Investment Newsletter October 2018
Night of the Living Debt Halloween is a time for spooky goings-on. The financial markets are also pretty jumpy at the moment, wary of horrors that may lie beneath.
American Horror Story?
Neal Foundly Investment Analyst
Equilibrium Investment Management
As we have highlighted recently, the US economy is booming. Growth is strong with low unemployment and high corporate profitability (much of this profit growth is due to President Trump’s large-scale tax changes introduced at the end of 2017). That’s fine, but ordinarily at this point in the economic cycle when growth is self-sustaining and many of the productive resources are at capacity, there is no need for further stimulus. To prevent the economy from overheating, the US central bank, the Federal Reserve, is raising interest
rates. This draws money out of the economy and reduces the capacity for greater lending to fund growth. The problem here is that you have two opposing forces which can cause major issues for the economy. It’s like driving a car with one foot on the accelerator and one foot on the brake – at some point, something’s going to go bang.
Zombieland The emergence of the zombie in contemporary culture is thought to have started with George A. Romero’s cult film “Night of the Living Dead” which this month celebrated its 50th anniversary. Featuring a nightmare story about the dead coming alive to terrorise the living, the film made $30m at the box office but only cost $114,000 to make.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter October 2018
In financial terms, a “zombie” fares less well. A zombie is defined as a company that is unable to pay its cost of debt from profits over an extended period. These “living dead” companies are not only on the verge of death but reduce economic activity overall by using resources that would be better used by more productive firms.
that their probability of remaining a zombie for another year has risen sharply as well, to 85%. The BIS study also found “that when the zombie share in an economy increases by 1%, productivity growth declines by around 0.3 percentage points”, reflecting the wider cost to the economy of the misallocation of capital to these enterprises.
A low interest environment has provided an ideal environment for zombie companies to escape death because their interest costs were reduced so dramatically. However, with interest rates now rising this could prove fatal for such companies. To illustrate what is at stake, the Bank for International Settlements (or BIS, known as the bankers’ bank) recently produced the following research in Chart One. The blue line (LHS) shows that these companies now comprise around an incredible 12% of all non-financial quoted companies in the major stock markets, up from around 3% in the mid90s. The low interest rates have meant that the zombie firms have been surviving for longer too. The red line (RHS) shows Chart 1: Simple averages of zombies as a share of all listed non-financial firms from Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, UK and US. Firms with an interest coverage ratio less than 1 for 3 consecutive years and over 10 years old.
Source: Banerjee and Hofmann (2018), Bank of International Settlements
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter October 2018
The Evil Debt
Of course, the big issue here is debt. Debt is inevitably the devil that brings most economic cycles to a halt. Not only is the cost of debt rising but the amount of debt held by companies (as well as consumers and governments) is higher than prior to
the previous crises. If we look at Chart Two of total corporate debt in the US relative to income (red line measured by GDP), we can see that it too has risen to relatively high levels. The grey shaded areas show US recessions.
Chart 2: US corporate debt vs GDP
Shaded grey = US recessions
The Omen
So, what causes this corporate binging of debt in the latter stages of economic cycles? As optimism grows about profitability, especially when costs of capital are low, managements become over-confident and start empire building with expensive corporate action. We can see this in the number and size of takeovers in the stock markets. Look at Chart Three, which shows the total value of deals worldwide valued at $10bn or more.
Source: Gavekal Data/Macrobond
Note that large-scale corporate activity tends to spike a year or so prior to recessions such as those in 2001 and 2008. These are not only some of the largest deals but also some of the worst ever in terms of shareholder value destruction. The record number of deals in the chart for 2018 (that only go to mid-year and excludes bids such as the Comcast purchase of Sky for ÂŁ30bn) is a trend we are watching closely.
Chart 3: US M&A activity since 1998
Source: U.S. Global Investors
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter October 2018
Who you gonna Call?
Of course, this newsletter has focused on some of the darker aspects of the markets today. We are not naturally Cassandras in terms of our outlook, more realists in terms of understanding the state of the economy and the motivations that drive allocators of capital. With the danger of excesses at the end of market cycles, we agree with Warren Buffett when he said: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs�. We have particularly heeded that advice in the portfolios with relatively larger weightings in alternative equity and cash which have low correlations with equities and bonds, as well as defined returns products that offer a degree of capital protection in the event of a significant downturn. Indeed, it’s not all gloom and doom. We have put the cash to work as the FTSE 100 fell from its high of 7,904 in May
with the purchase of a defined return last month at around 7,300 and an index tracker fund for a volatility trade at around 7,200 this week. We have also increased our outlook score on equities over the last 3 months from -3 to -1 reflecting our rising expectations of returns from stocks over the next 18 months as prices fall. Overall, we think at this point it is right to be opportunistic but remain vigilant for the more pervasive forces that may lurk as the current economic cycle matures.
Disclaimer: The content contained in this newsletter represents the opinions of Equilibrium Investment Management. The value of your investments will fall as well as rise. The commentary in this newsletter in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter October 2018
General Economic Overview Investors have reacted with risk aversion to some of the growing geo-political risks, in particular the trade tensions between the US and China and the Brexit negotiations. Many bond and equity markets have seen a pick-up in volatility with declines over the last month. Economic indicators, however, still point to growth across most major economies. The US economy, fuelled by fiscal stimulus, is seeing record levels of employment and the markets are anticipating further interest rate rises to help restrain inflationary pressures over at least the next few quarters. In the UK, growth has been steady but more sluggish given the uncertainties surrounding the Brexit negotiations. Against this background, we see little scope for interest rate rises by the Bank of England for at least the next six months. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets After recent falls, the UK and Japan markets are looking undervalued with China fairly valued at current levels and the US still expensive compared to its historic valuations. After recent sharp falls in equity markets in general, we have raised the score from -2 to -1 since last month.
-1
Fixed Interest Bond returns are likely to be positive but unspectacular in our view. The recent sharp sell-off in gilts underlines our preference for corporate bonds and there is only a relatively small holding in index linked gilts in the portfolios to provide a hedge against a sterling-driven inflation shock.
-3
Commercial Property Prospects for the asset class remain mixed. We still wish to avoid London offices and much of the retail sector. However, we are more optimistic about the office sector in regional cities. The industrial sector is reaching new highs in valuations and so we are avoiding further acquisitions in this segment of the market.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-3 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest, property and equity. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent EIM’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.