News & Insight • Market Insights

01 August 2024 | Simon King

A View from The Bridge - Whole of the Moon

We had originally decided to focus this piece on a recent presentation we organised entitled, “Everybody Wants to Rule the World- The impact of elections on financial markets.” Unfortunately, since we hosted the gathering, we have been somewhat over-run by events with snap elections, surprise results and US candidates subject to assassination attempts and ill health. In addition, much of what we spoke about in our presentation has now been discussed ad infinitum in the general press. As such, and since we are now at the mid-point of 2024, we thought it would be more useful to share with clients some of the major themes and challenges we are currently considering as part of our investment process. At the headline, level markets have been remarkably robust in the year to date, but beneath the surface there are various bubbles and tensions starting to appear.

The global economy is now at a watershed, still recovering from the ravages of COVID-19, learning to cope with high levels of debt, trying to guess where both inflation and interest rates will settle, whilst economic growth and living standards stagnate in many parts of the world. As The Waterboys warned in their 1985 hit “The Whole of the Moon” we need to be able to see the entire picture.

ELECTIONS – MYTHS & REALITY

Although we will not be talking exclusively of elections here, at the moment they are obviously front and centre. Our macro breakfast had two key themes: firstly, that much of the received wisdom on what goes up and down in election periods is simply wrong; and secondly their main impact was to create uncertainty, both before the event (as markets try to figure out who will win and what difference it will make), and afterwards, when markets must wait for policy to be devised and enacted. The worry for 2024 is that with so many elections this year, markets as a whole would go nowhere.

Even with the various twists and turns on dates and candidates, this has not proven to be the case, with investors, particularly in the US, choosing to look through short-term uncertainty and assume a fairly rosy future further down the road.

There are a number of factors that have emerged from elections around the world, which will impact markets. There is strong evidence of a rose-tinted spectacles effect, with electorates yearning for past incumbents and regimes eg Trump, Marcos, Zuma, Tusk, which is leading to an increase in populist policies, often doubling down on previous unsuccessful strategies. In our view, this leads to short-term, ill-judged decisions, which have an adverse impact on economies and therefore markets. The best example of this is the subject of protectionism and tariffs, which has become a political hot potato and is undoubtedly poor for both growth and productivity on a global scale. In addition, vitally important international organisations, such as NATO, have become targets for attention seeking politicians to sling arrows at. It has also become difficult for competing candidates to distinguish themselves on a wide range of issues, as they are constrained by the need for fiscal credibility and the high levels of existing government borrowing. This means the areas they can assert themselves in, are few and tend to be non-financial eg immigration.

CONCENTRATION – NARROWER & LARGER

We generally do not comment on the various components of our performance or indeed on individual stocks. However, given many clients currently ask us why their portfolios are not performing as well as the major equity indices, we would make the following points. Global equity indices are all now heavily weighted towards the US equity market. In turn US equity indices are becoming increasingly concentrated around a small number of exceptionally large companies, variously known as the Magnificent Seven, Fab Five, FAANGs etc. The majority of these stocks are in the technology or related sectors (Amazon, NVidia, Meta, Microsoft, Alphabet, Apple, Tesla, Netflix, Eli Lilly) and virtually all of them have enjoyed strong price rises. Until recently the rest of the market had collectively produced virtually no gains and therefore performance has been all about holding all of these stocks. At Vermeer Partners, we prefer to have balance in clients’ portfolios and as such, we hold some of those names but not all of them. We have seen similar periods to this in the past and remain convinced that our approach will bear fruit in the longer term.

ARTIFICIAL INTELLIGENCE (“AI”) – NOT A ONE-WAY BET

There have been only two themes driving equity markets in the past 12 months: AI and weight loss drugs. We have discussed the latter in detail in previous missives and generally find the positive views on the areas compelling but are becoming a little concerned on valuations and competition. The former is an altogether more difficult proposition. Suddenly everyone is an expert on Large Language Models, data scraping and on how AI is going to transform the world. We are very cognisant of the vast progress that AI enables in the handling of stupendous amounts of data and are enthusiastic about the real-life benefits this can have in sectors such as drug discovery, record keeping and the elimination of many mundane tasks. We are also conscious of its threats to many peoples’ jobs, its enormous power consumption and an overriding concern that it will be used for no good.

What we find the most difficult to understand is two-fold. Firstly at a macro level is it actually going to provide the step-change in productivity that the global economy requires. If it does not, then the global economy will have wasted an unprecedented amount of both human and financial capital, as the amounts of investment being made in the area are simply mind-boggling. Secondly at a micro level we have severe doubts that the individual companies that are investing in everything AI, will ever earn an appropriate level of financial return. For the very largest companies this will not be life threatening, but it will hurt. For some of the smaller players it will be far more serious. In addition, this over-focus on AI is resulting in less investment in other areas, which are potentially just as exciting. We think that some companies will do very well, but much of this has already been recognised in valuations. There will be many losers, not just in those that invest unwisely but also because the pricing structures of many companies will come under severe pressure. For example, the software sector will have to start to charge what it costs to develop and support a product, not what it believes the customer can and will pay. 

CONSUMER SPENDING – THE GIFT THAT KEEPS ON GIVING

We have been concerned about the consumer for some time and have been generally surprised about the resilience of consumer spend in most economies. What we most likely misjudged was the sheer scale of COVID accumulated savings, large numbers of workers enjoying decent absolute wage growth (even if it was poor, relative to inflation) and the feel-good factor that inflated stock markets provides to people. There is real evidence that at least the first two influences are starting to wane. Company results and trading updates in the sector have been mixed, with evidence of down-trading and even the luxury end of the market starting to decline. This was going on in 2023 but high levels of general inflation allowed companies to raise prices aggressively and compensate for the decline in volumes that the price rises created. With inflation now abating this has become much more difficult and because most prices have not gone down, they are just rising less quickly, volumes are not rebounding. There has been the usual plethora of excuses, including destocking after COVID, adverse weather, shipping issues due to the Middle East conflict and a slow economy in China. We suspect it is more deep-rooted, with increasing numbers of workers having to further tighten the purse strings. The good news is that times like these start to sort the wheat from the chaff, with weaker franchises exposed much more quickly. As always, we are looking for the strong franchises, and although they are not immune from the current trend, any significant price falls are generally good buying opportunities.

DEBT – FOOL’S GOLD

The overall level of debt in the global system continues to be a source of great concern for us. Since the financial crisis of 2007, much of this debt has transitioned from company balance sheets to governments and has increased significantly. The consumer has been bailed out by COVID support payments but is now reverting to type and slowly increasing personal debts in order to fight off the ravages of the inflation experienced in the last two years. As we discussed, our elections point towards a need for fiscal discipline by governments ie living within their means is already having a huge impact on both existing and future policy. We would also argue that all governments need to reduce interest rates, just to decrease the amount of interest they are having to pay for their existing debt.

Issuing more debt simply to pay interest on existing debt has never been a successful strategy. The US government in particular relies on foreign investors lending it money and it has long been assumed that the scale of the US economy, the dollar’s role as the preeminent global trading currency and the fortitude of its central bank would mean borrowing money would never be a problem. We are not suggesting this ends anytime soon but even a whiff of doubt would have serious implications. If the US chooses to pursue an ultra-isolationist strategy, then the resolve of all foreign investors will be severely tested.

PRIVATE EQUITY – TICK TOCK, TICK TOCK

We have been concerned for some time that Private Equity is not really a diversifier and in effect is only normal equity with a delayed pricing system ie public stocks are priced every day, whereas Private Equity revalue only every six months. In addition, there is now the worry of the ticking clock of private equity returns. We have long argued that private equity investment is over-crowded, with a large number of participators surviving on a diet of excessive leverage, low interest rates and generous new issue markets ie they borrowed too much money, at very low costs, did not invest or improve the companies they invested in and then sold the companies to the public markets at the wrong price. None of these factors are now in their favour with interest rates being much higher and public markets much more discerning. Unfortunately, due to the fixed length nature of the vehicles used by Private Equity to make their investments, their underlying investors (pension funds and sovereign wealth funds etc) now want their money back. Only then will they hand over new money for new vehicles to start the process all over again. Initially their response was to either sell companies to one another or construct some dubious financial structures to allow further borrowing to pay off exiting investors, but the remaining investors soon shut down that approach as an option. So now they are faced with a dilemma: either they start to sell companies to the public market (ie, flotations at prices that will not produce the returns they promised) or they keep them and finally admit they have decreased in value. Either way, we do not regard Private Equity as attractive.

DEFENCE – A DELICATE TOPIC

Defence is not usually an area that features highly on investment wish lists. The complexity, length and fixed price nature of defence contracts have made the companies involved highly volatile and often high-risk. In addition, the popularity of more responsible investment strategies has drastically reduced the available investor universe for many of them, since many people simply do not want to invest in unethical companies. Whilst we would have some caution about suggesting this has totally changed, the unfortunate prolonged nature of the conflict in Ukraine, the heightened tensions around North Korea and Taiwan, and increasingly the war in Gaza, have somewhat altered the outlook for the global defence sector. There is the painful task of supplying “consumables” ie bombs, missiles and bullets etc, which boosts short term demand and starts to make individual countries focus on their longer-term defence budgets and levels of expenditure. The tough rhetoric on NATO and who funds it, espoused by Donald Trump, only adds to the pressure. We are wary that demand may be peaking and the historic issue of long-term cost overruns on individual projects has not gone away. The valuations of many of the stocks are also at all-time highs. In summary we are still cautious.

HEALTHCARE – DEMOGRAPHICS DO NOT LIE

Long-term  readers  of our investment thoughts will be very aware of our predilection for healthcare, with the exception of the aforementioned weight loss stocks, performance of the sector has been mixed. Although there will always be winners and losers in terms of drugs development, we would continue to argue that as a group they should outperform the broader market over the long term. We are generally attracted to the power of demographic trends; they offer one of the few sources of long-term and forward-looking data, We believe the unfortunate trend of an ageing population in increasingly poor health will require a much larger portion of any country’s resource to be diverted to healthcare spend. Even that is unlikely to be enough, so we will have to become much more productive and efficient in all areas of healthcare provision. This will come from a combination of public and private providers, all of whom will need to be professional and well-financed. Although healthcare and profits are seen by some as unnatural bedfellows, the fact is that most of the global healthcare sector meet the standards required and as such, many will enjoy substantial growth in the coming years. We believe this will be a widespread trend and thus, have several investments looking to capture upside in many areas.

ENERGY TRANSITION – IN NEED OF A KICKSTART

One of the real disappointments of the current flurry of elections is the extent to which energy transition has slipped down the agenda. We have long argued that we needed to take a measured and controlled approach to transitioning away from carbon with a well-conceived long-term plan, which did not involve the immediate cancellation of existing power sources. Unfortunately, this was not the case, and the over- zealous initial approach has produced a backlash that has enabled naysayers and politicians to kick the subject way down the road. The amounts of capital required to effectively achieve a proper transition are simply huge and need high levels of visibility and certainty, particularly if the capital comes from the private sector. Therefore, the whipsawing of both policy and investment is definitely bad news. This is not to say that there is no activity, just not enough. We continue to identify numerous companies in all parts of the energy transition hierarchy that are already benefitting and will do even better in the future.

ADJUSTING TO THE NEW NORMAL

We keep returning to this theme but we do believe it is a major obstacle that everyone has to overcome. As a reminder, our thesis is that the developed world enjoyed a period of unprecedented stability and growth from the early 2000s to 2020, interrupted only by the short-lived financial crisis of 2007/8 and ended by the onset of COVID-19. From then on, investors, consumers, governments and companies have had to deal with large increases in interest and inflation rates and more latterly heightened geo- political tensions and conflicts. This has produced a generation who have known nothing different and are now struggling to adapt to how the world may look moving forward eg what is a normal rate of inflation and what will interest rates be over time? Inflation in particular, has been a real shock to many, as they do not fully understand the concept and are certainly unprepared for its impact.-time highs. In summary we are still cautious.

CONCLUSION

There has not been a proper bear market in equities for some considerable time, and there is the fear that today’s investors have become immune to risk, in that they have the perception whatever happens markets go up. We have seen some evidence of this just as we go to press with this article. The same goes for economies with very few individual countries getting anywhere close to even technical recessions. There is an entrenched belief the decrease in living standards will be quickly restored. The fact that this is likely to take some time, could be a real shock to many and whatever, will have an impact on corporate and consumer behaviour moving forward. Although this increases uncertainty, the obstacles it presents are not insurmountable. Governments need to set clear and consistent long term polices and frameworks that will allow companies and individuals to make considered and rational investment and spending decisions. The companies that will prosper in this environment will be those with strong franchises, and financial positions which have the ability to weather the various bumps along the road. These are the companies we seek to invest in.