31st May 2014
Fund Managers are often accused of being permanently positive about the asset class in which they invest. Not so. In this very frank insight article, John shares his very downbeat views on the current state of the UK economy.
John Wood, manager, JOHCM UK Opportunities fund
The classic 1990s film 'Groundhog Day' sees Bill Murray's character, arrogant weatherman Phil Connors, trapped in the same day, destined to repeat it again and again but with everyone bar Connors in the small town of Punxutawney unaware that their lives are stuck in an endless loop. Upon realising his fate and that his actions carry no consequences, Connors initially engages in a bout of hedonistic, reckless behaviour before beginning to re-evaluate his life and priorities.
Forgive this cinematic detour, but there is more than a hint of Groundhog Day about the stock market at the moment; a nagging sense that we have been here before, albeit with few signs among the professional investment community of the self-reflection to which Connors eventually succumbs.
We see elements of both 1999/2000 and pre-crisis 2007 in today's stock markets. The ludicrous valuations which technology stocks reached earlier this year, which surely reached their zenith with the bonkers valuation achieved with the AO IPO, certainly were redolent of the technology mania from the end of the last century. The subsequent savage sell-off in technology stocks since early March was swift and painful, but the fact that valuations were able to achieve such levels was a reminder of this industry's pre-disposal to amnesia.
Meanwhile, we also see plenty of behaviour that carries echoes of the pre-crisis years of 2006/2007. We have economic growth in the UK that still appears to be founded on debt and a London-centric housing market bubble. UK consumers remain horribly over-leveraged but cling on thanks to rock-bottom interest rates. Indeed, if anything, they appear to be increasing debt. What consumer recovery there is, appears to be confined to London and the South-East.
With the benefit of personally not being based in the South-East, my sense is that conditions outside of London and the South-East remain difficult and that the consumer remains challenged. Improving car sales are cited as anecdotal evidence of a reinvigorated consumer, but one-off PPI refunds have probably played an important role here. If we look to the United States, where I am even more pessimistic about the recovery, it is noteworthy that sub-prime car loans stand at record highs. If this is a recovery, it is one only being enjoyed by the very wealthiest in UK and US societies; the rest are resorting to debt and running down their savings just to try and keep up.
M&A back for all the wrong reasons
Elsewhere, mergers and acquisitions (M&A) are back and investment bankers continue to rule the world, a situation that usually ends badly for investors. The mooted AstraZeneca takeover by Pfizer underscores this point, representing the triumph of short-term financial engineering over investment for genuine long-term growth. This was a US$60bn deal that was being pursued for all the wrong reasons, namely tax management, as well as being a defensive move in response to government spending cuts in the US and Europe hitting healthcare pricing. The right way to resist pricing pressure is to innovate and create new products with pricing power. This attempted move by Pfizer suggests it has little confidence in its ability to be able to do this.
The failure of QE
The pricing cuts within the pharmaceutical industry are just one example of deflation in action. The unprecedented experiment with quantitative easing (QE) in the West led many commentators to anticipate an inflationary surge. But the biggest risk to economic policy makers is now not inflation but deflation; indeed, it is because of falling prices that real wage growth has finally turned positive in the UK, rather than any largesse on the part of employers. In my opinion, the unstated intention of QE was to unleash inflation that would erode the real value of the debt mountain built up within the UK (and the US). Judged by this goal, QE has been a stunning failure.
Why has this deflation arisen? The answer is overcapacity. Thousands of weak businesses that would have gone to the wall in a 'normal' recession have been able to limp on; the corporate living dead, sustained by cheap financing from the high yield debt markets, or banks applying a sticking plaster to non-performing loans.
The monetary drug of QE has lit a fire under stock markets, but what was needed was genuine structural reform of the UK economy towards a more balanced economy less dependent on financial markets and property. Depressingly, there has been scant evidence of any progress here since the crisis first hit.
Sticking with our two rules
It should come as no surprise, given the elevated cash level in the Elite rated JOHCM UK Opportunities fund and our downbeat commentary, that we struggle to find any value in today's markets. The liquidity-driven rally in stocks since the launch of QE has propelled long term, cyclically-adjusted valuations to above those of 1929 and every other stock market peak other than 2000.
Markets have re-rated enormously since the depths of 2009, yet there have been no underlying improvement in corporate cashflows to justify this re-rating. If we have a preference, it is for the 'dull' engineers and chemicals companies that perform mundane, traditional activities, but even in these sectors value is hard to come by. We maintain our absolute valuation discipline and, borrowing from Mr Buffett, stick with our two rules: “Rule No.1: Never lose money. Rule No.2: Never forget Rule No.1."
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. John's views are his own and do not constitute financial advice.