Going with the flow

Our April newsletter attempted to pull together the general themes of the final results reporting season that took place over the course of February and March.  As a brief synopsis, we described a period that was largely benign for the majority of companies that hit market expectations with their numbers, but fairly painful for those that didn’t.  We also felt that the returns in the first four months evidenced the start of the process of unwinding the “domestic discount” we feel exists in many UK equities.  The apparent ruling out of a No-Deal Brexit by a remain-inclined House of Commons helped steady the nerves of those who are particularly fearful of such an event.  So far, May has been characterised by a collective catching of breath by stock market investors.

For us, however, this period of calm has allowed for space to reflect on the global macro-economic backdrop, guided – as ever – by our two “Wise Men”, Bob Semple and Adrian Cunningham.

Frequently, the central positions taken in these Wise Man meetings can be quite contentious – either because there is a sharp disagreement within the meeting over the likely prognosis for various economic variables, or because the agreed view of the meeting is sharply at odds with the prevailing wisdom of markets.  In the past we have had pointed disagreements internally over the outlook for inflation (and for the record, I was wrong), but equally there was a unified view in the middle part of this decade that the UK economy was fundamentally in much better shape than virtually all external commentators were giving it credit for.

However, in our last meeting, not only was there general agreement amongst the participants, it was largely consistent with the prevailing economic orthodoxy.  There were three big discussion points in the meeting: the Brexit impact on the UK economy; the likely path of interest rates in the United States; and the short and medium term impacts of Chinese economic stimulus.

We now know that the UK economy grew by 0.5% in the first quarter of 2019.  We didn’t have that information at the time of the meeting, but the NIESR was guiding to a similar number, partially fuelled by substantially increased investment in stocks across the economy as participants prepared for the undoubted disruption that would come from an unprepared-for No-Deal Brexit.  The expenditure based breakdown of the GDP data won’t come until the second revision, but it looks fairly clear that stock building had a material impact on the Q1 growth rate.  Therefore, no one should get too carried away with this one quarter’s performance.  The bulls of the UK point to its labour market, with record levels of employment, multi-generational lows in unemployment, and rising real wage growth all pointing to a sustained underpinning of economic activity.  The bears of the UK can point to the fact that despite this extraordinary tightness in the labour market, businesses are steadfastly refusing to invest behind it.  Business investment was down in four consecutive quarters in 2018, which has not happened since the financial crisis.  No only is labour scarce and rising in cost, companies are generally cash rich and debt funding is plentiful and cheap.  This demonstrates an astonishing lack of confidence in the future by UK businesses.  However, it equally shows where the upside would come from should any kind of sensible Brexit resolution be reached.  Business investment is running well below trend and its international peers.  Recovering that gap will bring a material fillip to economic output.

Perhaps the biggest change to economic expectations between our last two Wise Men meetings has been in the expected path of US interest rates.  In the wake of its December meeting, the dam of the FOMC’s denial of what constitutes “new normal” finally yielded to reality of financial market flux.  The brief flirtation with yield curve inversion has heralded a much more sober appraisal of the complexion of short term interest rates.  At its December meeting, only two FOMC members (out of 17) felt that the Fed Funds rate would remain unchanged throughout 2019.  By the March meeting, this was up to 11.  In December, five members believed that there would be three increases in the Fed Funds rate.  In March, the most extreme view was that there would be two such increases, and only two members held that view.  Furthermore, more than half the committee expect no more than one rate rise through to the end of 2020.

This has been fully assimilated by markets, and futures pricing suggests that the most likely outcome will be a cut to US interest rates at the turn of the year.  All of this has been set against a backdrop of easing inflationary pressures.  The impact of the Trump fiscal stimulus is starting to wane, and trade tensions are weighing on business sentiment.  Further, past strength in the US Dollar is keeping import inflation in check.  Even the very tight labour market is not translating into materially higher rates of growth in real wages.  My colleague, Stephen Grant, hates the expression “Goldilocks economy” (it is neither too hot, nor too cold) but he will have to grin and bear it here, because it is perfectly apposite to describe the United States at this time.

We have made no secret over the last couple of years that we view Chinese financial stability as the most significant threat to the continuation of the current global economic cycle.  Stimulative measures taken in the second half of 2018 have averted (for now) the kind of economic slowdown that could have presented real strain to a highly leveraged economy.  Indeed, these internal actions will probably be enough to ensure that current trade tensions do not excessively impact economic growth.  However, in achieving this, the Chinese government has had to sacrifice its policy of progressively reducing gearing across the economy.  The threats to the current business cycle have been reduced in the short term, but at the cost of increasing the damage done when it does finally come to an end.

Does any of the output or conclusions from our last Wise Man meeting change our approach in the short term?  For the major part, no.  The UK market remains relatively unloved and under-owned.  There is still a significant discount applied to the valuation of domestic equities, and as long as the business case and financial dynamics of our investee companies stack up, we won’t be afraid to go after it.  However, there are reasons to be slightly more circumspect over timing.  At the time of writing, we are sitting on a 16% return in asset values so far this year.  That has not been driven by an equivalent increase in earnings expectations.  It has been driven by an unwinding of a valuation anomaly.  To make money from here, earnings and dividend growth will need to play a part.  At the aggregate level in the market, earnings revisions are heavily in negative territory.  We do not believe that this will persist for the remainder of the year, and we also believe that our portfolio is well positioned to deliver attractive growth in both earnings and dividends this year and next.  It won’t do any harm, however, to be careful over timing.

Glen Nimmo

20th May 2019