Speaking to prospective and actual clients everyday, we get a fair sense and understanding as to the pulse of the market. Throughout those conversations, there are often common themes and questions. Among these, first, should we continue to own equities? Second question, where to allocate in a world of continued low interest rates? Thirdly, we keep hearing about inflation, but what does this actually mean?
While we are unable to provide advice or answer these questions directly and individually, we are able to voice our general opinions and positions on the subjects in question. For us, we continue to stay fully invested from an equities perspective. This is with the understanding that there is, as with any given market context, always the possibility of a sell-off. In doing so we prefer to make use of prudent risk-mitigation strategies such as put-options over the index as opposed to trying to time the market. Why? Simple, we aren’t smart enough to predict exactly when or where the catalyst for the next sell-off may come from (far too many moving parts). Anyone that tells you they can? Run the other way. With that bit of context, let's get to unpacking the questions listed in reverse order.
For those that have read previous articles, you may be aware that I am somewhat of an inflationista. Despite rhetoric and the consistent management of inflation expectations by central bankers across the planet pertaining to the transitory nature of current trends, we simply don’t buy it. This time it really may be different. This was never our base case historically, despite the doomsday predictions during the initial rounds of QE (Quantitative Easing), where commentators consistently mentioned that liquidity injections into the financial system would result in runaway inflation. This is, we feel, a rather basic misunderstanding of the process through which it takes place. Firstly, increasing bank reserves does not necessarily translate or correlate into credit growth in and of itself. In fact, one could argue that money was stuck within the commercial banking system and this was reflected through increased asset price inflation. Credit growth is what is required in bringing about inflation in the real economy, via the money multiplier effect. Instead we saw continued downward pressure on the cost of capital for businesses (reflected in margins) and the increased use of share buybacks, especially in the US, which translated into massive EPS (or earnings per share growth).
Secondly, the labor arbitrage in the form of China and the ever downward pressure on real wages as a result, combined with technological innovation, saw a perfect deflationary scenario. Something that Japan and the EU continued to grapple with until quite recently. So, what about this time is different?
What Covid brought to the forefront, we argue, is the fragility of supply chains globally. Just-In-Time inventory systems and interconnectedness that were at the heart of historic earnings and equities growth. Yes, it is true that these supply bottlenecks, as indicated by the increased shipping rates and border closures, are transitory. What is not is the increasing role that governments are playing in re-calibrating supply chains which will put increasing cost pressures on companies which will inevitably be passed on to consumers. Secondly, the labour dynamic. Labour and wages continue to be the biggest driver of inflation to this day. Historically, since the 80s, monetary policy makers have been reluctant to see what is termed in economics as secondary round inflation. That is, the increased cost of living leading to wage earners demanding higher salaries which then causes another round of inflation in a somewhat self-perpetuating manner. It is rather telling that even the RBA Governor constantly talks about wage growth (not full employment) when coming up with his reasoning for the cash rate policy. Similarly, the appointment of Janet Yellen, a labour economist, as Treasury Secretary in the US is another sign of the priorities of policy makers. There is the second point, we will likely see an increase in labour's share of GDP in the real economy (again, inflationary). Combine this with falls in immigration and more generous social benefits which enable workers to be more discerning and increases bargaining power. This brings us to the first point to watch out for as investors, don’t just look at the headline employment data but rather the transition time in short-term unemployment. This is a good indicator of the actual nature of unemployment. Workers being incentivised to stay out of the workforce for longer because of better bargaining power is inflationary. This is perhaps the reason why we continue to hear about labour shortages in the US, for example, despite official unemployment figures staying above 5%.
Returning to the China question, we believe the Evergrande crisis may in fact be a catalyst for a rethink of policy making. The controlled exchange rates which saw the PBOC hoard a phenomenal amount of foreign currency and debt on its balance sheet may be in its final stages. The nation is the only outlier in terms of broad money growth, only annualising 8% (compare this to developed economies such as the US and Australia which remain in the higher double digits). The reason we raise this is that having pegged or managed currency limits the monetary authorities in their policy making. Currently, the RMB is allowed to operate within a band that is deemed acceptable. However, in order to do this, it is disproportionately impacted by outside influences in its policy decisions. Should this happen, there will be a short-term deflationary shock as the RMB is likely to fall on a relative basis, providing a short term boost to exports and foreign investment. But longer term, given the policy impetus, we see this aspect to be rather transitory. This aspect is perhaps the other reason for Beijing's confrontational tone as it pertains to cryptocurrency (they more than most cannot afford an alternative to the home currency).
So, point number one, inflation is coming. Not runaway as many of the readership may currently believe, like the 70s but a secular trend. Our call is that it will continue to average around 4% for the foreseeable future. The reason we don’t say runaway is, one, that it is very likely that measurements will be changed (important as this is what markets use in any case) and, two, the aging demographic and associated excess liquidity will put a dent. Think about when the period of greatest expenditure often is in a person's life, usually in their mid-30s and when starting a family.
So, where do we allocate?
Before going any further, consider this fact. The current portion of the US Federal Budget that services outstanding debt stands at 7.8% as of 2021, the numbers are similar in Australia. This is with the Fed Funds rate at 0.75 - 1% (expected between now and 2023) and the RBA cash rate at 0.10%. The question then becomes what would happen to this number should rates go back to 2007 pre-GFC levels of around 5%? This would imply that close to half of these respective government budgets would be allocated just to servicing the debt without any new expenditure. So we feel certain of one thing, we will not see a “normalisation” of monetary policy for the foreseeable future. What does this mean for you? First, the implication will be that the secular run in the bond-bull market is over, with real yields quickly going negative (they arguably already are). The only way out of this pickle, returning to the inflation thesis, is that inflation will be allowed to go above the official target rates (all things equal) and inflation control will increasingly come in the form of regulatory intervention rather than through an “independent” central bank.
In real terms, this means that the nominal growth rates of company earnings will continue to outperform while the discount rate (which has always been, and will likely continue to be, the official rates) stays put. Now, this may theoretically imply infinite equities valuations but it is important for investors to be a little more discerning. That is, your growth in dividends or capital must be higher or at least on par with CPI.
For those still unconvinced, think about the centrality of asset prices to the modern day economy that was the direct result of the financialisation of everything.
At TAMIM we continue to invest the equities portfolios in real assets with fixed debt structures, industrials, M&A targets (there will be continued activity here) and infrastructure. A side note about the M&A aspect: many of you may be investors in Sydney Airport (SYD.ASX), there is a different angle you should consider when looking at potential and so-called conservative assets. Let's use the example of a utilities company with a dividend yield of 6%. For an institutional investor looking at fixed income substitute or similar replacement, happy with say a 3% annuity-like return stream, the equities investor would have also had significant capital growth. This could potentially be both lucrative and rewarding.
This brings us to the second point, the easy returns on the index have already been ascertained. It will pay to be a little more discerning in what you look at going forward. There are certain metrics that will matter more such as 1) pricing power; 2) ROA (Return on Assets); 3) Debt (in particular composition of said debt, for example, a large proportion in long duration and fixed can act as an effective transfer of wealth from the debt holders to the equity holders); and 4) Government or regulatory intervention, for example, recalibrating or reshoring supply chains also has the effect of protecting companies from competition. Finally, chasing M&A activity could be especially rewarding.
Finally, should we continue to own equities?
The answer is a resounding yes. Are valuations beyond historic norms? Yes. Will we see sell-offs? Yes. But where else can one allocate? Cash? We argued that we do not see a normalisation of monetary policy, your purchasing power is eroding by the day. On a side-note, looking Stateside, the recent news has been the Treasury asking banks to disclose a greater amount of detail on customer transactions (i.e. to the IRS). This is a sign of where the wind is blowing. We would rather own good businesses that generate cash flow and maintain our purchasing power as opposed to what is effectively an unfunded state liability.
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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.