Risky Business

The summer is often regarded as the political “silly season” where campaigning bluster and over egged promises are more important than what can actually be delivered politically or economically.  One can argue that the political establishments in most of the major economies are currently in perpetual silly season; but if anything this has ratcheted up a notch over the last week.  As such, the announcement of the prorogation of parliament in the UK was an appropriate backdrop to the latest of our “Wise Men” meetings on Wednesday, where we – with the help of Bob Semple and Adrian Cunningham – try to read the world’s economic tea leaves, conditioning our thinking on the issues that should be front and centre of our thoughts when building our portfolios.

Ordinarily, one would have expected Brexit to dominate the discussion.  And whilst it did feature heavily over the course of the day, it was not the issue that left us with most to ponder as we wound up proceedings.  On a day to day basis, conversations that we have internally between ourselves, and externally with clients, emphasise the need for a Brexit resolution, the damage that could be done without a resolution, and the upside that exists should a sensible resolution come to pass.  However, we all know that the UK equity market is not the same as the UK economy, and large swathes of UK equity investments are much more dependent on what happens in the rest of the global economy than the performance of this scepter’d isle.

The economic landscape across the globe is uncertain, and is potentially facing challenges that we have no known road map to navigate with.  Growth is anaemic in most of the developed world.  The combination of a mature economic cycle and increased geopolitical risks have dented business confidence in many regions.  Most readers will be aware that the United States government bond yield curve has inverted a number of times over recent months (i.e. longer term yields are lower than short term yields), and that historically this has been a harbinger of a near term recession in that economy.  Another sign of future weakness comes from the IFO World Economic Climate Survey, where the “expectations” series has run lower than the “present situation” series for the last year.  Within this century, this happened in 2006/7 and in 2000.  We know what happened in the years following those two readings.

Across the US economy, there are a number of areas where concerns over future growth are rising.  Residential construction activity is now falling in response to sustained softness in the secondary market.  Capital goods orders and backlogs are also falling.  Secondary data like freight shipments look weak.  By contrast, the labour market still looks very healthy.

All of this is reflected in collapsing bond yields.  The same cannot be said for equity markets.  Index levels and valuation multiples have retrenched only modestly.  Moreover, little attention is being paid to the systemic risk posed by the build up of highly leveraged (junk) corporate debt throughout the banking system.  This is particularly acute in the US.  Across the globe, banks are much better capitalised than they were at the peak of the last cycle.  However, the Bank of England estimates that there are $3.2trn of leveraged loans in the system, over half of which sits on banks’ balance sheets.  These loans have not faced serious economic stress for quite some time.  With lending covenants typically very slack in this market, the value of these assets could quickly come under pressure, testing capital ratios across the sector.

Faced with this backdrop, one would normally expect Central Bankers to loosen credit conditions and make borrowing cheaper.  Yet most central banks used up all their traditional policy ammunition in the last cycle, and haven’t been in a position to replenish their armouries. To have any success, policy makers are likely to have to resort to ever more unconventional measures.  Our meeting discussed the possible use of “helicopter money” several times during the debate.  The impact of such policies on the valuation of bonds, equities and real assets is highly uncertain.

It is possible that fiscal stimulus could fill any gap in demand.  There are certain countries (most noticeably Germany and the UK), that have the capacity and the need to invest heavily in infrastructure to promote activity.  However, in the United States, President Trump’s injudicious tax cuts in 2017 has left the federal deficit at levels more in keeping with the bottom of an economic cycle, rather than the top.  Significant fiscal expansion will place extreme pressure on the sustainability of a government debt burden that is now well over 100% of GDP.

In many ways, the Chinese economy is facing similar challenges.  Its corporate sector is over indebted, the household sector is heavily exposed to the residential property market, and its manufacturing sector is struggling to maintain its past momentum.  It defies economic logic, therefore, that either the US or China should wish to embroil themselves in a damaging trade war.  Yet, economic logic has little to do with it.  This is a game of political imperative in the US and maintaining “face” in China.  No matter the end result from this trade spat, confidence in the global economic platform will be damaged.  Global trade will be more muted than it was.  Foreign direct investment will be more circumspect.  Economic growth will suffer.

There is a lot to worry about.  It is entirely possible (or even probable) that the current slowdown is no more than a mini-cycle within the larger economic cycle; akin to the conditions seen in 2015 and 2016.  However, the risk that it tips into something much nastier has increased.

By contrast, most of the risks associated with the UK economy are in the shop window.  The immediate consequences of a chaotic departure from the EU are unlikely to be pleasant.  It is the number one risk to growth.  However, it is also true that any sensible resolution to the crisis offers real upside.  The last three years of political uncertainty have ensured that the UK economic cycle has not reached the maturity seen elsewhere.  There is a huge investment gap in both public sector and private sector capital formation.  UK companies have not geared up to the levels of their US counterparts and have the wherewithal to invest.  The UK government has capacity to ease fiscal policy to stimulate more activity.  Perhaps more importantly, the price of UK assets sits at a significant discount to their equivalents overseas.

Last week’s meeting crystalized some of our developing thoughts.  You should expect to see changes to the portfolio over coming weeks and months.  This will not be a wholesale about-turn in investment direction, but a further diversification of themes in the portfolio, and a tilt away from some of the areas most exposed to a downturn in global activity.  We will deploy the proceeds in areas where growth is secular, rather than cyclical, in nature.  We will retain a little cash to exploit the bad days and the panic that follows poor trading updates.

This is active management.  No-one has a crystal ball, so active management works best when it looks at risks dispassionately, and decides which risks are worth taking, and which aren’t.  It is at times like this that it becomes clear that “passive” investing is anything but.  Investing in passives in the UK is actually a determined decision to place a large chunk of your assets in oil stocks, irrespective of the oil price.  It is deliberately emphasising momentum over value, irrespective of the valuation risks.  It is buying large over small, irrespective of the micro-economic opportunities.  When economies are gliding along fine, that is normally OK.  A rising tide lifts all boats.  It is not necessarily an all-weather strategy.

In economic terms, we’ve had a decent time of it for nearly a decade.  Things are not about to turn into a maelstrom overnight.  However, we recognise the maturity of this cycle, and the risks that have built up.  There are still many attractive investments in the UK equity market, and in aggregate it is not in any way expensive.  It is just likely that many will suffer short term stumbles as the global cycle plays out.