1987 Redux?

It is over 32 years since Black Monday (19th October 1987) when markets fell 25% in a day.  The immediate causes were two-fold: in the United States a proposal by the House Ways and Means Committee to eliminate some of the tax breaks on lucrative M&A transactions; and in the UK a failed rights issue by BP and a hurricane-like storm across London which prevented the London Stock Exchange from functioning properly.    The underlying cause of course was different: equity valuations had stretched too far from bonds.  Behind this was a jump in global liquidity combined with a back-up in government bond yields. Global liquidity as measured by our friends at CrossBorder Capital rose from 27.2 to 84.5 (index 0-100) in 1987 and equity historic PERs rose to above 20x.  At the same time bond yields backed up by 15%, which is why the valuation elastic was ready to snap. Roll forward to 2020 and there are some eerie similarities.  The US has turned on the monetary taps: CrossBorder Capital’s most recent numbers for both US and global liquidity is over 70, having been below 20 a year ago.  It has been the sharpest US liquidity surge in 50 years and the fuel for the 2019 rally in equities and also gold, up 22% since May.  There are parallels in the trade tensions between the US and China today, and Japan then, which were partially resolved by the 1985 Plaza Accord on currencies.  If, as we rather suspect, there is a similar accord today resulting in Chinese easing, we can expect the PBoC (NB. larger balance sheet than the Federal Reserve) to join the liquidity party.  In music terms, the volume just got turned up. It all starts to look rather like 1987.  Perhaps the final bit of the jigsaw is investors’ appetites.  Today investors are reluctantly allocating to equities despite valuations much higher than 1987, simply because everything else looks even less attractive.  CrossBorder’s data indicates that they are still largely underinvested, particularly in Emerging Markets, but also in Japan, the UK and the US.  In 1987, after five years of largely rising markets, investors were wary but were dragged back to the party. We are not suggesting a new Black Monday is imminent.  Rather, the opposite.  The music is playing and we expect investors will feel they have to dance for some time yet.  We will only get nervous when we can see a clear catalyst to make the valuation elastic snap again.  There are candidates around but it is probably going once again to be something unexpected.   We will of course be keeping our usual eagle eye open for early indicators: a back-up in bond yields is the prime candidate, but look out also for heightened equity volatility.  Black Monday was preceded by a couple of mini-crashes on the stockmarkets.  There may be another tax proposal, perhaps to rein back the influence of the large tech stocks.  And we will don our flak jacket in the shape of an allocation to gold.  But 2020 may yet again prove to be a good year for investors. If you’d like to discuss this in more depth, please call us on 020 3637 6341.

​Linchpin 2020 survey of inflation trends - now our 8th year

Annual inflation/deflation briefingThis is our eighth annual update on the long-term outlook for inflation, in which we monitor a range of inflation indicators.  Last year we wrote just before the Federal Reserve’s surprise cut in US rates in January.  We could see the seeds of inflation sown quite clearly but, against what we saw as an overly tight monetary policy, our inflation needle moved back towards disinflation.  This year it is almost consensus to assume that much of the West is going into a period of very low growth, and the only question is whether it will follow a Japanese deflationary or a British stagflationary model.  When we wrote a year ago, we said that monetary policy was too tight and, if continued, would lead to a recession.  Federal Reserve Governor Powell still threatened further interest rate rises which, despite the end of austerity and the inevitability of higher inflation in the long term, was sufficient for us to conclude that inflation would stay low for another year.   A year later there has been a sharp change in monetary policy, with three cuts in US rates and the clear commencement of QE4 at least in America, Europe and Japan.  Politicians have also thrown the fiscal lever, as witnessed by the latest loosening by Abe in Japan and the promises made by UK election candidates. Despite these policy shifts, inflation and inflation expectations continued to fall in 2019.  OECD data at October 2019 shows G20 inflation almost 1% lower than 12 months earlier at 1.36%.  The major outliers are China at 3.8%, and Japan and Korea at close to zero.  The implied break-even US inflation rate ten years out has fallen by about 10bps to 1.7%, while the five year forward rate five years out has behaved similarly. As we said last year, in the longer term the final abandonment of fiscal austerity by most developed countries is clearly inflationary.  Not only does it build up government debt levels but, by adding to demand, it increases pressures in areas such as labour costs.   It confirms our view that western fiat (ie. paper) money will ultimately be debased.   The question for investors is when.  The output gap at the bottom of the Global Financial Crisis stood at over 4% (OECD data) but that had been eliminated by last year.  We would not place too much weight on this but is a gentle indication that there is no longer a deficit of demand. More important in our view is the likelihood that QE4 will be very different from previous periods of QE.  In the 2009-2015 period additional money was largely used in technical ways to mop up bad debt and prevent the financial system seizing up.  It did not find its way into the high street, though it did of course create price inflation in both financial and real assets.  We think that QE4 will see more finding its way into the real economy, simply because that is where the political imperative is.  Politicians don’t need to use helicopters or believe in a magic money tree to realise that their political careers depend on making better lives for those who didn’t benefit from asset price inflation.  That means getting money into their pockets.    We commented last year that our ‘deleveraging’ indicator was really leveraging and we have now changed its name to reflect that.  Fiscal and monetary easing makes it cheap to borrow, particularly when the ultimate lender is a government whose primary agenda is not about returns. Against these pressures are strong disinflationary ones caused by technology.  It’s noteworthy that both Japan and Korea, very different economies, have zero inflation despite tight labour markets and we don’t have to look very far to find plenty of evidence of technology cutting out layers of cost.  We particularly like the comparison between a 1990s child playing with Lego and their 2020s offspring learning through Minecraft on their phone.  In this one example we can see chemical and plastic factories, packaging, distribution services and retail toy shops all largely removed from the cost chain.    Also on the costs side, in 2018 the main feature in commodity prices was a 25% rise in the oil price.  In 2019 there was no general impetus to inflation from commodities and gas prices were notably weak.  Agricultural and base metal prices were broadly unchanged (data 12 months to end-November) though iron ore was +16%.  Precious metals rose (gold +20%, silver +17%).  Oil and oil-based chemical prices generally fell, though crude oil (-3%) held up much better than natural gas (-34%).   On the other hand, labour cost pressures are clearly inflationary.  Many developed economies are close to full employment and for the UK BREXIT may add further frictions to employment.  The US has chosen to use trade sanctions as a primary weapon in its economic policy, most notably against China.  A substantial reverse in globalisation can only add to supply-side frictions and inflationary pressures. If demand and supply factors, supported by policy, are broadly inflationary, the conundrum facing investors for the third year in a row is the fact that market indicators are facing in the other direction.  Bond yields have fallen sharply during the year while implied inflation rates are modestly lower.  For example, the ten-year US Treasury yield started the year at 2.66% and ended it at 1.90% after reaching a low of 1.47% in late August.  Some may argue that yields are distorted and not a reliable measure, but we are wary of assuming that this time it is different. In summary, while monetary and fiscal policy must lead to higher inflation eventually, our indicators suggest that we have not reached a tipping point yet.  Five are pointing to inflation, four to deflation, and four are neutral.  Three indicators (bond yields, commodities and overcapacity) have moved in a disinflationary direction, and two (gold price and liquidity creation) the other way.  Current market estimates of inflationThe IMF estimate for Advanced Economies’ inflation as measured by the deflator is unchanged from 12 months ago at 1.9% but the five years’ out forecast (ie. 2024) has fallen from 1.5% to 1.0%.   Consumer price inflation (CPI) forecasts five years’ out are close to the OECD’s at 1.9%.   The CPI forecast for Emerging Markets is higher but again little changed from the forecast 12 months ago at 4.2%.  This may reflect the forecasting process but there is little sense that the number-crunchers expect inflation to take off over the next few years. ConclusionAt Linchpin our base case remains (much) higher inflation in the longer term, primarily because of the levels of debt in the West and an increased level of political dysfunction.  Since last year, policy has swung clearly in this direction but market indicators have gone the other way.  Our conclusion is that inflation trends in 2020 are likely to be similar to 2019 - the subject of two opposing forces but resulting in low positive inflation in the 0% to 2% range.  However, if this is all that can be achieved even with liberal policy support, without that the risk of a descent into Japan-style deflation would become significant.  As this would have significant implications for investors, it is not the time to be too dogmatic about the future. The  historical record of the indicators we follow can be viewed here, or if you wish to discuss anything in this article with the author, please  contact us on research@linchpin.uk.com ​

Review of SF3 data – is the LGPS slide to negative cashflow accelerating?​

Two years ago I published an article on LGPS cashflow trends following publication of the annual SF3 forms (data at 31st March 2017).  I pointed out that aggregate contributions fell short of pension payments by about 0.4% of total assets and that the gap was bridged by a 1.5% cash inflow from investments.  I compared the numbers with 2011, when there had been a 0.8% surplus of contributions over payments and investment income brought in an additional 1.9%.  I pointed out that the Scheme would, if the rate of deterioration continued, be cashflow negative by 2024. Two years later I have reviewed the same data as at 31st March 2019.  Since then LGPS assets have risen by a total of 6% and, when the actuarial valuations of the same date are finally published, funding ratios for most funds are expected to be in a healthy 90% to 110% range.  However, financial solvency should not lead us to ignore the issue of deteriorating cashflow as the Scheme matures. This year’s SF3 data again comes, as ever, with some caveats: 2019 income is understated because some employers chose to ‘pre-pay’ three years’ contributions in 2018; there were some large transfers for a variety of reasons which distort the data; and investment income may well not capture the incoming cash inflows from all investments (eg. private equity distributions). However, the 2019 numbers do appear to confirm the slide to negative cashflow I highlighted two years ago.  It may well even be accelerating.  Total outgoings (including management and investment costs) were £12.7bn, up from £11.8bn in 2017.  Pension payments rose by 9% over the two years but other costs charged to the fund by 27%.  This may reflect the extra costs of pooling as well as investment costs resulting from the growth in assets.    Contributions in 2019 were £9.3bn, which left the Scheme with a shortfall of £3.4bn before investment income.  The latter amounted to £4.4bn on the data.  In aggregate the LGPS therefore only had net cashflow of £1.1bn - or a miniscule 0.3% of assets.  Even adjusting to allow for contribution prepayments, the net cashflow number was below 1% of assets, a further fall from 2017’s 1.1%. As you’d expect, individual funds are in different places.  Two years ago I highlighted ten funds which weren’t particularly mature but had negative cashflow even after taking investment income into account.   In 2019 38 funds had negative cashflow on this basis, though 19 of them were positive once net transfers out were taken out of the calculations.  Of the other 19, nine are less mature in the sense that the ratio of active members (ie. paying in contributions) to pensioners (ie. taking their pensions) is greater than the national average.  In theory, they have longer to put strategies in place which will ensure they do not run out of cash. However, five other funds are significantly less mature (ie. the ratio is less than 80% of the national average) and it is these five funds which most worry me.  If I were advising them, I would be encouraging a strategy of putting in place reliable income to match their cash outflows.  And yet according to the SF3 data none of them is receiving investment income of more than the national average and two, both London boroughs, are receiving less than half.     I also note that both these two are receiving markedly less in dividend income than the national average, perhaps because they are invested in accumulation rather than dividend paying units of collective investment schemes.  That could well be an issue to look out for in the pools which are now responsible for implementation.

Could this be the best opportunity for investors in 30 years?

I spent some time with Mark Pearson of Arcus Invest a couple of weeks ago.  He has been investing in Japanese equities for 30 years and is known for having visited more companies there than anyone else working today.  He told me that in all his investing career he had never seen such an investing opportunity for value investors.  It is bigger in his view than either the dot.com bubble or the aftermath of the Global Financial Crisis.  Of course it comes with a caveat - neither he nor we know how long it will take for the valuation anomaly to correct, ie. the elastic to ping back - and so investors need patience.  But given the overall perception that ‘everything is expensive’, we think investors should be interested. Some of his reasons are global: investors’ quest for quality income in the aftermath of the GFC has pushed valuations to record highs, while value stocks have languished.  In Japan the gap between the former and the latter is as extreme as it has ever been, and additionally value stocks are close to their cheapest ever in absolute terms.  Mark’s small cap portfolio stands on a PE ratio of around 5x. An interesting point he makes is that that future earnings growth among the lowly rated stocks is not appreciably lower than those rated highly.  To believe highly rated stocks will outperform, investors have to expect further valuation appreciation.  Of course it’s not impossible but it seems an improbable scenario given where we start.But some of Mark’s reasoning is more Japan-specific, particularly the transformation in Japanese corporate balance sheets, which is still largely unrecognised by investors.  Here are some statistics to ponder. In aggregate, Japanese corporates have created over Yen 560 trillion of cashflow over the past 25 years, despite very low levels of nominal economic growth.  As a result a debt mountain has turned into a cash pile.  It has been done by a tripling of recurring profit (equivalent to pre-tax profits) margins from 2% to around 6%.  If we drill down, both operating and non-operating margins have improved, but the bulk of the change has come from the latter. What have they done with this cash?  Let’s start with what hasn’t happened.  It hasn’t gone to employees.  Despite the tight labour market, the % taken by labour has stayed at approximately 13%.  It has only modestly gone to Capex, which remains at around 3% of sales.  Some has gone to M&A - there have been some high profile acquisitions such as Takeda’s acquisition of Shire.  Importantly, however, this has not led to an increase in intangible assets, which remain at around 15% of book value for TOPIX companies (cf. US S&P 500 at 70%). Shareholders have been the big beneficiaries.  Both dividends and share buy-backs have risen fast.   Combined, they equated to around 5tr yen in 2004, around 20tr yen today.  And the reason for this isn’t far to seek.  A generation ago, around two thirds of shares were held for corporate reasons by connected entities, whose interest was in stability and corporate relationships.  Now about two thirds are held by independent shareholders who want financial returns. So we have the combination of ultra-low valuations and a vast improvement in both corporate quality and shareholder friendliness.  If you can afford to be patient, our view at Linchpin is what’s not to like? ___________________________________________________________________________ This blog is intended for professional investors, and nothing within it is or should be construed as constituting advice as defined by the Financial Conduct Authority.  If you are in any doubt about this, please consult your legal advisor.  The information contained in this blog has been obtained from sources believed reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such.  Linchpin IFM Limited has a consultancy agreement with Arcus Invest.

This time it really is different - or is it?

All my investing career I’ve been told that the four most dangerous words in the English language are ‘This time it’s different’.  So it was intriguing to hear a debate between two thoughtful portfolio managers at the excellent    Room 151 LGPS Asset Allocation Conference last week. The first used the example of her children to argue that mean reversion is old hat.  She gave her children Lego to play with when young, as she had when she was a child.  However, at the age of five or so they stopped opening the Lego box and preferred to play Minecraft.  Her point was that Minecraft requires nothing physical except a device.  If her children are typical of their generation, at a stroke Minecraft has disrupted whole swathes of industry and services.  There is no need for a chemicals factory, the Lego factory, the Lego packaging, the Yodel or Hermes to deliver it, even infrastructure such as roads.  I haven’t even mentioned the retail shop, as that has already gone the way of all flesh. In investment terms, if you believe that the disruptors, in this case Minecraft, are going to just get larger, there is no mean reversion.  And yet mean reversion is what lies behind whole swathes of investment theory.  If it really is passé, then everything we have learnt from Benjamin Graham onwards is worthless.  The only thing worth doing is investing in disruptors and clinging on. The other speaker argued that the vocabulary we have been using to describe our objectives when investing is no longer relevant.  We currently describe portfolios in terms of value, growth, momentum etc.  He argued that in 20 years’ time the only metric which will count other than a financial return will be how the money has been used for the good of society.  The old style factors will simply become irrelevant. He was describing an extension of what we now call Responsible Investment but it resonated with me.  It seems inevitable for political and social reasons that the current form of market capitalism is going to morph into something more focused on the world’s non-financial needs.  That does not have to mean the disappearance of the financial metrics and disciplines we are accustomed to, but they may have to move over. And perhaps here is the flaw in the first speaker’s argument.  In her world, those who are flexible enough to adapt to rapid change will do very well.  But almost by definition the great majority won’t be able to and I’d suggest that the social pressures which her model will bring will eventually result in a degree of mean reversion.   That doesn’t mean the disruptors as an asset class won’t flourish.  But they will be brought back to earth by the simple fact that their performance will be viewed by all – investors, governments, society as a whole – through a prism which is not purely financial.  Do they pay their taxes?  Does their activity have undesirable second-order consequences, such as traffic jams, empty high streets or unemployment? Is it different this time?  I do believe that disruption is here to stay.  I do believe that the capitalist model of the last 40 years is changing to something more attuned to society as a whole.  For investors that will lead to a form of mean reversion.  Microsoft (yes, they are the owners of Minecraft) will have to give up a greater part of their profits to society and will therefore generate a lower free cash stream.  Investors will react by placing a lower valuation on them and Lego (or perhaps the Lego box package producer) will appear relatively more attractive.​ Find out more by contacting us.

William participates in LGPS Asset Allocation Forum

On 7 November 2019, William was a panellist on the topic of using consultants in a pooled environment, at this forum in London.

​Why (most) investors should be investing actively in 2020

Occasionally we find ourselves drawn into the active vs passive debate.  Most recently we commented on an FT guest article written in the context of the LGPS, where the debate is still live. Let us start by raising our colours to the mast: we are firm believers in active management.   That’s not to say that passive investment doesn’t have its place.  We are aware of the statistics showing that returns from active managers have generally been behind passive over the past ten years.  It is, at least in theory, cheaper- which for us is the only good argument for passive. The picture is clouded by the growth of smart beta products and the proliferation of indices.  They sit somewhere between passive and active.  They remain primarily mechanical in their operation, but they are more complex (i.e. more scope for investors not understanding) and more expensive.   In fact, fees charged for complex smart beta strategies can actually be higher than large mainstream institutional active mandates. We have lots of reasons behind our beef with passive.  But let’s start with the fact that traditional methodologies don’t take absolute risk into account.  Because they are based on market capitalisation weightings, the more a share price goes up, the bigger the index weighting.   It has served investors well over the past ten years when momentum has been so strong. But the result is massive concentration of risk.   At the moment, an investment in a passive global equity fund results in 63% in US equities (and the US$), and 13% in just the nine largest stocks  (five tech, one bank, two healthcare and one consumer staple – two if you wish to reclassify Amazon).  The moment that any of tech., large cap, growth, the US, or the US$ starts to do badly, investors in this strategy are going to suffer relative underperformance.   Any half-awake active manager will diversify some of that specific risk away. Let’s then look at the mechanics of owning an index fund.  Our first point is that if you own an Exchange Traded Fund, beware.  That’s not because all ETFs will get into trouble, but, depending how they are structured, the bid-offer spread may be substantial, especially if liquidity in the underlying markets dry up – i.e. at times of stress. Most large passive managers aim to make money from activities such as stock lending and the regular rebalancing in order to offset the cost of running the fund.  There is nothing wrong with that, but they all involve extra risk.  99.9% of the time they will harvest the fee, but at time of stress there may be problems and some capital loss. Our final point is to do with customisation.  If an investor wishes to tilt his portfolio away from or even exclude sectors such as fossil fuel, an active manager can usually accommodate that.  With a passive mandate it is up to him to choose an appropriate index to follow.  Because non-standard indices are more complex, they will almost always be more expensive, substantially negating the no. 1 advantage of passive investing. We know we have many forces ranged against us.  When we commented in the FT, we didn’t get many likes.  Some elements in the Government still believes that the LGPS should go completely passive on the grounds of cost.  But from the perspective of 37 years investing, we venture to say that they are misguided.  If there was ever a time when the balance of probabilities favours active over passive, it is now.​

Investing with impact summit - 10th october 2019

Representatives from Linchpin attended the excellent Investing With Impact Summit last Thursday.  Organised by Pensions for Purpose and DG Publishing, it was twice as large and lasted twice as long as last year.  It was probably the hottest pension fund date in town this year and didn’t disappoint.  Here are some of the learning points we took away from it. Impact investment has come a long way in 12 months.  We’d hesitate to say it was mainstream but there is an acceptance that pension funds can legitimately look for more than just a financial return.  The LGPS Funds seem to be in the vanguard of the movement. There are still arguments about what constitutes impact investment.  Is it enough for a company to be aligned with one or more of the U.N.’s sustainable development goals?  Or does it require an intention to make a positive or social difference, as per the PLSA’s definition?  And if the latter, can companies on the secondary markets truly be called impact investments? The scale of most impact investment is quite small, while pension funds with limited governance budgets want investments of greater scale.  We were struck by the number of smaller managers attending and the relative absence of investment consultants.  Given that they are often the gatekeepers to pension funds, are the latter missing a trick? We were also struck that the audience gender mix appeared to be at least 50% female.  It is a huge contrast to a couple of other mainstream fund manager events we have attended this year where attendance was 95% male.  There is a substantial good news story on several fronts, which is being drowned out by the howls of climate change protesters.  There is more to be done, without doubt, but the industry needs to make sure the world know what we are doing.  Otherwise we risk being seen as the enemy. Could we invite some of the crusties outside to join us next year? 

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