More Questions than Answers

Earlier this week, we had the last of 2015’s “Wise Men” meetings – a slightly grandiose term for what others would normally call an investment strategy meeting.  That we don’t use that term is down to two key reasons.  The “Wise Men” element refers to the fact that we retain the knowledge and experience of two external advisers to these meetings, giving us an external – and importantly, unbiased – perspective on the prevailing investment environment.  The second, is that the objective of these meetings is not so much to find “answers” to today’s investment questions; rather the emphasis is to make sure that the prevailing investment questions are indeed the correct ones to be asking, and that there are not more pressing questions that no-one has yet thought of.

We have written at length over the last three months on our perceived shift in the risk environment for UK equity investment, and our consequent moves to take a much more conservative position with client portfolios.  For those who like to cut out the suspense, the conclusion to our meeting did nothing to change that perspective.  Indeed, in many ways it simply reinforced what we felt over most of the late summer.  However, there were one or two nuances that maybe pointed to a more robust outlook further down the line.

We can summarise our prevailing view as thus:

Our beef at the moment is with capital markets; not with economies or (by extension) companies.  Continued QE, and the delay in normalising monetary policy, has created an environment where equities are only good value relative to other assets, and not good value relative to the stream of future cash flows coming out of them.  When the bubble of excess liquidity is burst, equities may not be in the front line of casualties, but they will be vulnerable to collateral damage.

Whilst we see the current challenges as primarily relating to valuation, our meeting raised further concerns over the extent to which a more fundamental shock may emanate out of Asian emerging markets.  The last four years have seen a massive shift in both the quantum of bond issuance in Asia, and the extent to which these bonds are being issued in foreign currencies – particularly the US Dollar.  With their domestic currencies depreciating against the USD, the real debt burden of borrowers is increasing.  An analysis by the Bank of International Settlements suggests that credit growth in relation to GDP growth is now most out of kilter in China, out of a group of the major emerging economies.

On a prima facie basis, there is no need for interest rates to rise almost anywhere in the world.  Inflation looks dead and buried.  Yet one must recognise that policy makers are placing increasing weight on labour market data in determining the next move on rates.  Real wage growth in the UK is already strong.  It has not fed through to inflation because of falls in commodity prices and the relative strength of Sterling.  One cannot assume these offsetting trends will persist.  On top of that, the UK is consuming much more labour than it can produce.  Of the 350,000 jobs created in the UK in the last 12 months, less than 100,000 of these went to UK nationals.  Over 250,000 were taken by people from the rest of the EU.  If European growth picks up to the extent that workers are more inclined to stay in their home countries than come to the UK, then pressure on UK wages could be severe indeed.

We still believe that US and UK rates will rise sooner, rather than later, and that the consequences of such a move are highly uncertain.

However, if anything, there was a more positive bent to the presentation of data on the real economy – particularly in the UK and US.  In both of these economies, the stock cycle has acted as a drag on headline economic growth.  With a neutral stock position economic growth would have been much stronger.  If stock levels in the economy build from here, that will be a fillip to growth.  After a couple of softer reports, the jobs market looks to have built up momentum again.  With inflation low, the outlook for consumer expenditure is robust.  The FOMC in the US highlighted that very point in its last meeting.  In the UK, the long term need for more housing, and a broad political consensus to increase supply, will keep construction activity robust alongside large infrastructure projects like Crossrail, HS2 and the current roads programme.  Indeed, in its latest World Economic Outlook, the IMF nudged up growth expectations for both the US and UK this year.  These remain attractive markets to be exposed to.

In the UK (and to a lesser extent in the US), the missing link between a decent economic outlook and a decent equity outlook is a decent corporate earnings outlook.  Unfortunately, earnings revisions have been persistently negative for three years, and it is difficult to see the catalyst that is going to change that for the better in the short term.  In many areas of the stock market, companies are already making record profits are record margins.  That does not mean that they cannot rise further, but it is likely to require above trend economic growth to drive it, rather than growth that is closer to the long term average.  Ironically, there are a few of areas of the market that are not anywhere close to peak margins and profits, and they may well be the areas that we need to focus on to make attractive medium term returns.  The Oil, Mining, and Banking sectors all have the potential to recover as their separate cycles roll through.  At the moment, we don’t think that we are far enough through this process to act now.

Yes, we are sitting on cash in our portfolios.  But we are not sitting on our hands.  There is much work to be done to ensure that if we act, it is with all the relevant information we need.  These are not sectors that we have been particularly active in over recent times.  Elsewhere, we will also look to re-invest in familiar names when prices come back to what we deem attractive levels.

Our Wise Man meeting raised plenty of relevant questions.  Time and investigation will hopefully provide the answers.