Everything Must Go

Our last newsletter of the year is being written in the aftermath of the annual attendance at my daughter’s carol service at the end of last week.  The theme of the sermon was again the Miracle of Christmas.  And yet again, I resisted the urge to collar the Minister after the service and tell him that if he wanted to see the revisionist version of the Miracle of Christmas, he needed to come to Revera and observe the capacity our Marketing Director has for battering both his liver and the credit card over an entire month.

With December, however, also comes our last “Wise Man” meeting of the year, where we spend a day kicking the metaphorical tyres of the world’s economy and its financial markets with our two consultant economists.  The last meeting of the year always seems to have a more “watershed” feel to it as we sum up the events of the last year, and look forward to what the next might hold.  That 2016 was such an unusual year in so many respects made that process for summing up this year slightly trickier.  However, most of what was discussed has already been covered in earlier newsletters, so needs no further exposition here.

Looking forward, much of our conclusion could have been lifted from any of our year end deliberations over the last six or seven years.  The future is uncertain, and particularly the further one looks out.  The UK looks better placed in the short term relative to other developed economies to maintain decent economic growth, but faces medium term challenges that are as yet indeterminable as to their scale or complexity.  So far, so familiar.  However, there are marked differences from the past.  A policy shift towards greater fiscal expansion, combined with a tighter labour market and weaker Sterling significantly raises the prospects for inflation to lift off.  This is not necessarily perceived as a bad thing, potentially raising the prospect that business investment might finally increase if the likely path of wage rates has an upward trajectory.  Set against this, it is possible that corporate profits suffer because end user prices cannot be raised sufficiently to offset rising labour and other input costs.  So, as we ourselves highlighted during the summer, companies with pricing power must be more attractive than those with none.

Within the global sphere, our views are probably fairly consensual.  The US economy already has enough momentum to allow (if not necessarily warrant) short term interest rates to rise.  We have no idea just how expansionary the Trump administration’s fiscal policy is going to be, but it is unlikely to hinder economic growth in the short term, and will offset some of the contractionary pressure associated with a strong US Dollar.  Some kind of corporation tax amnesty which would allow for the repatriation of the vast corporate cash reserves held in overseas subsidiaries could have a stunning effect on domestic business investment.  The strong US Dollar does put pressure on corporate financial strength in emerging markets, and we remain fearful of the Chinese debt bubble eventually going “pop” – but non-financial business activity statistics (e.g. rail freight volumes) do suggest that there has been some improvement in economic activity in that country.  As ever, Europe’s key challenges are primarily political in nature, particularly as elections loom in France, Germany, Holland and potentially Italy.

Having long held the view that bond prices were unfathomably high, we feel that we are much more likely to be right going forward that interest rate risks are very much more geared to the upside.

The meeting also debated the concept of “tail risk” in the range of outcomes we might possibly face – that is the normal assumption that extreme outcomes to events have a small probability of taking place.  It was suggested that in the current environment, there is no such thing as “tail risk”; every possible outcome is just as likely as any other.  In a year when not only Brexit and Donald Trump rocked political norms, but Leicester City and Connaught Rugby won stunning sporting victories, it is a difficult theory to argue against.

All of which can be brought together to give us some inkling of what might drive companies and markets forward, and deliver potentially some upside surprise.

We have an environment where the short term is possibly as good as it is going to get for some time if you are a business owner or manager.  In a political context, incumbent politicians have had the fright of their lives, and a more expansive fiscal policy is one area of action they can take.  Yet, the cost of long and medium term debt is rising, so the timing imperative is to do something sooner rather than later.  All of this means that next year may well turn out to be much better than current forecasts suggest.  Indeed, there is a very tangible sign emerging that acting now rather than waiting until later is at the forefront of corporates’ minds.

In the last two months, there has been an explosion of corporate activity in both the quoted and unquoted space.  All of the factors listed above are driving this, aided by the fact that Sterling denominated assets are now materially cheaper to overseas buyers.  A wide range of business types have been acquired, but it appears to us that there has been a clear “bargain-hunting” theme to proposed purchases; businesses that have been significantly de-rated due to short term trading issues or because of their perceived exposure to the UK economy.  Financial buyers are shunning UK assets.  Corporate buyers are not.  Unlike the so-called “Sales” which will dominate the High St from now until the end of January (the vast majority of which are not really “Sales” at all; the merchandise is bought in specifically for the event and is being sold at exactly the price the retailer expected it to be sold), the bargains on offer in the stock market are real.  These are businesses that are pretty much identical to the way they looked a year ago, but for sale at lower prices.

If the current rate of corporate activity is maintained, the stock market environment in 2017 is going to be markedly different from that in 2016.  On a number of levels, we would welcome that development.

Finally, as is customary, we wish to thank all our investors for their support over the course of the year.  Particularly after a very difficult first half, where we clearly were not positioned correctly for the extreme events of the summer.  There was a return to form in the second half of 2016, and hopefully this serves as a roadmap for what we can expect into next year.

Merry Christmas, and a Happy New Year from all at Revera.