The name of the game

What is the point of investing? How has that changed over time.? Do we still need so many choices? Are single stocks relevant? And we salute the prime palindrome.

We were taught that investing is an economic process for allocating capital to allow competition to seek out the best opportunities and fund the best businesses for the benefit of all. Countries with good markets have good capital allocation, grow faster as enterprises with the best return on capital, and then attract more of it.

Really? Not what it looks like now. Things change. The old gateways got knocked down, so anyone can access any investment anywhere. The paternalistic City was never sure about that, but in reality, markets followed communications, which went global.

The FCA (and to a degree the SEC) has a muscle memory of these protected times, and constantly wants to suppress innovation, keep new issues and ideas away from investors. Slow it all down, so they don’t just regulate markets, but control them. But excess capital flows are changing all that. It is instructive how the SEC, by trying to stop Bitcoin, has simply made it respectable and transacting in it safe.

And looking skyward and not understanding how this excess liquidity is created by quantitative easing is sadly no longer viable for investors; entire economies are built on it, like Japan. Nor is it transitory, it is embedded in the US and EU as much as anywhere.

Governments hoped to take control, using QE they forced the cost, to them, of debt down to zero, on the way creating such a shortage of bonds, that  prices rocketed. Paradoxically as did equities, for they could keep offering a yield and had no “lower bound”, so their prices could rise for ever.

Then equity investors got back in control, they realised they could move the price, on the thin sliver of equities that are actually traded, pretty much as they wished. In particular they could signal or co-ordinate, so that everyone was on board with the price direction. Which is both the meme stock phenomenon, but also at the heart of momentum investment.

And liquid, global, interconnected exchanges were designed to let all those price signals out in an instant. Of course, co-ordinating them takes only a few seconds more.

THE POINT IS

Which brings us back to what the point of investing is. I am only interested in capital allocation, if by understanding it and dissecting the choices, I can get better returns.

I can have an altruistic angle of course, I just like old style engineering and banking outfits, I sponsored the IPO of an art gallery once. I have a soft spot for Kenya and Bulgaria. I want to avoid ‘defence’ industries, I dislike tobacco and polluters, and not sold on slave labour either. How nice, and in the investing world, how utterly useless. Never, ever, fall in love with a stock they said: quite right, sadly.

Indeed, what you and I call capital allocation is what others call hot money, and it moves faster and faster. As for those bad actors, well money always attracts crime, the faster it moves the more options for criminals exist, quite a few of whom wear suits.

But then who needs stocks and analysis when you can now buy a market cheaply? Everything says invest in multiple geographies, but really? The process I have outlined above favours one or two markets, they win, so they give a good capital return, so they win again, almost regardless of what the underlying business does.

Indeed, Bitcoin shows, it can indeed be regardless of the underlying asset. Coordination and belief matter, not reality.

So, what of all the rest, the unfashionable markets, unfashionable stocks, they just keep underperforming, keep being sold, with very little scope to recover. With rates low it was possible to pay a competitive dividend, but when money market funds are expected to offer you twice the rate of inflation, even those dividends are unattractive, and they get taxed hard.

NO COMPETITION IN COMPETITION

While the Government has also destroyed the competitive market for companies, by largely sidelining hostile takeover bids. In any event issuing poorly rated paper for poorly rated paper never sounds great. But that closes out profitable exits; sure you get insiders sweeping the Aim floor for cheap deals, but by definition those are not competitive, you can’t have two sides both inside.

The government knows that almost any deal has a loser, or someone not as well protected for life, as they had hoped. Which means media noise and MP’s getting lobbied, so far better to ‘long grass’ it, via a competition investigation. Isn’t it odd that the competitive market in asset allocation created by an active takeover market, is the one market the competition authorities simply won’t investigate. But without that cheap stocks just stay cheap, it is why buy backs are so prevalent: the companies are right, the price is wrong.

Of course, index investing has issues, you buy the bomb maker, cigarette seller and dodgy legal firm all in one bundle, but that’s the game. If it is big enough, it goes in the index, and you buy the package.

And hot stocks are likely to favour low commission markets, and low transaction costs. It may be an accident, that UK commission and tax is based on total deal value, but US commission is based on share count (and there is no stamp tax). But it does mean that you buy a share in Berkshire Hathaway for the same dealing cost as one in Game Stop, or if you prefer Nvidia and Trump Media.

Assuming sanity, you trade in the US, or in stamp free index ETF’s, not UK stocks. Although the FCA are fighting a rearguard action against both ideas, with the discrimination against holding ETFs seeming particularly bone headed and indeed against consumer interests.

But few stocks, fewer markets, more hot stock volatility, it is just the way we have set it up, don’t be surprised that is how capital is now allocated, growth funded, prosperity achieved and destroyed.

TIME FOR A BREAK

As for this market, it had to break, we have said it for a while.

Levels have dropped sharply, and money is rotating back into bonds, or at least not flowing out of bonds.

Waiting to see through the summer, when that first rate cut arrives and who wins the US Presidential election, is all impacting the hot flows and making staying in cash feel easier.

While a more sinister undertow is coming from the narrative that the terminal interest rate settles out higher.

Our core assumption is still that real interest rates are now in a steady decline, but the equity bonanza of negative real rates is not coming back anytime soon. While for now, only one Central Bank and one market is going to keep on winning the hot money race. No prizes for second anymore.

The Winner Takes It All.

by Charles Gillams

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.

by Charles Gillams