“Back again? Dear oh dear” is how the King greeted the Prime Minister at her second weekly audience, prompting speculation about what subliminal message the King was inadvertently delivering and into which bit of Bagehot’s encapsulation of the role of a constitutional monarch it fitted: “to be consulted, to encourage, and to warn.” There has been plenty of international comment about what the Government called not a budget but a “fiscal event” – and it sure was an event. The head of the IMF has made some lofty remarks. President Biden has said the consequences were predictable. Other members of G7 have weighed in.
Most of us had never heard of Liability Driven Investment before now. We did not know that pension funds, in order to achieve a rate of return sufficient to immunise their liabilities, were using derivatives to get exposure to long term Government bonds on a highly leveraged basis, so that when yields rose abruptly they had to sell other assets (including, ironically, the most liquid, which are long term Government bonds) in order to produce enough collateral to satisfy their counterparties. Rising interest rates are meant to be good for pension funds because they reduce future liabilities. LDI managed to turn what should at least have been positive for pension funds into a potential disaster.
The Bank of England, which had done nothing about the spread of LDI, perhaps knowing as little about it as the rest of us, lapped up praise for dealing with the crisis. The Government does not criticise the Bank – bad form and bad for confidence to do so - and it didn’t. On the eve of the fiscal event the Bank put up short term interest rates by half a per cent. Any fule kno, as Molesworth would say, that if you have a weak economy and a fragile currency, and the strongest currency in the world has just on the day before had a three quarters of a per cent rise in interest rates, not to do at least the same is going to lead to a collapse in your currency. And so it did. That was the backdrop to the “fiscal event”. Had the Bank seen that the first priority was to stabilise sterling, the Government might have got away with measures which had been widely foreshadowed, despite the spectacular inappropriateness of some additional features such as the proposed reduction in the highest rate of income tax, the arrogance of doing without official forecasts, and the limitations of the Prime Minister in answering questions and imbuing confidence. The UK is now on its sixth Chancellor in 3 ½ years, about to reverse the “fiscal event”; we may soon be on to our fourth Prime Minister.
As a firm, we have substantial UK holdings in most of the portfolios we manage for clients, and we are sorry to report alarming negative returns in them. More broadly, all of us who live in the UK are troubled by the series of humiliations in the government of the country and the culture of apparent indifference in high places. Internationally, while there may be a touch of schadenfreude, most of those who comment are conscious, one senses, that there but for the grace of God go they, and that the troubles of the UK, though magnified by the Government’s own recent actions, are too close to home for comfort. After all, the UK has a ratio of government debt to GDP which is the second lowest in G7. What is disquieting about the sudden focus of markets on the level of government debt is that it could happen anywhere, and, with inflation as high as it is, to some extent is happening. Additionally, what is disquieting about LDI is that a similar crisis could be lurking unseen in other unpredicted places.
It hardly needs saying that there are ample reasons for caution. Geopolitically, Russia and nuclear threats; China and Taiwan. Economically, inflation and possible recession. After the global financial crisis, the ratio of labour costs to GDP kept on falling; now it is beginning to rise with a vengeance. At the beginning of this year the ratio of stock market value to labour costs was at an all time high. It is time for these ratios to reverse direction. The wave of counter-globalisation, encouraged by Covid and lockdown and now by interruptions in supply because of war, is not good for inflation. A generation has got used to interest rates being about the same as the rate of inflation, or lower. But this is not the norm: the norm to which in due course we should expect to return is for interest rates to be a point or two higher than inflation. Prospects for profitability and interest rates make for a difficult background for equities.
We cannot rule out more trouble ahead, and a sort of attrition in markets as they adapt to new hard realities. But there is always a danger, in talking about market factors, that one describes what has just happened rather than what is about to happen. What may be about to happen could be considerably more positive. The supply problems for inflation may have peaked. Californian freight rates are down sharply. Some commodity prices have been coming down. The furore about inflation may be at its noisiest just before a period of less bad news.
Equity markets anticipate, and they are down a lot. We have frequently quoted the Investors Intelligence Survey of Advisory Sentiment, an inverse indicator. This is now at an extreme, with 42% of those surveyed bearish and 25% bullish. The last time the figures were so skewed was in March 2009, not a bad time to be buying equities. The Survey is for the US, but is a decent proxy for world markets. In terms of valuations, there are still enough companies and sectors looking expensive to make the market as a whole expensive in the US; but markets elsewhere are not expensive, and there are wide swathes which are downright cheap. Cheap for a reason, maybe, in many cases, but not always.
Our portfolios have average price-earnings and cash flow ratios as low as we can remember. Contra-trend, we have a suspicion that we hardly dare whisper that returns over the next year or two could be surprisingly good, and that the disappointments of recent times could be redressed.
Oldfield Partners
September 2022