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Private Client Letter - July 2014
The US economy is bouncing back.
Payrolls jumped by a robust 288,000 in June, bringing the unemployment rate down to 6.1% from over 10% in November 2009. It was the fifth consecutive month of growth over 200,000 for the first time in 14 years. Morgan Stanley’s Business Conditions Index rose three points to 62% as increases in hiring and capital expenditure underpinned a strong gain in expectations. The impact of a harsh winter has proved shortlived.
The upturn rests on increasingly firm foundations. The federal budget deficit has fallen from 9.8% of GDP in 2009 to 4.0% last year. The trade deficit has declined from 5.6% of GDP in 2006 to 2.8% in 2013. Household debt service payments have fallen to their lowest share of household income since measuring began in 1980, and corporate balance sheets are the strongest in recent memory.
U.S CORPORATE CASH AS % OF TOTAL ASSETS
The natural consequence of the pick-up in economic activity is higher inflation, and the Personal Consumption Expenditure Deflator accelerated by 1.8% in May from the low of 0.8% last October. The US labour market is entering the zone where wages start to rise, which will provide important income support for the household sector, reinforcing the upturn. Inflation will also be lifted by tighter rental markets, reduced disinflationary pressure from imports and rising producer prices.
Are we there yet?
Does accelerating inflation herald the bottom of the interest rate cycle? Certainly wages growth would be a strong signal to the Fed with its twin mandate of price stability and maximum employment to commence the process of returning interest rates to more normal levels. However, despite the pick-up in inflation, demand for Treasuries has continued at high levels for a variety of reasons:
- alternative sovereign bonds have become relatively unattractive. For example, Treasury yields are at a multi-year premium to German Bunds, reflecting the inflation differential between the two countries. Even Spanish 10 year government yields have fallen to the levels of the 10 year US Treasury as sovereign debt fears have faded!
- tighter regulatory requirements for banks and insurance companies require higher levels of risk-free assets;
- the funded status of pensions has improved on the back of higher asset prices, leading the managers increasingly to immunise their pension portfolios by purchasing long-duration debt;
- despite elevated debt levels, the world still has a savings glut. High household savings in China and Germany, together with huge corporate surpluses in Japan, Germany, the US and UK, are providing structural support for safe assets:
THE GLOBAL SAVINGS GLUT IS DEPRESSING
- geopolitical tensions have boosted demand for ‘safe haven’ assets;
- Chinese foreign exchange reserves, substantially invested in Treasuries, continue to rise.
All these factors are coming together at a time that the fiscal position of the US government has strengthened considerably over the past 2 years and fewer Treasuries are being issued. This has held Treasury yields down.
Janet Yellen, Chair of the Fed, has dismissed the pick-up in inflation as ‘noise’ and maintained her overtly dovish policy. She foresees policy remaining loose ‘for a considerable time’. Some have questioned whether she has a good handle on the data! Perhaps she should rather be seen, like Deng Xiaoping in China in the 1990s, as ‘crossing the river by feeling the stones’. Tapering is an experiment, as will be the next step of raising interest rates back to historical averages in the face of high leverage levels. Mrs Yellen – and investors – are in uncharted territory.
Scanning the horizon
In addition, Yellen will be balancing the short term uptick in inflation against the strong secular forces of disinflation. This is a key point. If inflation remains low and stable in coming years, the investment context will remain benign. A jump in inflation is the most likely catalyst to disrupt the backdrop.
What are these strong secular disinflationary forces?
- Demographics - the world’s population is ageing, which means slower labour force growth and slower income (and spending) growth.
- Globalisation - causes wages around the world to converge, which is good for emerging market workers but not those in developed countries. So far this has been limited mainly to the semi-skilled sector but is now spreading to the much bigger service sector.
- Digital technology - enables the substitution of labour with capital, again so far primarily to the detriment of blue collar workers, but now spreading to white collar service employees.
- Rising income equality - the rich are getting richer, but they spend a smaller proportion of their incomes.
- High levels of leverage throughout developed economies. This is the reason that quantitative easing has boosted banks’ reserves but not found its way into the real economy.
Thus, while a cyclical upswing in inflation is anticipated, inflation is unlikely to prove a monster in the longer term.
Should investors fret about the elevated levels of markets? Certainly equity valuations are full after the rises of the last few years, but year-to-date returns have been driven more by earnings per share growth than multiple expansion, which is healthy.
S&P 500 YTD RETURN DECOMPOSITION (%)
The economic recovery may be expected to boost profits further, which would provide a support to equity prices. The US is in a cyclical ‘sweet spot’.
On the other side of the Atlantic, the Governor of the Bank of England, Mark Carney, also crossing the river by feeling the stones, appears to have stumbled over the prospect of next year’s General Election. Despite the UK housing market over-heating, he has eschewed interest rate rises, instead opting for toothless mortgage lending limits that even he admits will have a minimal effect.
In extremis: negativity
The €uro economy, in contrast to the US and the UK, is struggling. Export demand is constrained by the strength of the €uro and the slowdown in China. It had been hoped that German consumer spending would pick up the recovery baton based on robust jobs growth. However, the addition to jobs has gone mostly to the unemployed youth from Club Med and East European countries who have been pleased to work for substantially lower pay than German nationals. Annual wages growth has fallen from 4% in the first quarter of 2013 to only ¼% in the first quarter of 2014 as a result. With pay gains below inflation, consumer spending has been sluggish.
Thus the President of the €uropean Central Bank, Mario Draghi, is navigating his river in the opposite direction to the US and UK, and fighting the threat of deflation. Deflation increases the real value of debt, which can be dangerous for an economy struggling with high leverage. In his efforts to stimulate growth and weaken the €uro, he has taken the extreme measure of cutting the ECB’s deposit rate to a negative -0.1%, as well as offering the banks €400 billion in cheap loans with built-in incentives to spur lending.
These measures weakened the €uro for all of an hour before traders scooped the currency up again. A strong €uro reduces export competitiveness and import prices, aggravating deflationary tendencies. Draghi has been resisting quantitative easing, but that may be the only way to bring the currency down. Structural reforms, especially flexibility of labour, are also essential. The Club Med countries have embarked on them, but more are needed.
In Japan, Prime Minister Abe’s efforts to counter deflation have progressed from his first two arrows of fiscal and monetary stimulus to his third arrow of reform. Nine reform bills were passed last December, including in agriculture and electric power, while a cut in the corporate tax rate is in prospect in 2015. However, none of these address the fundamental issue, which is the lacklustre consumer spending of an ageing population.
China’s government is moving forward on their reform programme at a more rapid clip than Japan. Some state-dominated sectors are being opened for private investment, including banking. Controls over deposit rates will be lifted in the next two years, to follow the freeing of lending rates in July 2013. Reforms are also planned for agriculture, urbanisation, healthcare and education.
Environmental protection is on the agenda too – but on this score, Beijing’s greatest challenge will not be pollution from factories and cars. It will be the increases in cow herds as the Chinese people upgrade their diets to consume more protein! Carbon dioxide from fossil fuels is the primary man-made gas warming the planet, but methane’s global warming effect is 20 times greater than that of CO2. A typical cow’s burps emit 250-300 litres of methane a day, enough to power a car. A White House climate initiative has launched a search for the ‘cow of the future’ whose greenhouse gas emissions would be cut by anti-methane pills or gas backpacks.
Investing in complexity
We are investing in a complex and changeable environment. Policy makers are unable to predict with confidence how their actions will affect the economy. Greenspan as recently as November 2013 observed that ‘forecasting is somewhat of a coin toss’.
Against this backdrop, we believe that the Veritas approach of focusing on the combination of fundamental drivers and valuation is entirely appropriate for the long term investor seeking real returns, ahead of inflation. We do not try to time entry and exit of equities in aggregate; rather we adopt a rifle shot technique. As and when we find companies that meet our criteria - sound businesses, financially strong with a competitive edge and a moat, and with the equity trading at a discount to our own intrinsic value - we will invest.
The filter of our themes directs our stock selection at present to structural growth companies (‘rising tide’), those with sustainable competitive advantages in attractive industries (’industry winners’) and those with pricing power (‘scarcity and supply constraint’).
One of our core ‘rising tide’ structural growth sub-themes is healthcare. The ageing of the population increases medical product utilisation while emerging market economic development increases access to healthcare. In addition, ‘Obamacare’ will be boosting healthcare volumes.
U.S. NATIONAL HEALTH CARE EXPENDITURE GROWTH
We have added Baxter to portfolios where appropriate to the mandate. Baxter develops and manufactures medical devices and pharmaceuticals to treat primarily haemophilia, immune disorders, infectious diseases and kidney disease. It is global in its reach, manufacturing in 30 countries and selling in 100.
Concerns that Baxter, like many pharmaceutical companies, is facing generic competition to key drugs such as high margin Suprane (induces general anaesthesia) has brought the share price down to levels that are at a discount to our intrinsic value. However, Baxter has several products in the pipeline to mitigate the impact of generics. Furthermore, life-saving treatments such as haemophilia and immune deficiency should avoid utilisation restrictions in budget-constrained developed markets and are at the forefront of emerging country healthcare systems.
Baxter’s free cash flow is strong and management has bought back over $1bn in shares in each of the last two years. Dividend growth has compounded at 15% p.a. over the last 5 years, and the share is on a prospective yield of 2.7%. We find that attractive.
9th July, 2014