News & Insight • Market Insights
17 October 2024 | Simon King
A View from The Bridge - Riders on the Storm
With our investment process being unashamedly bottom-up we do not spend vast amounts of time trying to forecast which geographic areas will outperform in the short or medium-term.
We prefer instead to identify and invest in companies with great franchises across the globe or in companies with exceptional market positions in individual economies. However, as you would expect we do have broader longer-term views, and we therefore thought it would be useful to share these with our client base. We have previously commented on how different the next ten years will be when compared to the previous decade and we have not changed our mind on this.
Economic and market conditions will be volatile and navigating these will make all investors, in the words of the 1971 Doors classic, “Riders on the Storm”.
Most of the world faces a similar set of broad economic challenges. In the short-term that is to establish interest rates at a level that is conducive to achieving an inflation target of c.2% and not creating high levels of unemployment or a period of real recession. We sometimes wonder if a certain set of market participants stop there and do not focus on the real long-term issue, which is how to stimulate meaningful productivity gains and therefore, most crucially, economic growth. Put simply, unless we grow the pie quicker than the mouths it must feed, life will continue to be difficult for the majority of the world’s population. In addition to these generic challenges, each country/economic area faces its own specific obstacles, and we will now explore each of them.
USA - TWIST OR STICK
We approach any commentary on the USA with a great deal of trepidation at the moment, given how quickly things may change. Whilst we are of the view that US elections have a limited impact on long-term economic performance, the forthcoming version in November will have a major influence on the short to medium- term direction of both economic and financial market performance.
To be clear, there are some very stark differences between what the two candidates are promising, namely low taxes, big spending, reduced immigration, and tariffs from Trump; compared to increased taxes, restrained spending, controlled immigration and some isolationism from Harris. The promises from both sides must be treated with a healthy level of scepticism, since neither will be able to enact all their manifesto pledges, due to the checks and counterbalances that are engrained in the US political system. It will, however, make a significant difference to markets at the actual time of the election result.
Interestingly, although we are strong believers in dollar strength over any reasonable time period, we cannot see a dollar rally any time soon. If Trump wins, he has stated he wants a weak dollar to make US-produced goods and services cheaper. However, the dollar has already weakened significantly and we maintain the view that the sheer size of currency markets means that no individual or entity can have a lasting impact on them in any case.
One feature that has received a great deal of comment in the past year is the fact that the US stock market makes up over 70% of the total global stock market. This compares to the share of global GDP (a broad measure of the size of the economy) that the US enjoys of c.25%. There is a plethora of reasons for this mismatch, ranging from vast swathes of other economies not being quoted on public markets, to outright over-valuation of US equities. Regardless of the reasons, we do not anticipate this situation changing any time soon. The US remains the world’s most dynamic economy, and the dollar remains the world’s reserve currency i.e. the one people prefer to trade in and to run to in times of stress. It is also the home to a large number of the world’s largest and most innovative technology companies with a unique ecosystem of education, research, funding at all stages and a huge domestic market for technology companies to benefit from.
Whilst we remain sceptical of long-term returns on the simply vast amounts of capital being allocated to technology at present, we see no signs of it slowing down. Individual technology companies may come and go but they will be replaced by others and the very largest ones have the balance sheets and cash to endure extended periods of low returns on parts of their business.
Overall, we expect the US to continue to lead on an economic and financial markets basis but expect its political influence and foreign policy to adopt a far more isolationist approach. Assuming the Federal Reserve holds its nerve and manages interest rates and inflation in a sensible and consistent manner, which may be more difficult with a Republican administration, then markets should continue to edge upwards. The major potential fly in the ointment is the simple fact that the US has borrowed a lot of money to fund a huge fiscal deficit i.e. the government spends a lot more than it receives in tax. This deficit has grown to nearly $2 trillion pa and total government debt is now over $35 trillion.
To be fair many harbingers of doom have highlighted this position for many years and markets simply have not worried. We are concerned that if there were to be US specific events or adverse set of circumstances and that the US was unable to take on more debt, then the global consequences would be severe.
CHINA - PUMP UP THE VOLUME
China is a real conundrum at present, with conflicting data leading to a wide range of opinions on how the economy will perform in the next few years. There can be no dispute that China is in a vastly different position to where it was even 5 years ago. It allowed, or was unable to restrain, a rampant property boom, which attracted the usual suspects of bad actors, over- exuberance, leverage and lemmings. This led to far too high a degree of both investment and savings going into the property market i.e. everybody had a second home/investment property. This made the Chinese economy overly sensitive to a property crash, which duly occurred. This has left the economy with a large unproductive asset, since much of its excess property is empty, many large financial and construction companies effectively bust and severely reduced both the spending power and consumer confidence of a significant portion of the population. This has resulted in actual growth being way below reported and targeted levels and has produced a poorly performing equity market.
As we write this piece, the Chinese government has announced a slew of new policies and strategies essentially looking to pump prime the economy generally and specifically incentivise new investment in the property sector. Initial stock market reaction has been positive, but we expect this to wane and focus will return on how the problem can be dealt with in the long-term. We have long argued that the Chinese government is in a unique position with its incredibly strong policy implementation apparatus and its complete control of its economy. It does get things wrong however as ineptitude; corruption and vested interest impact its processes. However, we continue to believe that China will grow at a quicker rate than the rest of the globe over the next decade. How much of this recovery will filter through to equity markets is much more difficult to assess.
We have long been of the view that it is impossible to have any faith in Chinese numbers of any variety because they are not accurate in the first place and are also subject to an unhealthy degree of manipulation. This is even more so in periods of stress, such as we are seeing at the moment. By definition, any investor looking at China has to revert to a long-term perspective of its prospects. Given our preference for a bottom- up investment process, this makes it difficult for us to invest directly in individual Chinese companies. Put simply, we would not know what we are really buying. However, the sheer scale of the Chinese economy and its different approach to politics and timescales means it simply cannot be ignored. It is the second largest economy in the world, with a 1.4bn population, it has a unique balance of payments position i.e. it exports far more than it imports and has accumulated a vast amount of foreign currency reserves (much of which it lends to other countries). However, the Chinese economy faces the aforementioned imbalances in its economy and must also handle a transition from an economy based on low price labour, to one of added value and innovation, as it faces the implications of an ageing and declining population.
EUROPE
The speed at which the political situation in Europe has deteriorated has surprised us. The electoral swing to the right has accelerated, with Germany, France and Italy now suffering from the decision- making stagnation that the fear of extremism always seems to lead to. The timing of this trend could not be any worse with the structural fissures of the EU being amplified post-Brexit and a real requirement for Europe-wide policies and responses, rather than the nationalistic and protectionist reactions we are currently witnessing. We would argue that this is having a real economic impact with most economic data worsening. It will only be a matter of time until this is manifested in individual company performance.
We are of the view that the outlook for European economies will be incredibly challenging for the foreseeable future. The structural issues of the EU; namely the dominance of Germany and France, an overly bureaucratic legislative and economic structure and trying to set monetary policy centrally without effective control of individual countries’ spending; have never been dealt with and show no signs of doing so.
In addition, the EU operates a flawed energy policy that is far too dependent on imports. We would argue the risk is of further Brexit style departures, rather than the dawning of a new age of co-operation. Although the EU begins from a relatively strong starting position in terms of living standards and productivity, it risks a Japanese-style period of stagnation fuelled by political unrest and a deteriorating demographic outlook
UK - STUCK IN THE MUD
The title is not merely a reference to recent weather conditions but an acknowledgement that now that the post-election honeymoon of renewed optimism has subsided, the focus has returned to a very dull outlook for the UK economy. Growth is somewhere around 0% and even lower when adjusted for inflation. Interest rates are high. Inflation itself has reduced but real wages are still lower than ten years ago. The government’s balance sheet is stretched and there are simply not enough tax revenues to provide the level of public services that the population believe they are entitled to. As we have continually highlighted, there is little room for financial manoeuvre or flexibility. Despite these negatives and whilst we strive to maintain our guiding principle of refraining from party political affiliations, we are in little doubt that the new government is over egging the dire state of its legacy.
Businesses, consumers, and markets alike are now awaiting the UK budget at the end of October with bated breath. Rarely has there been such a level of debate, conjecture, and crystal-ball gazing as to what it may or may not contain. Our concern is that there may be a series of knee-jerk and poorly conceived policies in reaction to a perception that the new government needs to be seen to be doing something. We rather hope, maybe naively, that instead the Chancellor stands back, does as little as possible and then lays out a roadmap on tax, highlighting where they would like to get to and how they may achieve it.
It has surprised us how strong the sterling has been against virtually all other major currencies. We commented above on the weakness of the dollar, but the pound has been even stronger than that would imply. Part of this is certainly down to the expectation of UK interest rates not declining as quickly as other countries. This assumes that UK inflation will not be any higher than the rest of the world, otherwise in theory, the pound should weaken to offset this. However, we sense there is something else at play here.
In our view, there is little in the way of alternative to the dollar as a reserve currency i.e. somewhere to park assets in times of instability. The rouble and the renminbi are out of bounds and although gold is a home for investors with extremely negative views, it has no yield i.e. you do not get paid to own it. Bitcoin may be an alternative for some but again, has no yield and is very volatile. Hence, although the UK economy may not have the best outlook in its present post-election status, it is regarded internationally as reasonably stable both politically and economically. It will be interesting to see if the new government is able to take advantage of this, particularly in attracting long-term inward investment.
It is aspects like this that give us some cause for optimism that the UK can exit its current state of inertia. Global competition is always there but as this piece highlights, many other countries face similar or even more challenging circumstances. In our view, a sustained period of economic and political stability coupled with a credible and deliverable set of achievable and attainable goals, would make the UK an attractive place to invest.
JAPAN - DANCING TO A DIFFERENT TUNE
One of the reasons we have liked Japan for some time is that its economy, policy and stock market marches to a vastly different drum beat to the rest of the world. We will not recite a full history of the economic woes of Japan, but essentially following a period of economic boom that led to numerous asset price bubbles, there was a severe stock market reaction.
A series of policy missteps led to the 1990s being known as the lost decade i.e. a period of stagnation and virtually no growth. Since then, a policy of extremely low interest rates and huge government debt has failed to counter an ageing, but wealthy population, combined with an isolationist and protective economic stance. Contrary to the rest of the world Japan is desperate for its population to spend money, its companies to raise wages and crucially to generate some domestic growth and inflation. Most recently there have been tacit signs that the Government is easing its stance and allowing interest rates to rise. We have long been attracted to its stable, if dull, domestic economy, a large number of very high-quality companies, many with global franchises, and persistent low valuations.
We took the view some time ago that much of the systemic mispricing of Japanese equities was down to laziness by financial markets. It has taken a long time for our faith in its stock market to bear fruit and even then, a swathe of returns to sterling investors has been lost to the ravages of a very weak Yen. A large part of the recent uptick has been the result of an attempt by the Japanese Government, via its control of the Tokyo Stock Exchange, to encourage and cajole Japanese companies as a whole, to make better use of their incredibly conservative and risk averse balance sheets. They have done this with the threat of name and shame, which has worked well in a society that places a high value on honour. As such, a slew of companies has returned capital to shareholders via increased dividends and buybacks, sold off assets, reduced crossholdings in other companies and even taken themselves private. We remain convinced that this trend has a lot further to go.
INDIA - FLY ME TO THE MOON
Despite its extraordinarily robust performance in recent years, in our view India will continue to be the jewel in the crown in international markets. It is far from perfect with a complex and potentially unstable political structure, long-standing structural restrictions and a reliance on imported raw materials, but its sheer scale, highly favourable demographic profile and the largely pro-growth policies of the government, means that in our view, it will continue to be the stand out economy for some time to come.
The government has proven adept at managing a huge, diverse and fast-growing population and in particular, has managed to create enough jobs to satisfy a very youthful country and generally increase living standards. India has also demonstrated a skilful approach to international politics, managing to cope with virtually every major economic power, including China and Russia.
Its stock market has been one of the best performing in recent years. This has undoubtedly been aided by the fact that its elevated level of inflation has been less apparent, as most other countries have caught up in the last couple of years. There is a chance that as inflation subsides in the rest of the world, India’s higher level will once again draw attention and the rupee may therefore come under pressure, as it historically has. However, we see no evidence of this.
To continue to perform, Indian companies will need to continue to beat forecasts, given the high valuation of the market exhibits. We remain confident that they can achieve this.
CONCLUSION
We are very conscious of the fact that our perpetual notes of caution on markets and constant refrain of, “it could be different this time” are starting to sound like a broken record.
Markets continue to trundle up and share prices are still tending to recover from any bad news that appears in specific companies. To be clear, we are not anticipating a major correction but just continue to argue that news flow will continue to be mixed, economic data will ebb and flow and that things like growth, inflation and interest rates might not move in straight lines.
The above tour of the world highlights that all countries face heightened risk and uncertainties that markets seem unwilling or unable to price in at present. A perfect current example is the unrest in the Middle East, which concerns us greatly and has the potential to escalate into a major conflict with severe global economic consequences. We have been amazed by how sanguine all asset markets have been regarding this matter, with short-term price moves being completely counter intuitive. There are numerous conflicting signals with gold still in demand, bond yields increasing, the oil price only edging forward and equities maintaining their upward momentum. Short term volatility has increased and although we are not predicting a major market correction, we remain cognisant of the fact that there may be more downside than upside at current levels.