The Weekender

JULY 15, 2023

“Invert, always invert" again.

We talked last week of the importance of “fighting in the gaps” and challenging accepted narratives, like the fear of concentration risk in Tech, broad recession risks, and why everyone seems bullish on bonds. We find more reasons to do so this week. Indeed, the economic narrative looks to be morphing from recession to resilience. (Or even growth?) The equity rally continues to broaden; US homebuilders had their best week in months (+7% as I write, Thursday evening) and the economically sensitive Russell small cap index was the best of the majors, up over 4%. South Korea, a cyclical proxy, rallied 3.8%, Brazil is near all-time highs (yet only on 8x P/E with commodities at their lows???) and industrial sectors did well globally. Miners had their best week in months, helped by growing expectations of deflation fighting stimulus in China (think US circa 2008/2009). Oh, and the best performing stock in Europe was a UK company called Kingspan. It rallied +20% after raising guidance on solid US demand. Now this is where things get interesting. They see an end to destocking (more on this below) and “industrial and tech end markets which are proving resilient with AI demand starting to feature in the order book.” Hmm. Kingspan is a building supplier, not a tech company. What gives?

Military Keynesianism

What gives is that an enormous fuse has been lit under US manufacturing the scale of which we haven’t seen since WWII. Like then, this current policy is embedded with “national security.” (Just imagine what we would be calling the IRA if it was Trump’s plan, not Biden’s.) What’s interesting is the benefits of such muscular policy will not only flow to the focal sector (Defence in WWII, Tech and Renewables now,) but to many others. Ashtead two weeks ago and now Kingspan are just two relatively small examples of what can happen. There are hundreds of other ways to play it, many are on very low multiples generating high unlevered free cash flow (so not reliant on expensive debt) and now likely to experience years of structural growth thanks to what could easily be termed “Military Keynesianism.” And for clues as to what Americans can produce with the right incentives, consider that one Chrysler factory in Detroit between 1941 and 1945 produced more tanks than the entire Third Reich! The so-called Fed put could now be a fiscal one.

Fiscal put

With the US Treasury seemingly content to run fiscal deficits and high employment simultaneously, it appears the Fed Put might have turned into a Fiscal one. If true, then de-risking portfolios could mean selling long duration growth (Nasdaq) and adding exposure in the form of undervalued industrials, commodities, or sectors exposed to US capex. Regarding tech, while I think the mega-cap names are fantastic businesses, a number of the reasons I got excited by their shares earlier this year are starting to fade. AI hype seems to have peaked (see Google Trends) as have efficiency gains, where layoffs have trended from 100k or so to about 10k last month (per Layoffs.fyi). I also think the discount rate, the 10-year yield, has stopped falling and could start to rise again as the market wakes up to the impacts of fiscal stimulus, we see more longer-dated treasury issuance and Japan steps back from YCC. A third of US debt must be refinanced by year end and with a more dogmatic Fed, combined with lower rates out the curve, more 10-year supply looks likely. Imagine if that were to hit the market just as the Japanese saver decided to repatriate? This is an outcome that looks more and more likely (see recent inflation data and Yen for clues). Apple vs the FTSE (and most of Brazil). Anyone?

What’s Sovereign Wealth up to?

The annual Invesco Global Sovereign Asset Management Study has been released. Unsurprisingly, last year was a bad year, the first time since the survey began that they suffered negative returns. And like many other complex asset owners, they have been forced to rethink allocations based on a changed environment. Most expect inflation to fall but remain an issue. They see rates being higher for longer, more fragmented geopolitics, and demographics playing a significant role in asset return profiles. Consequently, they have decreased their cash positions as a reflection of the corrosive impacts of inflation. They have increased fixed income, mostly in emerging markets: regions that have high starting real yields and where inflation is falling (like Brazil). They are increasing exposure to private markets, although as we discussed elsewhere, are becoming more discerning, and looking at them to provide access to thematic areas hard to express in public markets, like renewables infrastructure. This all makes sense. But there is one thing that strikes me as odd. Despite record purchases of gold (as a hedge vs currency volatility) they have little commodity exposure, only 1.1% in fact. This is despite enthusiasm for clean energy. They clearly haven’t read Material World. Nor have they read the Credit Suisse Global Investment Returns Handbook, where they would find commodities the second-best performing asset class over time and the best during periods of inflation. A variable they see being quite persistent.

The Material World

While on the topic – I thought worth resending the OECD report, "Raw Materials Critical For The Green Transition." It’s very bullish on the demand outlook for minerals with green technology use cases such as copper and iron ore. They estimate demand for minerals will grow 4x to 6x, on average, between 2020 and 2030. Extraordinary. There are not many things for which you could say the same,  with the exception perhaps of EVs (which are dependent on those minerals). And here’s an interesting stat: China is set to double its capacity of wind and solar power by 2025, reaching its 2030 goal 5 years ahead of time, according to Global Energy Monitor. In other words, China will install more solar capacity in one year than the US has installed in its history. This should be good news for Silver demand and comes at a time of growing supply deficits, like there is in copper. I like hunting investments in the material world. You can buy high starting yields (much higher than bonds) with inflation protection very cheaply.

Supply constraints: for people

I live near Henley, famous for the Rowing Regatta, which was held last week. I seldom use a taxi. However, last Saturday I was charged £50 to take a taxi from the river to my house, about 6 miles away. It would normally cost £10. I assumed it was a function of demand, as the population swells for Regatta week. I had to use the same Taxi company yesterday. Normally there would be several cabs in the rank, but I had to wait 5 mins for one to arrive. I questioned the driver why. He said ‘“driver shortage.” They used to have 25; now they have 9. The rest either retuned home (during COVID and can’t get return visas) or now work for UberEats, RoyalMail, or Amazon – sometimes all three. This is not just a Henley issue, it seems. According to the Licenced Private Hire Association, the UK has lost 50% of its taxi drivers since March 2020. A massive supply constraint. For moving people. That’s inflationary. But t’s not just road transport. Last Thursday was the busiest day ever for commercial aviation, with 134,386 commercial flights recorded. And that’s prior to Chinese travellers being back in full. Not sure what that says about price, but I struggle to see them falling. (Is it coincidence, perhaps, this record, was the same day the World recorded its hottest ever temperature……)

When it pays to pay more

More to say on UK capital market reforms next week, but a quick comment on MIFID. If you are an asset owner or allocator in the UK, there’s a good chance you could soon get a call by one of your managers informing you that you are now paying for their research. As discussed, I would welcome that call. There is evidence to show higher research spend leads to higher performance which, logically, it should. As argued by Evercore ISI and Frost Consulting, MIFID 2 created information asymmetry where funds using client money vs those using P&L generated a significant performance delta (265 bps in 2019). Yes, they spent roughly 4x more on research, but that was dwarfed by the returns, especially in areas like tech, ESG or markets with less research coverage like the UK and Japan. So, it might pay to pay more, especially for a value-added service like Research. If cost sensitive, you might even consider paying less for services where value is harder to ascertain. Like trading.

Trade less or outsource more

The Journal of Financial Economics showed some years ago that funds that trade frequently generally underperform. Now, of course, traders will say they add value, and some do. This is especially the case in more illiquid or esoteric markets where domain-specific expertise is required and/or where relationships matter. And yes, some traders add value in the investment decision making process, making them more aligned to PMs than dealers. But for many others – especially in more transparent and/or liquid markets – it’s difficult to justify value, especially given the proliferation of outsourced solutions that deliver similar expertise with greater flexibility, resiliency, and scale but at much lower costs.