The Weekender

JUNE 17, 2023

Happy Birthday John Maynard Keynes 

It was Keynes’ birthday last week (he turned 140) and I was reminded of one of his great quotes about change: “the difficulty lies, not in new ideas, but in escaping the old ones”. This has particular relevance to several topics we explore this week, namely the UK, Japan, oil and ESG. 

A hidden Brexit dividend: a US-UK free trade deal?

Have you read the White House statement on the Atlantic Declaration negotiated between Sunak and Biden recently? You should. While not legally binding, the signalling is powerful. It aligns the UK with the US on key verticals for geo-political and economic security: defence, climate, quantum, supply chains, AI and space (?). It aims to provide investment funding and expertise to start-ups (ref: ‘the great unlock’). It speaks of being a new template for how nations conduct bi-lateral agreements and is another signal of the fragmenting world order, where allocators need to think more about country risk, and so, country-specific returns (e.g., UK! Japan, EM ex China). It calls out China as a challenge to international order, it speaks to ‘friend-shoring’, more resilient supply chains, and a reduction of strategic dependencies (Taiwan). Critically, the UK is to be considered a ‘domestic source’ under the Defence Production Act and any EV materials supplied by the UK will qualify under the Inflation Reduction Act. I’m staggered more is not being made of this. Most commentators criticise the lack of substance and agreement on free trade. But if my reading is correct, to qualify for preferred supplier status under the IRA, the UK must be a free trade partner with the US (see Critical Mineral Requirement here). In other words, does this agreement suggest Sunak may have negotiated a deal, but he just hasn’t announced it yet?

Closer economies, closer valuations?

Just this week we’ve heard the UK are to hold talks with the US on Space Solar, Intel have discussed becoming an anchor investor in ARM (a UK company), Andresson Howitz announced that they are setting-up in London (following AIMCo Canada and Aware Super from Australia), the Atlantic Declaration talks about sharing patient capital and IP to invest in UK start-ups and Sunak has announced he’ll host a forum on AI regulation with support from the US. These now seem more than coincidence. And if our economies are to become more closely aligned, then surely, over time, market valuations should follow? And if they do, then consider the starting point: the UK has a CAPE ratio of 14x vs the US on 28x. Just saying.

When markets go down on good news

Brent crude can’t rally despite seemingly bullish signals from OPEC, Chinese stimulus, strong equity markets and Ukraine’s counter-offensive. That’s poor price action. Street analysts are well ahead of the forward curve (by $24/b in Q3’24) meaning oil prices need to stage a remarkable comeback, or downgrades are coming. I (still) think the latter more likely and while I like commodity exposure generally and would consider increasing allocations to such on a long-term view, oil is one I drop from the mix. Its future is not in the past. Yes, it will rally from time to time and oil stocks have different drivers, but the incentives are now heavily weighted in favour of an accelerated transition. When you combine industrial policy (domestic subsidies), with innovation and a common enemy, incredible things can happen. Take Chrysler, during WWII, whose Detroit factory alone produced more tanks than the entire Third Reich. The common enemy is now climate change and muscular industry policy (with Keynesian thumbprints all over it) is now driving production costs in a race towards zero, thus lowering the threshold for substitution. Like AI, it’s an arms race (and you wonder why we have tight labour markets?). This is, of course, not the end of fossil fuels. We still need them to live, and they provide the bridge to a cleaner future. But it is time to challenge old ideas about supply and accept certain dynamics are changing. For as we have seen in other domains recently (i.e., golf): money talks

Engagement vs Exclusion

This conversation between Nicolai Tangen and Darren Woods, CEO of ExxonMobil, is important for anyone grappling with how to frame the engagement v exclusion debate. Woods is not a climate denier. He believes we have a climate problem and that fossil fuels contributed to such. But he argues oil companies have a crucial role to play in transition and that we need to become more balanced in thinking through solutions. It’s not a binary, ‘stop-oil’-type thing. For example, if the incentives for natural gas drilling was removed, we might increase thermal coal usage (see New Zealand in 2021, where less gas investment combined with lower renewables capacity led to record imports of thermal coal). And, as we will still need fossil fuels in future (think nitrogen fertiliser, silicon) if they (i.e., Exxon) don’t produce it, a less efficient and/or less caring actor will (like Venezuela or Russia). But perhaps the most interesting comment was he refers to Exxon not as an energy but as a technology company. One that can bring their innovation and business acumen to bear, to solve other problems, quickly. What Chrysler was to war, they could be to emissions. And if they can preserve their infrastructure as they transition, then that’s a much lower cost solution for society. Clearly a complex and emotive topic – but I found Woods to be very disarming, pragmatic and thoughtful. He’s someone I would rather engage in any solution, than exclude. It’s well worth listening to.

Space Solar reaches critical milestone

On the topic of demand destruction for oil, the California Institute of Technology last week demonstrated the ability to wirelessly beam power from its satellite to Earth for the first time. This solves a key technological barrier for space solar, an energy that show tremendous promise on account of it being 40x more powerful than conventional solar and non-intermittent (i.e., baseload). It’s relevant then, that the combined UK-Saudi project with Space Solar Plc, which I mentioned some weeks back, took a step closer this week after the UK government committed £4.3m in funding to it. The energy minister was animated about its prospects, suggesting space solar could one day account for a quarter of total electricity needs and power almost ¾ of UK homes. Interestingly he also mentions the Americans (see above: Free Trade?) who no doubt have a vested interest, as the spoils are not just free non-intermittent power, but asteroid mining and ubiquitous Wi-Fi. With China looking at launching their own mission by 2028, the Space Race 2.0 is clearly underway. That’s change. Yet few seem to discuss it.

The World is (not) Flat…..

In 2005 Thomas Friedman wrote The World is Flat where he examined how the rise of the internet, outsourcing, and supply chain innovations had transformed the global economic landscape, leading to increased competition and collaboration on a global scale. It became the playbook for globalisation. Now, with that view challenged, we have a new playbook for this post-global era. It’s called Homecoming written by FT columnist, Rana Foroohar. This new era, she argues, is where international free trade is usurped by national-centric interests, reshoring and muscular industrial policy. It’s, as the FT puts it, a new order “where the interests of Wall Street and multinationals are listened to less, and the interests of “people and place” are listened to more”. If the world is fragmenting, becoming less international (cooperative), more national (competitive), less geopolitical and more political, should we not be thinking the same with our asset allocations? Indeed, country-specific risk is already impacting performance and valuations. So, expressing these factors via country allocations could be a good way to find non-correlated returns and tracking error against a reference index which draws heavily on the idea the world is still flat. An old idea. But another we might need to challenge?

Liquidity management

Our Liquidity Solutions team has never been busier and Liquidity management remains a hot topic, for all investors. It’s became quite topical this week as Gilt yields surged ABOVE levels of the mini-budget crisis. This in response to hotter than expected wage inflation figures, and also, I believe, the implicit acknowledgement from the Bank of England (BoE) that their models are wrong. “Models are essentially taking averages of behaviour in the past" said Huw Pill, the BoE’s Chief Economist. The problem with this, is by the past he only draws on the last 30 years - a period of falling inflation, falling rates, global cooperation and the Washington Consensus. That world has now changed (see above: Homecoming) which is why it’s encouraging to see the BoE admit their mistake and that they plan to address them. I digress. While investors have learnt from the previous experience and have measures in place to withstand further stresses, it’s a reminder of the importance to have protection and liquidity, lest access thereto, before the time it’s needed. For no one, as Luke Ellis, the departing CEO of Man Group said, ‘wants to be the schmuck selling at a 30% discount’. But with higher cash buffers and/or liquidity solutions (like FICC Repo)¹ in place, these issues can be managed. That said, it also, I suspect, brings into question the allocation model itself – and the over-concentration to credit – at the end of a credit cycle. Through little fault of their own, and under the auspices of de-risking, the majority of defined benefit funds in this country hold debt at much higher prices and must suffer the corrosive qualities of inflation.  

Another reason, perhaps, to challenge the old ideas, revive a cult of equity, and summon the spirits of George Ross Goodbye. You can read more on these themes in recent editions of The Weekender. 

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