological) are high, disruption will cause the fringe or marginal job to be unfilled. Yet again more in the transient column than permanent.
Someone will waive the rules, or the government will notice, well before all drivers get paid high enough wages to cause embedded inflation. In any event articulated fuel tanker drivers tend to work for big employers, with good conditions, and are well organized. They have to be, after all they drive mobile bombs. The spot operator on a rigid rig is in a different market.
Inflation will most likely be transient
So, if it is not an actual labour shortage, it wonât cause wage inflation, and will be transient. Some other areas reliant on highly skilled older workers will continue to see standards fall, but generally younger workers will over time fill those slots and gradually acquire those skills. And it wonât be a long time.
Our view from way back was of 5% plus inflation and labour markets that struggle to clear this year. We were wrong to not foresee the failure of regulatory processes to keep up. However we still do see a permanently higher post COVID cost base and therefore in certain sectors, a large amount of marginal productive capacity are likely to be withdrawn from the market.
With a banking system that still struggles to offer commercial finance to the SME sector, because of excessive regulatory caution, there are swathes of jobs that have simply gone. So that labour will in time be redeployed. The current concern is that many of these workers show no desire, or ability under current conditions, to return to the market. But when they do, the capacity that has been destroyed will slowly return, and once more drive down prices.
Nor should we forget just how much the Exchequer loves inflation, as fiscal drag, their beloved tax on higher prices, smooths away so many budgetary blemishes. They will let it go, if they possibly can.
Commodity prices
On the input side we do still see commodity price rises as transitory, at least within the energy market. As others have noted much of that too is regulatory failure on a grand scale, not a true shortage. Price fixing by the state is a notoriously foolish concept, as we learnt in the 1970âs.
There are a number of other supply factors at play too, but while some will recur, most are temporary. Â Â
How long do we think the inflation spike will last?
So yes, inflation will spike, and yes it will stay elevated for much of next year, but no, we donât see it as necessarily durable, once COVID restrictions and related behavioural changes vanish.
We are still pretty certain that the political costs of aggressive interest rate rises will outweigh any perceived price control benefit. As long as some Central Banks hold off rises, it will be very hard for others to do so, without sharp currency moves or bringing in formal exchange controls. That would in turn spook markets far more than rate rises. Â
The next phase of markets
All of this says to us that a major market dislocation, despite the benign signals, lies ahead in the next six months.
Markets shifting rapidly are more a sign of uncertainty than of a new degree of confidence, and we simply donât trust it. We see inflation as apparently out of control, but no significant interest rate rise response is feasible. That can feel like stock nirvana, but also like investor purgatory, as you have no idea what is or is not a sustainable profit.
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