Yesterday Once More

Since our last missive, we have enjoyed the company of our two “Wise Men” for a day of debate and deliberation over the prognosis for the UK and global economies, and the subsequent implications for financial assets.  To jump straight to the conclusion, we were left with the sense that much of what has prevailed over the last five years is likely to stay with us for some time yet.  Whether one should be reassured or disappointed by such an outlook is very much a matter for ongoing debate.

With regards to the UK economy, there was a general consensus over the short term drivers likely to prevail.  Employment remains robust, and job vacancies are at their highest recorded level, yet this still has not resulted in meaningful increases in nominal wage growth, and inflation is gradually eroding the real-terms impact of the little wage growth that there is.  This backdrop is unlikely to be supportive in keeping last year’s strong consumer data going.  The derived household savings ratio in the UK has already fallen to its lowest level since records began, and there are signs that consumer access to debt funding is starting to tighten.  Relative to income, unsecured household debt levels are back at their pre crisis peak.  Yes, interest rates are much lower now than they were then, so servicing the debt is less onerous, but in a rare episode of acting before the horse bolts the stable, the PRA/FCA are taking action now to reduce levels of permanent unsecured debt on consumers’ balance sheets.  The particular focus is on consumers who do not, or cannot, repay the capital balances on credit card debt.  It is possible that up to 40% of outstanding credit card debt is maintained by only making minimum payments every month.  The PRA/FCA has instructed banks and other lenders to manage customers out of that position.

All of this suggests that the aggregate capacity for the household sector to take on more debt or reduce savings is limited, and the boon that has been provided by £24bn of PPI refunds over the last five years is coming to an end.  So, any growth in consumption from here must be paid for by wage increases.  And this, perhaps, presents us with our greatest conundrum.  A spike in inflation and a tight labour market should have been just the triggers for wage growth to push on – but so far it has not.  The breakdown of collective bargaining, and the perception that individuals still care more about holding on to a job than holding out for a pay rise, appear to still be the defining characteristics of explaining this conundrum.

On the flip side, Mayism as a political credo is showing itself to be much more interventionist that its Tory predecessors, and with the commitment to balance the government’s books pushed further back again in the Conservative manifesto, the capacity for the state to be more simulative to economic growth has improved.

In summary, the UK is OK – but not brilliant.

Elsewhere, the Great Orange Hope in the United States is starting to unravel.  If we thought the US political system was dysfunctional in the past, then it is even more so now.  All of that should not matter, so long as consumers and businesses continue to spend and invest.  However, there is evidence that that is also starting to unwind.  The robust labour market should have kicked off strong consumption, but the consumer recovery in this cycle remains weaker than in any of the four previous cycles.  Apparent increases in business capacity and reductions in aggregate profitability also suggest that the recent soft patch in hiring is not simply a timing blip.  Adding to this, there is some evidence that bank lending to companies and households is starting to roll over.

In the interests of balance, though, it is only fair to report that this more downbeat tone is in stark contrast to the bullish commentary coming out of companies on the ground in the US – particularly in the capital goods space, but not exclusively so.  If we were to “nowcast” US economic activity based on company feedback, it would be at odds with the IMF’s recent trimming of its 2017 GDP projection.

In summary, the US is OK – but not brilliant.

Elsewhere, we have a similar picture of point and counterpoint.  In aggregate, the world economy is expected to grow at a faster rate this year than it did last year, helped by better momentum in the EuroZone and Canada. Outside of China and the G7, the rest of the world is expected to deliver a useful jump in economic output, helping offset the gradual slide of Chinese growth towards developed economy levels.  However, recent adjustments to growth expectations have almost uniformly been in a downward direction, and certain imbalances continue to worry us; most acutely the level and nature of debt accumulation in the Chinese financial system.

In summary, the rest of the world is OK – but not brilliant.

Which all kind of leaves us pretty much as we were.  The last five years can be summed up by that same phrase – OK, but not brilliant.  Perhaps the more pertinent question for us, given that equity values are higher now than they were five years ago is “is OK good enough?”.  The answer to this question will come down to valuation.  The age old question of how much one should pay for a given level of earnings and dividend growth.  In this, we may end up sounding like a broken record, but we believe that the greater risk in equity investment today is associated with valuations, rather than the ability of companies to deliver on the execution of their business plans.

The most expensive equities in today’s market, we contend, are not highly rated because of a buoyant outlook for the delivery of future cash flows, but because there is a paucity of alternative assets offering any kind of positive real income yield.  We may have called the end of that trade too early in the past, but every time the US Federal Reserve puts its repo rate up, the closer it comes.  No-one will be able to say they did not see it coming.

Our portfolio sits on a calendar year price/earnings ratio of 13.4 times 2017’s earnings, and generates a near 4% yield dividend.  On these metrics, we are confident that OK will continue to be good enough.