The Weekender

JUNE 3, 2023

Trade of the decade

This podcast with contrarian investor Rob Arnott (start 11mins in, lasts ~30 mins) is worth listening to. It touches on many of the topics we’ve been discussing – not least why he thinks the 2020s may be the “the decade for diversifiers” and for those prepared to move out of mainstream stocks and bonds and into assets that haven’t been talked about, like the UK: “the trade of the decade”. This, of course, requires the temperament to live in the ‘out of consensus square’ (Tangen) and “to shed the desire to have similar results to your neighbour”. If you want different results, you must do different things.

We’ve cited already the study Arnott did on inflation (here), why returning to 2% after breaching 8% seldomly occurs quickly (at least 10 years), and why he believes inflation volatility is the most likely outcome going forward. This is bad news bonds. It not great news for stocks, unless those stocks are potentially undervalued (UK, Japan, Brazil etc) and commodities also do well (like copper!). He also touches on demographics, particular the issues surrounding aging populations in Japan and China, a topic we discuss more next week. The only point I would differ on is that he believes rate hikes impact demand only. As the experiences of the 1970s demonstrate, and as this paper illustrates, a credit contraction also impacts supply by restricting capital formation – meaning we are storing up greater inflation for when demand inevitably returns. So, now’s the time to be building positions in diversifiers, as this show is far from over.

All models are wrong but some are useful - George Box

“We have a lot to learn about inflation” said the leader of a G7 Central Bank when questioned by his government’s select committee last week [1]. But I doubt they will find the lessons if only using 30 years of data (which they are). Excluding the ‘70s means their model’s assumptions are based on a period of benign inflation and rate volatility. That gives a biased view of the present, and impacts extrapolation. The same idea pervades our pension system, which evolved over a similar 30-year period. With benign inflation, bonds worked well from a matching perspective.

But now, inflation and real liabilities have increased, so too should investment in supply-constrained real or growth assets, lest those with some ability to protect against inflation. So, I applauded the news this week the Pension Protection Fund (PPF) was increasing its allocation to forestry and infrastructure[2]. What was interesting however, was that the funding asset wasn’t bonds. But equities. Now, in fairness the PPF have regulatory constraints to consider. And perhaps the data doesn’t exist to go back further than 30 years? I’ve even looked myself and the best I came up with was an obscure book entitled: "That's the Way the Money Goes: Financial Institutions and the Nation's Savings. Obscure and out of print, but full of lessons for investors, for regulators and for governments, especially in what not to do (think price controls).

Catalyst for change

Staying on the UK: what will cause investors to change their behaviour? What could unlock a risk culture, increase liquidity for growth assets and drive markets higher? There are lots of suggestions being proposed: less red tape, simpler rules, reforms to the matching adjustment (Solvency II), tax breaks for home bias, the creation of a £50bn Future Fund and reshaping the PPF to include funds that haven’t failed, forced consolidation of the private pension market.  Or more radically, as The Tony Blair Institute (TBI) suggests, creating ‘GB Super Funds’ with assets of up to £500bn, a la Canada or Australia[3]. The London Stock Exchange has been vocal about corporate pay and listing rules, and MIFID II reforms seem likely, notably ‘re-bundling’ as per the recommendations of UK Finance could increase research coverage/sponsorship for small-cap listings and help revive the IPO market. All helpful, but to really change behaviour, we must change the culture. And change is a contact sport. You need the people and pieces in place, but you then need leaders who embody the vision – great communicators who galvanise support and often, a champion.

Reviving the cult of equity

A lot has been written recently about the need to improve equity culture in order to wean investors off an over-reliance on fixed income (at the wrong phase of the credit cycle). The FT suggested selling the government’s stake in Natwest (formerly RBS) to the public to mimic the successful policy of privatisations during the ‘80s where retail participation tripled[4]. Alasdair Haynes, the chief of rival exchange operator Acquis, wrote of the need to make equities sexy again, through better financial literacy and education (which I agree with, especially a better understanding of how inflation can destroy fixed returns, if those returns are sub-inflation). But what we really need is someone with the grit and temperament to blaze the trail. Someone like George Ross Goodbey. Heard of him? Me neither, but in Plender’s book (mentioned above) he was credited for creating the cult of the equity in the UK. So, forgive me for being a little British again this week. But his story needs telling. There is a lesson here for us all. Including our elected representatives.  

Change needs a champion

When George Goodbey started work at the Imperial Tobacco pension fund in 1947, the prevailing asset class of choice was fixed income. He felt the yield on government debt failed to compensate, in real terms, for inflation. And being fixed, it would destroy value over time (for what good is getting your money back if it’s lost its purchasing power?). Rather, equities – which were higher-yielding and with growth potential – offered a much better chance of delivering above-inflation returns. After some persuasion (involving a second-hand Bentley, a rushed golf-club membership and hilarious propaganda campaign) the trustees allowed him to do what no other fund had done: sell all their gilts and replace them with equities[5]. This change in thinking became so popular, it led to the Trustee Investment Act of 1961, allowing general trust funds to invest up to half their money in equities. By 1963, every professional money manager was climbing aboard the bandwagon. The market and economy soared. By the early ‘70s professional managers owned nearly half of all listed share capital in the UK.

French flair

When faced with similar issues in 2012 (namely an over reliance of debt/debt-finance) and to promote an equity/risk taking culture, BPI France was set-up, staffed by successful businessmen and entrepreneurs and given the mandate to become a French Investment Bank for French assets, a one stop shop for entrepreneurs. Through direct investment and loans, education, subsidised consultancy, coaching and mentorship they’ve nurtured a thriving entrepreneurial risk culture in France. They get first dibs on great ideas and so can provide critical assess to an ecosystem of venture capital investors and other limited partners looking to co-invest (think fee revenue) and of course, they generate significant profits, more than €1bn in both 2020 and 2021. Could we not take the idea proposed by the Lord Mayor of a UK Future Growth Fund[6], perhaps combined with Innovate UK, inject it with public capital in the form of equity (avoiding fiduciary conflicts), ensure sufficient working capital to attract real talent (with a track record) and then go find the best Britain has to offer? Build a funding vehicle in other words, that takes direct stakes in UK growth businesses, generates investment and commission revenues, one that uses tax incentives (broadening the scope of the Enterprise investment or Individual Savings Account schemes), and helps to democratise access of an asset class perceived mostly for ‘the rich’? Perhaps that’s already the idea? If it’s not, a little French Flair may not go amiss.

It's possible that this time is different – J Powell

Turning to other matters. If searching for bearish commentary, there’s plenty to pick from, examples include the Chinese Balance Sheet recession a la Japan in the ’90s (which is why I suspect direct support to the property sector is likely forthcoming), collapsing credit supply, an imminent corporate default wave, a looming CRE crisis, US-China tension (which at the margin is not getting worse), demographics (old before rich), US concentration risks (I’m not sure that’s even an issue) and seasonals (‘sell in may’). Sweden just posted its third worst PMI print ever, US homebuying activity has collapsed the most on record and UK house prices have fallen at the fastest rate since the Great Financial Crisis. And yet, employment figures – a key driver – remain resilient? As Powell said “it’s interesting we’ve raised rates by 5% and the unemployment rate is even lower than where it was when we started[7].” So, what gives? As we’ve discussed, one reason we are not seeing job losses in construction, as you might normally expect, is job-hoarding due to the enormous capex going into manufacturing. This is, of course, driven by the current obsession with national security and reshoring policies.  

In evidence, look at non-residential construction figures released this week[8]. Spending soared 31.2% y/y driven by manufacturing buildings, which rose 8.7% m/m and has more than doubled y/y! Yes, some of this price related, but mostly it’s subsidies for electric vehicles (EVs) and other new energy technologies provided by the Inflation Reduction Act (see Toyota has just committed $2bn+ to an EV plant in North Carolina and will expand production in Kentucky). There is a capex boom underway in the US which should accelerate energy transition by lowering the cost of capital. That’s the good news. It is, however, bad news for oil investment, where the prospect of stranded assets remains an ever-growing risk.  

Peak hype?

“Mitigating the risk of extinction from A.I. should be a global priority alongside other societal-scale risks, such as pandemics and nuclear war,” reads a one-sentence statement released by the Center for AI Safety. The open letter was signed by more than 350 executives, researchers and engineers working in AI. Now, I’m generally not a cynical person, but the notion the risk of human extinction from AI is on a par with a global pandemic or nuclear war suggests we could be getting closer to peak hype. Yes, Nvidia is an awesome company, AI is likely to unleash enormous productivity gains, improved healthcare and those who know how to use it, may well take your job, but it will eventually, like all prior platform revolutions (PCs, internet, mobile, social) become ubiquitous. And you still won’t be able to find a spot welder. Or a plumber. Or any copper. 

If you would like to receive future editions of The Weekender, feel free to email me at gdp2@ntrs.com.

_{[1] Bank of England has a lot to learn in battle to reduce inflation, says Andrew Bailey, The Times, May 24 2023}

_{[2] UK’s pension lifeboat fund slashes equity allocation, Financial Times, June 2, 2023}

_{[3] Tony Blair Institute proposes ‘radical’ UK pension superfunds, Financial Times, May 29, 2023}

_{[4] NatWest: mass free share offer could revive UK stock ownership culture, Financial Times, May 19 2023}

_{[5] That's the Way the Money Goes: Financial Institutions and the Nation's Savings, John Plender, 1982}

_{[6] Britain draws up blueprint for multi-billion fund to back start-ups, Reuters, May 11 2023}

_{[7] Takeaways from the Federal Reserve meeting, CNN, May 3, 2023}

_{[8] Monthly Construction Spending, April 2023: United States Census Bureau, June 1, 2023}