Some equity managers, who presumably sold heavily in March and April, are still calling this a ‘dead cat bounce’. It is unusual for the cat to bounce higher dead than where it was when alive. Yet this is now where we find ourselves. And so we must ask, is the future becoming clearer?
Briefly returning to our rebounding deceased feline, the bounce was always likely and we did suggest that it would cause maximum pain by being rapid and large!
We recently began to switch back toward safe and steady stocks and away from our cyclical positions. We did this too early but we did remain fully invested. It is our investment philosophy to remain fully invested and to re-invest dividends.
At current levels on the S&P 500 (3,200 as we write this) we calculate long term nominal returns as being a little over 6% p.a.. This is based on a long term present value dividend and buy back model. All models are wrong but some are useful; we have found this approach useful in anchoring our expectations.
This annual return might not sound much but, when compared with the US Treasury Note (10 year bond) yielding less than 1%, this is a decent risk premium. Don’t forget that there is some relationship between asset class returns and bond yields near zero imply lower rates of profit growth and productivity growth.
Our equity return forecasts do assume dividend cuts and a reduction in share buy backs in the USA. Given the long term risks for equities and investors in all asset classes rising, this 5% premium may however be needed as a bare minimum?
We pontificated in an article a few weeks back that the new world post Covid-19 would look different in that the three key participants (government, corporations, and individuals) would behave differently.
It is becoming a bit clearer now what these trends may look like. Consequently we summarise what we think the new risks are for investors. Risk is an essential part of investing but it is better to identify the sources to avoid big mistakes.
What are these emerging long term risks?
We see clearer evidence of a rise in government intervention in corporate strategy. National interests are increasingly cited and companies are ‘encouraged’ to re-invest back ‘home’. This is true of USA, Japanese and Chinese companies. Foreign takeovers of businesses are also likely to be more heavily scrutinised. Consequently, there will be fewer efficiencies in future from global capital flows and knowledge sharing than there were before. Fewer takeovers mean lower short term returns. More government ownership means dividend reductions, suspensions and cancellations.
Examples abound - Cathay Pacific has received a Hong Kong government rescue package (the first in the history of HK) in the form of preference shares and two positions sitting on the board. The French have announced a rescue package for their aerospace industry and this is likely to affect Airbus, Thales and Dassault Aviation. All are listed companies and, based on their negative share price reaction, more French government intervention is not viewed positively?
We await the terms of any Boeing package. Notwithstanding the self-inflicted travails of the 737 Max programme, Boeing is an important Defense contractor and so can’t be allowed to go under.
In other non financially strapped industries such as Semiconductors, the USA government has instructed TSMC, a Taiwanese company, to apply for a licence if it wishes to manufacture chips using USA design, for foreign companies. This certainly shuts out Huawei, the Chinese telecom equipment supplier and ‘encourages’ TSMC to orient themselves to the USA. TSMC now intend to spend $12bn on a lab in Arizona so government intervention is not only bad news but may encourage additional capital investment?
We adjust our relative return expectations UP for companies with good balance sheets and low operating leverage; we adjust UP our expectations for Asia since this government company industrial policy is something they do while asleep. (NB it does NOT mean that all Asian companies are saved – quite the opposite...)
For a more detailed series of conjectures about this, please check in with The Hinrich Foundation website. They specialise in analysing global trade and capital flows.
There is a chance that ‘moral hazard’ can be partially removed from the system. For example - Hertz has been ‘let go’ and is now in Chapter 11, and clearly some companies will not be bailed out. Virgin Atlantic was refused a public ‘loan’ an has had to go to the private sector. Here is a selection of USA retailers & restaurants which have filed for Chapter 11: - J Crew; The Cheesecake Factory; Sears Holdings; 99 Cents Only; GNC, Ascena Retail (Ann Taylor, Loft). If you think this will have repercussions for town taxation revenue and high street spending multipliers, then you are correct. Do we hear a suggestion that internet based retailers pay at least some corporate taxation and a digital tax is a good idea?
Our sectoral considerations now assume that consumer stocks are on their own for survival. Be wary of financial leverage in owning these stocks. This is also likely to accelerate the on-line shift - sadly. There should be more investor risk which needs discounting – it hasn’t been yet.
Geopolitical tensions are rising and these tend to last for years rather than months. In a USA election year it will be surprising for anti-China and anti-European sentiment to not be heightened. This will increase equity risk across the board.
The whole system depends even more now on confidence in paper or fiat money. Constant quantitative easing has achieved little in the way of sustainable growth or jobs; and yet whole careers at central banks have been built on the premise that zero interest rates are a correct policy setting but just haven’t worked yet. (All resemblances to apologists for Communism are totally non coincidental.) So, denial remains likely. The pandemic has resulted in MASSIVE increases in debt. This is just not going to be paid back and so some form of default is likely. This is not necessarily bad for the right kinds of equities but certain currencies, bonds and companies should be avoided.
Signs of stress in this constant supply of easy money are appearing. Most notably in Germany where their constitutional court ruled that the ECB was not adhering to the rules to the extent they were instructing the German central bank, the Bundesbank, to buy Euro wide debt ‘disproportionately’. Arcane perhaps, but relevant because without the Bundesbank buying Euro wide debt, the likelihood is that Euro bond spreads widen and cause a financial crisis. This will not be contained easily within Italy - the likely source of the crisis. On the other hand if it forces Germany to move toward fiscal union to support the Euro (currency union needs fiscal union needs political union) then this is a good thing for the Euro albeit not so good for the German taxpayer.
Our central case now assumes we have a higher inflation bias or tolerance in policy settings and the chances of a mistake are correspondingly elevated.
So, we therefore suggest that investors remain diversified; become a little more defensive in equity positioning; and favour dividend paying companies and debt issuance in strong currencies.
Robert Swift, also CIO at Delft Partners, manages the TAMIM Global High Conviction portfolio. Click here to learn more.
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.