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.

 


The Sleep of Reason

Big picture risk assessments today, and worries about the prevailing style of regulation - we look at where the next bank blow up maybe. We’re assuming this will again be caused by regulators and their herding behaviour. On the upside, an improving medium-term market outlook. Also, dollar danger.

But before I begin…

First of all, many thanks to those who replied to our sentiment survey, you are a cautious crowd! Over half (53%) sitting on the fence, alongside us. The largest directional group is bullish on equities (18%), but it is a pretty even bull/bear split with bonds, and quite a few equity bears too.

Regulatory Myopia and Declining Banks

Bank boards (and auditors) are still clearly confusing regulatory approval with sound banking, in the odd belief that excuse will wash, when they implode. In particular we worry about the vast amount of debt that is sitting on bank balance sheets, at below current market levels, and not in this case issued by governments.

We have notable anxiety about two areas, fixed rate mortgages and investment grade debt where, especially for the former, the numbers are vast. Perhaps the tightening steps to date appear so ineffective, just because so much of this old low-cost issuance, is only very slowly rolling off .

Big picture – the effect of long dated low-cost loans, with rising interest rates

This leaves cheap money in the system, funded by banks, that have to pay way more to keep funding these long-term deals. They’re doing this typically with short-term sources, like deposits. In sub-prime, asset finance, trade finance, consumer finance, none of it matters much, as they are pretty short duration.  Which is where most people worry, because of default rates, we don’t.

But in mortgages especially the regulator typically issues the future economic scenarios to banks, who then price (originate) and provide for losses against that projection.

If that projection is absurdly few rate rises, for a decade (as it was till fairly recently), it seems banks just follow obediently along. As a result, they have issued vast amounts of long dated, low cost loans based on false or unrealistic assumptions.

Those regulator driven economic assumptions/scenarios are key, and yet are lost in the detail. Each bank has to publish them if you dig deep enough.  (Some are on p155-157 of the HSBC accounts, for example, if you have the stamina.)

Re-mortgages – what they contribute to our big picture

The other part is refresh rates, in a falling interest rate world, borrowers re-mortgage every few years, but in a rising one early redemptions virtually stop. So, the whole system gums up, without fresh liquidity. Regulators have not seen, and have no data, on such a ‘higher rates for longer’ world. So, it is assumed that world cannot exist. While the key thing (still) on these scenarios is that interest rates are still assumed to be like rockets, straight up straight down.

Now if you assume that, there is some short term pain, but normal service resumes soon enough with no long-term issue. But is it realistic? It is a vast slow moving market as in this publication of the FCA’s mortgage lending statistics .

Inevitably the scenario dispersion used is small, indicating a regulatory finger remains on the scales. So, most banks take the Central Bank forecast as the middle way, with say 10% either side. All as at the historic balance sheet date. Last year they were nonsense even before publication, two months on.

That is aside from Hong Kong, where real economic models, with real outcome ranges are visible. For most markets you see a skein of twisted rope drifting laconically into the future, but on HK they produce an exploding ammunition graph, smoke trails looping everywhere.

To a lesser extent BP debt (a classic investment grade, big, global borrower) is a similar problem. It has half fixed, half floating issuance, but the fixed is at 3% with a fourteen-year average term and the floating at twice that, at 6%. Now someone holds that fixed debt, and if regulated it will have to now be held below par. Are BP going to prepay it? Despite the roar of cash coming in, why would they? It is stuck, unusable for 14 years, unless inflation (and rates) collapse as fast as predicted.

What else is driving markets?

The big upside drivers to us are, the end of COVID, the end of the energy spike and falling rates. The first two will help through 2023 and 2024. Rising rates are still hurting, but again 2024 and beyond  looks good.

While the biggest current downside driver is the recession, which will impact 2023, but again rebound in 2024. So, the issue is: will the rather timorous monetary tightening and anaemic reductions in the absurd fiscal overdrive, be enough to defuse all that good news coming in the next year?

Markets apparently think not.

We are particularly struck by the NASDAQ up 18% year to date, yet our tech bell weather share, Herald Investment Trust (HIT) is still (marginally) down YTD. So is this a bitcoin-type story (all about liquidity) or is it based on tech fundamentals? If the latter, then why is it seemingly glued to the US, and not translatable? Even failing to reach non-US holders of US companies.

For now, until the price of global tech shifts, I treat the US as a special case; growth is not back yet.

While the currency charts are unclear, it does also feel like the beginning of the end of the great dollar story, with sterling persistently ticking higher of late.

Graph showing the dollar share of global reservesFrom: this page published by the NY federal reserve.

That’s a real danger for portfolios that thrived on dollar power last year.

We close wishing you a happy Easter break. We will be back with St George.


The Art of the Possible

Image from Wikemedia - by Neide José Paixão

Looking at Absolute Return – Can it be Done?

A wise old hand once told me that all investors want is protection from inflation; do that, earn your fees and your job’s done. Read more


WHAT DO THEY KNOW OF ENGLAND?

Let us look at tech, private equity and this seeming market bounce, driven by those sectors. The NASDAQ is up almost 10% at 11,320 after a trio of twelve-month lows in the mid 10,300’s, the latest of those lows just this week. Meanwhile it looks like the US Elections have delivered both gridlock and a rebuff for Trump, which some see as a perfect mix.

Today’s post title is derived from Rudyard Kipling at his most sanguine and reflective.

I HAVE FLUNG YOUR STOUTEST STEAMERS TO ROOST

The true horror of the tech wreck has also been concealed for UK investors, by the climb in the dollar, a move that seems to be going into reverse. In terms of closing prices sterling has rallied hard from 1.08 to 1.18 in a little over a month. This has left the NASDAQ collapse, from touching 16,000 - brutally exposed, now without much of the concealing currency appreciation.

Where is the Nasdaq headed?

We suspect that the NASDAQ is heading lower still, but accept that is a big call.

Nasdaq over the year January to Mid november 2022

From this page on Tradingeconomics

It remains a crowded space for a lot of unprofitable companies to jostle, as they build market share. This disguises the possibility that in some spaces, even owning the entire market will still be loss making.

However, market sentiment has perhaps turned, the tech rubbish generally got chucked out early. The subsequent switching out of the tech majors probably had to be into Treasuries, where their recent price rises suggest some demand, or into cash.

It remains a crowded space for a lot of unprofitable companies to jostle, as they build market share. This disguises the possibility that in some spaces, even owning the entire market will still be loss making. Bumping up against that is the second phase of the market collapse, as the multiples on profitable tech giants returned to earth.

And cash (and oddly apparently the S&P) has also been seeing inflows from China and crypto, as those areas have sold down hard. There is also the unpleasant negative impact of holding cash, on returns. Put this together with sentiment, and this may well help the NASDAQ bounce into the year end. However, many fund managers cite the dotcom bust as meaning this is now starting a multi-year sideways recovery phase, not a quick bounce at all.

LONG BACKED BREAKERS CROON

A concurrent look at Private Equity is important. NASDAQ multiples drive much of their values and are falling, and with such a recent twelve-month low, Q3 valuations (private equity valuations are always lagged) have further losses built in. And a sprinkling of those will now also be based on a significantly higher dollar too. That won’t be pretty either.

Plus, as we know there are some spectacular blow ups lurking in there, the insolvent FTX was a big investor in, and investee company for, some well-known PE names. Overall, despite solid reports, I am still expecting some fair-sized holes in quoted private equity, as either the NASDAQ rises and the dollar falls, causing currency losses, or the NASDAQ falls and the dollar rises and the one again masks the other.

Access to distress financing, has it seems largely vanished, as it does at times like this, making the chance of highly damaging wipe outs, not just down rounds, much greater.  

A possible dollar sterling parity?

But those talking of dollar sterling parity are surely way off now. So, regardless of future disasters, I want more information before seeing UK Quoted Private Equity Investment Trusts as a buy. About six months after the NASDAQ bottom, will be a good valuation point, and that likely means Q3 2023. At that point we will know what the current large discounts really refer to; I don’t expect them to look anything like as generous.

THE UK - UNDER A SHRIEKING SKY

There is a lot of market optimism about the next UK budget, based on Hunt being really nasty. That may overstate his hand, as the Government has long abandoned reform, it can only support out of control spending by harsh tax rises, which will certainly kill jobs, but probably the wrong ones.

Nor can it do much to enhance investment and has foresworn labour market reforms, so both of those, with existing policies and more rate rises, must encourage the persistence of poor productivity.

Although of course the real budget numbers will be barely mentioned; energy, rate rises, and inflation are largely out of Hunt’s hands. He is lucky all three do look a lot better than when he was installed. So, the need for harsh medicine is rather reduced, and may even disappoint.

But just as the rally helped US risk assets, so it helped others, like property, come off a deeply oversold floor. TR Property Investment Trust has jumped 30% in a month, for example, and still yields over 4%.

Post Mid-term elections for the US

And coming full circle, although slowing inflation took a lot of the credit, at least some of the post Mid Term bounce came from realising that the Federal Reserve now has an ally in the legislature. It can be less vigorous in steering the economy, just relying on the brake pedal, as Biden and Congress are no longer able to simultaneously hammer the accelerator.

Overall, however we still remain cautious, we expect this pre-Christmas rally to fade, rate rises to persist into at least Q2 2023 and rate cuts to be a 2024 feature. And peak gloom lies ahead as those rate rises conclude and then start to actually bite.

Looking ahead

In general markets have had a solid look at the worst case this year, from famine to invasion and nuclear war, to out-of-control Central Banks and deluded politicians, and nothing terribly dramatic has transpired. So even with bad things still happening, we don’t see a repeat of this year’s dramatic falls either. 

Charles Gillams

  

  • The Kipling Society meets on November 16th, at the Royal Overseas League.