News & Insight • Market Insights
25 October 2023 | Simon King
A View from The Bridge - Driftwood
Driftwood
As we sat down to decide what we may comment on for the third investment piece of the year, the thought of further rants and raves about interest rates and inflation was just too much to bear.
Although we are usually not keen to spend too much time looking in the rear-view mirror, we thought it would be useful to share with clients the main things we now know which we did not at the start of 2023. This will not constitute a list of winners and losers but more lessons we have learnt, in what has been a generally perplexing market. So, in no particular order:
Conflicts Have Little Impact on Markets
The main feature in recent weeks has been the shocking developments in the Middle East. We will not comment on the right and wrongs of the situation, but global equity markets have proven remarkably resilient to events. Whilst it is not clear that this situation will continue it is further proof, after the onset of the Ukrainian war, that investors see these conflicts as largely contained and unlikely to spread to other geographic areas.
While this may be logical at the current juncture, we remain concerned that investors are too relaxed, regarding the general impact war has on global growth. If the situation in the Middle East was to deteriorate further, resulting in an interruption in oil supplies, then the inevitable rise in oil prices would also spell danger for inflation levels across the world. Obviously, we are all cheering for a speedy resolution to the conflicts but given their historic complexities this seems unlikely.
The New Blue Chips
We have previously commented on a handful of stocks, which we now regard as the new Blue Chips. These stocks, which include the likes of Microsoft, Apple, Amazon, NVidia and Alphabet, have shown a remarkable resilience in all types of market conditions and have continued to grow profits and cash flow. The absolute level of profits and margins they achieve and the fact that they require very little capital expenditure, mark them out from Blue Chips of virtually any previous generation.
Even we have been surprised at the performance in the year-to-date of all of these companies. In terms of equity performance for 2023, it has been all about how much of the new blue chips individual portfolios have contained. It is very difficult to have full exposure to this area and also maintain a balanced portfolio. In addition, the group has constituents with very different characteristics, so although we are attracted to several of them, we are not convinced by them all.
The Lost Art of Forecasting
Although we promised not to discuss interest and inflation rates, there is one aspect that we feel we must comment on. The ability of both markets and central banks to forecast both short and long-term levels of inflation, and therefore what is the appropriate interest rate has been, quite frankly, pathetic. This has led to both incorrect policy decisions by virtually all of the leading central monetary authorities and also unnecessary volatility in the markets.
The Bank of England has recently admitted that its core forecasting model is not fit for purpose. We remain concerned that its replacement will be little better, and also that the vast majority of the members of the monetary policy committee are academics and technocrats, who seem to have little, if any understanding of the real world. Any MPC member who had stuck their head out of the window last year would soon have realised that their models were not working.
Unfortunately, this is a situation which is mirrored in other countries. In terms of the markets ability to assess the same factors, we suspect that with so many investors now driven by historic price movements and analysis of other investors decisions and movements, that the market for the time being has lost its capability to accurately forecast even the most basic economic data.
Zero is a Nil Sum Game
Despite all the noise, it has been clear to us for the past few months that the global economy is growing at a very low rate in nominal terms and after adjusting for inflation, is actually negative in real terms. There are regional differences to this overall position with the US doing slightly better but the UK and Europe both remain well below trend. This highlights the importance of finding markets which can generate their own growth eg India and other Emerging Markets.
In a situation where growth is trending around zero, life in stock market terms becomes a nil sum game. We are already starting to see evidence in the reporting of company results and updates which highlight that for every winner there is a loser. In such a situation, it is highly important to be invested in the stocks that are the winners since the market will punish the losers very harshly. The good news is that in our experience when growth is scarce markets tend to reward any growth it can find with very high ratings.
The Wide World of Rate Interest Sensitivity
The negative surprise for us in 2023 has been just how many sectors the market has deemed interest rate sensitive. In particular our exposure to investment companies invested in a wide range of income producing assets has had a negative impact on our performance. Frustratingly the problem has not been their ability to generate income, with the vast majority of the companies we are invested in producing the expected level of dividends. The issue has been that where previously the market had been happy to receive a 5% dividend yield when interest rates were very low, they now require 8 to 9% income with the risk-free interest rate now at 5%.
This has ignored the fact that many of these types of investments have high levels of inbuilt inflation protection written into the contracts. We remain convinced that once interest rates start to fall, then the investment companies that have a high quality set of assets and the ability to grow dividend will recover very strongly in share price terms. These include property companies, which are hugely unpopular at the moment with the prevailing view being that nobody will ever work in an office or visit a shop ever again. Whilst this may be true there are many specialist areas such as student accommodation, hotels, supermarkets, health facilities and distribution facilities which remain in good demand and in relatively short supply due to planning restrictions.
Private Equity Rinky Dinks
One area that has become an increasing concern for us during the year has been the behaviour of the private equity market, which is starting to demonstrate points of stress. The simple fact is that valuations of many of the investments that private equity has made in the last 10 years have reduced. In addition, the quoted equity markets have finally adopted a much more robust stance when it comes to the valuations, they are prepared to pay for companies floating on the stock market, which has meant private equity has been unable to offload their investments.
Unfortunately, for various reasons, private equity companies are unwilling to crystallise losses on investments and have therefore resorted to a number of highly dubious tactics to effectively buy themselves time. These include selling investments to each other, refinancing their debt at very high levels of interest and increasing the amount of debt they are loading onto individual companies. All of these methods will essentially increase risk, particularly in terms of financial leverage, and could possibly lead to a series of negative events in the coming 18 months.
Private Credit = The Elephant in The Room
One of the other tactics that has been employed by private equity has been to seek more funding from the private credit market. This highlights another area of potential concern. As the traditional financing sector, i.e. banks have become more highly regulated and capital constrained, and this has resulted in an explosion in private credit i.e. non-regulated entities such as hedge funds, lending very large amounts of money to companies which would have previously borrowed from a bank.
Historically regulators have taken the view that since the investors who are providing private credit are generally wealthy and regarded as professional that it is an area that can be left alone. Fortunately, that appears to be changing as central banks and regulators have woken up to the fact that this has now become so large that it potentially presents a systemic risk to the financial system. We would be surprised if there were not to be legislation announced on this area, starting in the US.
Populism On the Rise
Although we prefer not to comment on political issues, we cannot ignore the fact that the world is becoming more populist and nationalist in terms of its political leaders. Regardless of the impact that this has on the economic performance of the individual countries, it will inevitably have further impact on the level of economic growth across the world as countries become even more insular. The mis-named Inflation Reduction Act in the US is a perfect example of this. Joe Biden has effectively reintroduced huge state subsidies into what is supposed to be a capitalist economy where subsidies should not be required. In doing so, he has changed the basis of global investment patterns, which will have very long-lasting impact.
It has also highlighted the huge differences in the capability of other countries to compete for this investment. Put simply, certain countries do not have the cash or the ability to borrow to be able to offer the necessary level of subsidies to attract new investment.
Sorting The Wheat from The Chaff
One of the few good things about inflation is that it has severely tested the ability of companies to pass on price rises to their customers. Pricing power is one of the key features we look for in identifying what we regard as high-quality companies. While a few have undoubtedly been too aggressive, the vast majority have simply sought to maintain their margins. As inflation abates, the key for these companies will be to make sure that the slight volume erosion they have witnessed as a result of price rises, does not continue when prices are not rising.
This is particularly the case with branded consumer goods and we are already starting to see evidence of some of the weaker players being unable to adapt. This of course would be further exacerbated if economies start to enter period of real recession.
The Titanic Had a Chartist
We have said, for some time that we are perplexed by the market’s desire to go back into history as a guide to what may occur in the future, and it has intensified during the year. We maintain a view that markets had never been in their current position before i.e. interest rates rising as economic performance deteriorates, and with the high levels of liquidity that still exist in the financial system, due to the fact that quantitative easing is still very much in place.
In addition, the market has an obsession with identifying large one-off events, often known as Black Swans. In doing so it tends to ignore what it regards as “normal” one off events, even though these can have a major short-term impact on market performance. Good examples would include the Liability Driven Investment (“LDI”) fiasco in the UK and the banking crisis earlier in the year in the US when the likes of Silicon Valley Bank went bust.
Conclusion
On a more positive note this last point also proves that overall equity markets have been remarkably resilient. Bond markets have suffered more due mainly to the resetting of interest rates and the so-called alternative space has been all over the place but largely correlated to general equity performance. In such a period of uncertainty there is simply no substitute for quality and as always that is what we continually seek for our investments. On a long-term basis all of the above observations are merely “Driftwood” which as Travis state in their 1999 song ultimately breaks into pieces.