Sunday Supplement – 20/06/2021

Jun 20, 2021

Welcome to the supplement as we motor through the year at a furious pace – next week’s supplement will represent the halfway point through the year, can you believe it? A great time to review goals and kick on in what has been a diverse and particularly tough trading environment, but is seeing far more people come out of it in far stronger shape than was expected.

This week I want to go macro and focus on some of the major points that have emerged over H1 2021, and also discuss some of the major macro events of this week – mostly overseas, but with potential UK implications. The federal reserve has spent the time talking up inflation, knowing that every word they utter has an impact on markets – and markets as a whole haven’t really bought into it too much. Plenty of commentators without that sort of dog in the fight – who are simply expressing opinions, to generate content, debate and build their credibility, as always – have also been on this bandwagon (myself included of course) – with their own beliefs as, generally with economics, various schools of thought battle against each other and THEN they all battle with reality – the emergence of Modern Monetary Theory towards the mainstream would be a good example of that, because it is difficult to deny the magic money tree (MMT) has been alive and well over the past 15 months, without, at this time, significant consequences (but they come later, of course).

There’s plenty who believe inflation is transitory here, caused by the pandemic and supply shifts/shocks (and surprise demand) – and plenty also who believe it will be persistent or even secular (long-term persistent). There are so many ways to approach that debate it would take at least a month of supplements to deep-dive into all of them. But many should remember, what’s REALLY the point of all this to the readers of the supplement (or what I understand to be the readers, from those that comment, like and share every week) – the real point is the “so what” for the UK property market; mostly resi, but commercial and development sites too.

I think some readers have taken my beliefs around the inflation direction of travel to mean that rate rises are going to be a) significant b) soon and c) sustainable. I’m not sure I believe much of that at all. There has been a significant shift in the Federal Reserve stated policy (I think it is wise to ALWAYS say stated policy, rather than actual policy, because of the way they play with words to get an impact) – they had quite literally said they were moving to unemployment targeting in the first half of this year (implying they were not targeting inflation), and now have, this week, brought forward their previous forecast of rates rises (which was not until 2025, stated last year) to 2 rises in 2023. They haven’t talked about the quantum of those rises, but I would suspect they are still thinking in 25 basis point increments.

The US does have an unemployment issue at the moment, but the market needs to work itself out. Data will follow but there have only been a few months away from home schooling placing extra demands on adults and work time, and migration figures are difficult to trust over the past 12 months (or at any time, because of the volume of non-documented immigration) but there certainly seems to have been a massive impact in the UK, and as an economy that imports a huge percentage of its low-paid workers, it is fair to project this to the US. This was the language used by the Fed – looking at an unemployment rate of 6% when it was around the 3.5% mark pre-pandemic is a good reason to target unemployment, but as always the skill is in what’s not being said, i.e. we will let inflation run away before rates are rising. That time window has effectively, this week, been shortened by a couple of years. This could just be because of better than expected post-pandemic data, naturally – the stimulus “experiments” in both the US and the UK, combined with scaring the hell out of a decent percentage of the population, AND stopping them from spending money on some of their favourite pastimes like meals out, days away, holidays, etc. etc. – did not have a known consequence. At this time, the consequence has been for consumers to pay down debts, and hoard cash. That’s changed a little bit, but not as materially as yet as someone like Andy Haldane, outgoing Chief Economist of the Bank of England, has been talking about and predicting (although, again, I would query the gap between what Haldane HAS to say given his position and his real views).

There are all sorts of thoughts about the delay in unlocking until “at least July 19th” (or is it – there seems to be chatter that it could be brought forward if the data does improve). For the 634th time it seems the curve is flattening again on new cases, the rate upwards is not as fast as it was last week (although it is still going upwards). Clean data is very difficult to find to draw sensible conclusions from, so I will steer clear of that one – but anecdotally, I would point out a few conversations with a few friends that I’ve had in the past two weeks. The cliff notes are that distancing, masks, etc. take the edge off the customer experience (of course they do) and so people are not bothering at anything like the rate they were. More entertaining at home than going out. “Proper” days out to a sporting event (for example) still deferred as the draconian rules put people off. I struggle not to see that being the opinion of a large slice of people.

With plenty still unwilling to board a plane, the move towards amber list countries being allowed to visit without quarantine if double vaccinated will be looked at by some as a bribe to get the vaccine for those who are unsure, sceptical, or too young to really feel like they need protecting/concerned about the side-effects (whether this concern is justified or not, is not where I want to go with this conversation – save to say, I support a free society and moving away from that needs really significant justification). I’ve long said “wait until you can’t get a cheap flight to Spain without a vaccine and see what happens” and that looks like it might have been an accurate call, one way or another.

While this continues (and I have seen a number of references to winter provisions and what will be happening, and am cautious of the language in use at government level) it is difficult to see a full, brakes-off plough forwards. As such the inflation that IS transitory (and, as an aside, almost guarantees some transitory deflation in the next year or so, because commodity providers are all hands to the pumps while the going is good but notoriously bad at switching off the taps when things go south) is not being as pumped up as it could be by genuine aggregate demand by those who have built warchests thanks to restricted spending opportunities, and property price rises in their own homes, amongst other cheap money and stimulus.

Much of central bank decisions is about timing. Before going into the Fed meeting on Wednesday, the corporate high-yield bond sector (junk bonds) were running at a negative real yield (returns, minus inflation) for the first time on record. That does of course make a bit of a mockery of the sector! (High yield, anyone?). REITs were even lower. (be fair, the headline rate in the US is 5% right now, so that puts it into context versus the UK 2.1% – it is their highest reading since August 2008). Bonds sold off aggressively, whilst the stock market was relatively calm. But bonds have already sold off earlier this year raising yields, and as yet this is not a massive issue (compared to past taper tantrums). There’s a bit more to say about bonds later (and why it is important to consider them and their attractiveness, or not).

So – the long-term relationship between inflation and interest rates has not entirely broken down. Some really strong inflation numbers in the US have moved expectations significantly of the people on the Fed committee, although they have still explicitly said they will ignore all 2021 inflation numbers because of the base year being all over the place (not that we are back to normal yet, as discussed). However, they are still talking of looking at averages rather than the rate today, and the average in the recent past has been “well below” 2% which gives some rope for it to run “somewhat above for some time” in order to achieve what they consider to be full employment. So the official line is still the focus on unemployment with inflation being secondary – the average rate coming out of the US committee members at the end of 2023 looks like about 0.75%-1%.

The UK has a different backdrop. Lower unemployment at this time with a central bank forecast of 5.5% as the nadir – the US are not yet back there (5.8%) – but still high from where it was. An average over the past 5 years of below 2%, but, principally as a result of the referendum, nowhere near as far from target as the US’s was. Sterling has also strengthened since the post-referendum 15-20% drops it saw against major world currencies, although it has weakened against the dollar this week on the back of that news. In recent times the UK has been far more cautious and slower than the US on the interest rate increasing front, and my view is that the BoE will potentially think in 10 or 20 basis point moves rather than 25 point moves as the US seems keen to stick with.

Bonds need further investigation this week because the idea that some throw around – “the central bank just buys them all” simply isn’t true. In the US less than 20% of those bonds issued between 1 Jan and 30 Apr 2021 were bought by the Fed. There appears to have been HUGE rebalancing between equities that have gained a lot in the US with the many market all-time highs that have been hit, and the reality that there really is not a lot of other places for this money to go. $785 billion has been put into bond funds, net, over the past 12 months in the US and this is at relatively deep negative yield. This is at least partially because there are time-dependent points for investors – retirement age. Kids get to college. Etc. So you either stay heavily overweight in stocks as the only thing providing a real return, OR continue to diversify into bonds to preserve funds as you near a target. Hobson’s choice, when stocks look as expensive as they do in the US right now.

UK pensions are a key part of this – a drive towards taking less risk in defined benefit schemes (i.e. final salary) has seen a massive move towards bonds in these funds, moving to 80% bond 20% equity (from 60% equity 40% bond). That’s an incredible prop for bonds that won’t continue as DB schemes “play out” due to their lack of usage in today’s world. (Apart from, of course, the state sponsored DB scheme – which is not linked to final salary, but is defined benefit – and which grows every year).

The point made here is that this is not far from financial repression – true, it is not legislated (which is a definitional requirement of repression) – but bonds are arguably massively overpriced due to the horrific real yields, and yet have lots of “willing” buyers.
My argument here would be that this is unlikely to persist in the long term. Within a couple of years (accepting there is SOME inflation here, whether it be transitory, persistent or secular) this will be more broadly spoken about – the age-old closing of the stable door after the horse has bolted. The alternatives will then be widely discussed. Heavier equity balance? Just won’t sit with pension fund trustees. Higher equity risk premia needed to pay for the bond drag on returns? Difficult one. A decent slice of the market doesn’t need bonds – mutuals, hedge funds, etc. etc. Pension funds need a certain rate of return and if 80% of a fund is returning a negative real yield, and barely a positive nominal yield, the other 20% will have to take incredible risks. That needle will need to move, OR that 80% will need to move to REITs or similar sorts of vehicle (not necessarily property based, but the future for build-to-rent/massive PRS schemes looks bright, IF the mix can be got right, which I am nowhere near convinced yet is the case). REITs looking at other resi – Grainger-style (or perhaps I should say old-Grainger-style) portfolios sweating the higher yield terraced stock in secondary locations, or social-housing focused exposure (institutions already get this through the bonds which have tended to only be returning c. 2% nominally in the past 12-18 months, so breaking even or losing money in real terms, but still 1.5-2% ahead of some gilt yields) – other commercial stock doesn’t look so “bond-reliable” after the pandemic and an even longer runway to get on an even keel from March 2022 or perhaps beyond.

These alternatives can’t fill the whole requirement, and we will need to see how far the bond tantrums go – and what happens if and when the Bank of England take a similar approach to the Fed (probably 6+ months away as yet).

The decade-long view I still have, however, is that the economy will struggle to support base rate at above 1% in any material way. This was my view last year when we were in the early stages of lockdown 1.0, and has yet to change. The massive productivity boost from working from home looks smaller and is potentially a complete red herring with a variety of challenges raised – the big losers are the city centres and associated businesses, but they will reinvent themselves – the big winners are the tech companies and the gig economy, but none of this is great news for productivity in and of itself.

This would, of course, be 10 times the current base rate – but not the “Widowmaker” that a significant hike in interest rates would represent. Bonds will sell off, but there will be some cushion in the massive demand for bonds. Equities will also sell off, but value stocks with sufficient yields and (deemed) “safe” cashflows could be in more demand than ever before, and the level of disruption thanks to Covid offers new opportunities and tomorrow’s growth stocks also.

As for the past decade, it looks like the US will move first. It might be fair to say that the markets are now tuned into the fact that Brexit will not be the promised armageddon by the Remain side of project fear. (Not that it will be the land of milk and honey promised by the ardent brexiteers either, of course). No-one remotely central will be surprised by that statement. We will as a national economy once again have the US to road-test the mature industrialised economy way out of the totally flat interest rate environment. There will still be curve balls – what does an independent Scotland look like for example – likely better than the markets will think, but there will be huge frictional costs if that is to happen, although this looks less likely than 12 months ago for a variety of reasons. Northern Ireland remains a significant curve ball because of the unworkable Irish Sea border, which the main plan seems to cover “pretend it isn’t really happening and just say some stuff” – on both sides of the equation. “Le sausage” or should I say the outgoing president of France, most likely, has covered himself in similar glory to Mr Johnson on that front.

The long-term view of the Fed is around 2.25% interest rate – I’m not sure how long-term that is, but that might be their idea of the end of the decade – the next recessionary event incoming by then, no doubt, which will have things back to zero…….the Bank of England were at around 2.5% in 2018 for a mid-2020s view, I think that’s genuinely reset to 0.5-0.75% at this time, and struggle to see over 1% by 2030 – not impossible, but under 30% probable, in my view.

At the risk of cutting things “short” by the typical 4000-word supplement, I was tempted to leave it there – but at least want to introduce another situation that will be called back over the next few months, I’m sure. That is Zombies.

Not the type that make great or rubbish TV/movies, depending on your preference, but zombie companies, and zombie landlords. The stimulus money has propped up some absolute nonsense in the past 12+ months, and the zombie landlords (bought large portfolio, no money down, in 2003-2007, have done nothing since and are weak on asset management, and have spent all the liquid proceeds plus remortgage monies) are even better off that before as they are inevitably on base plus a small margin (0.99, 1.49, often) – and I see no evidence of them changing their spots and habits of the past 12+ years. Zombie companies will be a drag on productivity, and lead to a slow death and non-repayment of bounceback loans and beyond, while they bleed out over the next few years. One more reason why returns won’t look superb and why aggregate demand will be somewhat suppressed – only a small percentage, but a meaningful one. In the UK we are 20% below the previous low of the last 28 years of corporate insolvencies, by number. The bankruptcy clerks are going bankrupt faster than the companies…….the theoretically smart money at the moment seems to be operating on the basis that right now, everyone is too big (or too important) to fail. The wind WILL change there (in the US first of all, most likely).

Until next week – good luck, keep calm, stay safe and invest with confidence but manage downside risks. I’m hoping auction is more fruitful this month – and have my eye on quite a bit more than several months ago. I will of course report back after the events! We might only be 10-11 days away from a fair few chain breaks, as I am hearing of lots of cases that “must” go by the end of the month…….