Asking the right questions

Curiosity and open-mindedness are traits shared by exceptional investors, who are keenly aware of their biases and ask numerous questions. Looking into 2024, a critical issue is identifying emergent themes that could overshadow the macro narrative, similar to the excitement generated around generative AI. What are the prevailing macro narratives in the absence of such themes? Before delving into thematic ideas, let’s address the paramount macro question: the trajectory of interest rates. As Buffett analogizes, rates are to valuations what gravity is to the apple. Accurate predictions on rates crucially influence investment decisions, and yet there’s no consensus.

Divergent policy rate expectations

Market predictions, influenced by the Taylor Rule, election year assumptions, and hedging against potential recession or conflict, anticipate significant rate cuts (7-8), in contrast to the Fed’s own expectation of about three. Comparisons are drawn to 1995 where ‘insurance cuts’ from the Fed provided the “magic sauce” for a ‘soft landing and subsequent SPX rally. However, differences in today’s economic conditions from those of 1995 raise questions. Arguably, current employment and CAPU rates more reflect the situation in 1968 where Fed cuts simply added accelerant to the inflation embers that had not been extinguished. But perhaps that’s a story for later in the year. A time when you might have wished you had bought insurance when it was cheap and/or supply-constrained real assets like gold, like silver, Bitcoin, UK and Japanese stocks (think declining share counts), mining, construction and even steel stocks.

And what of the long end?

Regarding the long-end market expectations for the 10Y yield, there’s notable disagreement among forecasters, with predictions ranging widely. Some suggest +5%, others below 3% with a standard deviation sum 2-3x higher than previous years. This year, inflation volatility rather than inflation itself may shape the macro narrative, demanding flexibility and a return to disciplined selling, especially in fixed income. Investors should seek higher yields in bonds, lower valuations in equities, and genuinely diversified assets. Not those which create the illusion of diversification. They’re about to be found out. More on this in time.

Competing narratives and long-term outlook

Looking beyond a year, structural disinflation and inflation both present compelling cases:

Deflation Scenario: AI innovations could relieve labour market pressures, while GLP-1 drugs could boost productivity, revive sex drives, fertility and improve the ‘dependency ratio’. Those workless travel agents, sommeliers, surgeons and script writers will re-train as builders, miners, spot-welders and farmers and fill the looming gaps left from succession and retirement. Automation lessens the impacts of reshoring to higher cost areas, so too could highly skilled migrants. China’s decade long balance sheet recession will export deflation and as geopolitical tensions thaw with the US, and Ukraine and hopefully the Middle East, supply chain pressure will ease, tankers will pass through the Red Sea once again, Europe will get its oil and Tesla its components. The energy transition will lower demand, and so price for oil. Such could mitigate the effects of de-globalization, demographics, and decarbonization, positioning innovators like Cathie Woods as vanguards of a new economic era.

Inflation Scenario: defense and manufacturing spending (both at record lows vs GDP) may increase, and global energy investment could ignite a commodities super-cycle. Labour regains pricing power and AI’s limitations in specific sectors becomes evident, especially in areas like mining, construction where structural shortages persists. Muscular industrial policy keeps unemployment low and exacerbates demographic pressures on the dependency ratio and inflation. Nationalist policy prevents immigration to ease the strain. Housing shortages become more acute as household formation increases (see above: increased fertility) and shelter costs rise. To improve affordability, QE restarts and financial repression provides cover for MMT Theorists to claim victory. The Deficit Myth wins the Pulitzer prize and its author, Stephanie Kelton is named Time’s Women of the Year. A commodity super-cycle emerges. Gold prices triple.

The answer? Yes.

I expect we get a mix of both scenarios, emphasizing the importance of managing interest rate volatility. A muscle very few have exercised.

Exceptional to average

With high US stock valuations and with uncertainty around the discount rate, more focus may be given to EPS growth as the key driver of equity returns this year. Interestingly, the Fed economist Michael Smolyansky, has written a paper which argues over 40 percent of the real growth in US corporate profits from 1989 to 2019 came from lower rates and lower corporate taxes. In addition, the decline in risk-free rates accounts for all of the expansion in price-to-earnings multiples. In other words, the exceptional performance of US markets these past 30 years could have been caused by drivers that are now ending. Possibly even reversing. This, I would argue, finds parallels to the period just prior to the 1970’s. High market multiples driven by the Nifty50 mania come into contact with interest rate volatility. Multiple compression occurs for most of the decade and markets range sideways for 14 years, destroying real returns. That said, many stocks did well during that period, so it’s not the end of the road. Unless you own the index.

PS: Don’t shoot the messenger. I still expect exceptional returns in some US stocks, I just don’t expect a repeat of the ‘23’s “year of efficiency”. For a gilded few, that great taste of revenue growth occurred despite lower calories (cost cutting) leading to an explosion in operating leverage. Also, it’s now ‘show me’ time for AI, and outside those same few who concentrate the scarcities of the AI value chain (data, network and computing) I’m struggling to see any other winners.

Regional alpha

Prior to Christmas I spent time with our Aussie and Kiwi clients. Both countries are far enough away from Wall Street to help investors develop perspectives and immunities to the potential groupthink that can pervade other regions. On this trip I was struck how few seemed to push back on my contention better long-term opportunities, as represented by lower starting valuations, change catalysts and secular thematics were in regions outside the US. And that given World Indices failed to capture such (buying the ACWI World Index for example is really just buying the US) they seemed happy taking active share at the regional level. In other words, moving away from the index in a regional sense represents a rich source of potential alpha. For many, the S&P has been crowded-out by indexing and  the only active decision is how much of the Mag7 to be under/overweight. And whereas the SPX could be rangebound for a time (see above), many other markets in Europe, Japan and UK look primed for the opposite. Many agreed with the idea a commodities super-cycle is remerging, but MySuper regulations and a home-bias which naturally leads to large commodity exposure, limits their ability to increasing exposure. However, the idea of buying regional stock markets with commodity links (UK, Brazil etc) appealed as it had less impact on their exposure limits. More on these (and Japan) in a minute. But needless to say, I expect to see a move away from broad regional indexation to more country-specific allocations over time.

Custom indices: regions and thematics

The ACWI world index reflects a past that may not be relevant in future. It was formed when the world was flat. It’s now fragmenting. It represents the ideal of a homogenous, convergent and US centric world, at odds with the growing trends towards multi-polarity, divergent national and economic interests. Hence the focus on individual country exposures. Another apparent countertrend is the growing relevance of thematic investing, which cuts horizontally and doesn’t sit conveniently in any one region, sector or bucket. This intuitively makes sense, for there are only two things that drive returns: numbers and narratives. Often the narratives dominate for long periods, and so being aware of the emergent stories and positioning accordingly, seems a reasonable way to allocate capital. One wonders what would have happened to US markets last year if GPT’s hadn’t emerged when they did. (This year if could be GLPs). What this means for asset managers is you can expect to see growth in custom indices, active ETFs and thematic funds. And those managers with the wherewithal and capability, will sell solutions as much as their own products. Reframing themselves in this way, could lead to new sources of revenues, while improving efficiency for those who can turn a cost (expertise and technology), into a profit line.

Japan – generational change

Having written extensively on Japan last year there’s little to say that’s new. I continue to see positives on Japanese stocks. There is generational change. Japan is transitioning from stakeholder to shareholder capitalism. It’s attempting to re-equitize and rebalance their ~$13T or so of domestic wealth, mostly in cash  into more equity (currently less than 20%). To encourage stock ownership, the government is revamping the tax-free savings scheme, NISA, doubling the amount of shares you can hold tax free and extending the benefits for the life. It’s creating special economic zones and encouraging international companies to set-up business, bringing their expertise. And money. The TSE will start publishing names of those companies submitted plans to get BVs closer to 1x. Pressure on those unnamed will build  to follow-suit. It’s noteworthy that 45% of the TPX still trades below 1x BV, with a fifth below 0.66x meaning prices must double to get to 1x. Corporate pension funds are now required to publicly disclose investment returns, which may pressure those underweight equities to increase exposure. While PE multiples are not rock bottom, they are still below historic averages and may not yet reflect upside potential from more efficient capital structures. Surplus cash on hand or cash-proceeds from minority buy-outs could be recycled as buy-backs. This process may accelerate due to new public disclosure requirements and new tax rules on minority buy-outs. The first will increase the burden of public ownership, the latter improves the incentive to take private (with 100% deduction of acquisition cost). Finally, it’s worth noting the Nikkei trades about 10% BELOW where it was on Christmas eve in 1989, thirty three years ago. Interestingly, it took the Dow about the same time to reach new highs after its 1929 peak. It then went on to compound at 10% for the next 11 years. Stay long Japan.

UK – confluence of mega-trends

Perhaps shamefully, my enthusiasm for the UK remains this year. Pension reforms will help, and I was encouraged to see the Pensions and Lifetime Savings Association (PLSA) announce that its top strategic priority for 2024 will be the role that pension schemes can play in supporting the UK market. I was also pleased to hear Chancellor Jeremy Hunt has kept open the idea of British Individual Savings Account (or BRISA), something I’ve pushed for in previous missives. The forced selling of equities from DB funds must presumably be over -  they have nothing left to sell - and the majority of corporate pensions  are now in surplus, freeing up cash for other purposes like capex. And buybacks. I mention ‘mega-trends’ above, one of which is compounding. Now, buybacks can act as a type of reverse compounding, where lower share counts will increase cash and dividends per share over time, unless of course share-prices rise – which they should. Artemis’ Nick Shenton has written a great article that explains this phenomenon perfectly. Simply, if you don’t buy these stocks they will ‘buy themselves’ while those patient investors who do own them get richer, doing nothing. He cites BP having bought 16% of its share count in 18 months, NatWest’s removed 22% in less than 2 years and Berkeley Group – 30% since Brexit. So, either prices go nowhere and you increase your share of their growing dividend stream, or you maintain a constant distribution and share prices soar. That’s the first mega-trend. The second is mean reversion, as framed by the Ethereal to Material construct we proposed last year. One driven by the Observer Effect where the growing realisation that to sustain the ethereal world of bytes, we will need more atoms and to transition to a greener world, we need a lot more materials to do so. And who lays claims to a lot of these materials? British companies. Argh yes, the benefits of Empire.

The productivity miracle from GPT GLPs

One of the greatest medical inventions of the 20th century was undoubtedly penicillin. Yes, it left scars on the landscape with unused Sanatoriums but it saved millions of lives and no doubt led to a multitude of social and economic benefits. Its equivalent today could be GLP-1 weight loss drugs, first invented by Lotte Bjerre Knudsen at Novo Nordisk in Denmark. As our own Carl Taunenbaum notes in Weighty Matters, the world suffers from an obesity epidemic and associated issues of heart disease, strokes, diabetes and some cancers. The Milken Institute estimates the costs of obesity alone in the United States is around $1.7T, or close to 7% of GDP. That’s just Obesity. Early trials suggest it might have application in the fight against Alzheimer’s, heart failure and inflammatory related illness like chronic arthritis, Lupus etc. Beyond health care it could improve airplane fuel efficiency, worker productivity and potentially fertility, thus solving one of the largest dilemmas of our time: a lack of babies. Improved health and longevity should enhance labour force participation and productivity. Vanity, another enormous industry, one turbo-charged by social media and the demands of being ‘camera ready’ is another opportunity. See Oprah for clues.

Of course, such a wonder-drug will not go unnoticed. It's likely to set-off a gold rush of copy-cat products that go beyond what Novo and now Eli Lilly can produce. Expect to hear more about Thermogenesis - increasing the body’s metabolic rate so that it burns more fat at rest (and why Novo’s partnered with biotech, Omega). Body boffins are testing a “vibrating diet pill” which works by stimulating nerve endings in the stomach to tell the brain that it's full. “SiPore” an orally-ingested gel, is currently under testing to slow uptake of carbohydrates and fat. But what of the negative, or unintended consequences? As discussed last year, lower appetites mean lower calories. Less frozen pizza from Walmart. Lower orders sizes at New York restaurants and more waste from un-eaten meals. It’s spooked Nestle into making companion products. The wellness industry will face pressure, from dieting plans to gym memberships. Insurance companies will face longer annuity pay-outs (although life insurers might gain more premium). And, fascinatingly, if it works on the parts of the brain that controls our reward networks, it might have a role to play in addiction. Indeed Scientists are finding those taking weight-loss pills are drinking less alcohol. Might this extend to such things as gaming, gambling, smoking or even  social media. Might GLP-1’s greatest impact be on the share price of those things buoyed by GPTs?  

Who knows, but herein lies another thematic we will all need to understand. For it cuts through more than just fat.

Next week

Next week we will focus on Taiwan’s Word of the Year: “lack”, and what that means for upcoming elections. We will talk through the bitcoin halving and the timing thereof (around the same time as Fed cuts) and why an even better alternative to bitcoin might soon be developed, one that’s already loved by boomers and central banks alike. Digital GOLD.