144. Why confusion over conviction will lead to bouts of volatility

29 July 2021 (pre-recorded 20 July 2021)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Chris Salih (CS): Hello and welcome to the Investing on the go podcast. I’m Chris Salih and today we’re joined by James Mahon manager of the Elite Rated Church House Tenax Absolute Return Strategies fund. Thanks for joining us today James.

James Mahon (JM): Hello.

[INTERVIEW]

[0:15]

CS: Inflation is obviously the sort of bogeyman in markets at the moment. It’s the buzzword, it’s all the talk. A bit earlier this year, you said that you were optimistic for the year and that the perception of inflation was more cause for concern than actual rises in inflation, the story may have moved along a bit. Could you maybe give us your view today? Has it changed? Is it more endemic? What’s your overview on inflation and the threat?

JM: Right, yes, okay. Well, it’s always unnerving to be reminded of something I said six months ago, but nevermind. Thinking back, I suppose it was a bit of a curate’s egg of a prediction, wasn’t it? I would say that I was right to be optimistic for the economy. I’m still optimistic for the economy. I think it’s going to carry on growing, obvious caveats around COVID.

The inflation perception point. Yes, inflation perception is very important, in particular, in the way that it influences wage expectations. That’s still important. But what’s changed is that the actual inflation figures are coming in rather higher than was expected. And that’s slightly not in the playbook.

Perhaps if I just step back a stage and just remind us that inflation was always going to be a problem this year, in terms of the figures, the figures are always going to go up. And if you go back to a year ago, the oil price, what in April 2020, the oil price went below $20. Recently it’s been up around $75. Incidentally, I think that’s probably the top of it, but nevermind. So what you can see is the comparison between last year and this year, we were always going to produce higher inflation figures this year, but they’re coming in even higher than that.

So the US inflation figures are probably the least messy and we’ve seen, we’ve seen two figures, 5% and 5.4% for US CPI inflation for May and June. And if you ignore a blip during 2008, when all hell was breaking loose, that’s levels we haven’t seen since the early 1990s. The UK is obviously not quite as bad in terms of headline figures, but that pattern is the same.

I think what wasn’t really anticipated was the extent of the production bottlenecks. So spending is recovering very rapidly. We’ve all been able to preserve our funds thanks to rapid government action. And that’s true in all the major Western economies. So demand is there. And as we get out again, demand is coming back in a big way, but the supply is just not there. There are bottlenecks all over the place and we’re hearing lots about it. So we’re hearing about semiconductor chips for cars, and we’re hearing about transport bottlenecks. And most importantly, we’re hearing about bottlenecks in the actual availability of staff and of course the recent, this recent problem with everyone being pinged. So that is leading to, of course, it’s leading to higher prices.

I think it’s worth just throwing in a number because it’s quite, I think it was quite interesting: European car production this year is actually down by 25%, but the demand is at the highest it’s been for the past five years. So way back before COVID, and of course that means the prices are going up. So the central banks are all maintaining that this is a temporary blip.

[4:11]

CS: Great. If we could just maybe go into an example of the impact of inflation in the longer term, to some of the listeners, could you maybe give us one to just show the actual impact and why it’s such a relevant question in markets at the moment.

JM: Well the big conundrum for markets at the moment is that of long-term interest rates. So despite these two recent, very high inflation figures, interest rates have actually fallen over the past couple of months. They jumped in the first quarter of a year and that was quite uncomfortable for bond holders, but in this last couple of months, when we’ve had these very high inflation figures, interest rates have actually fallen. And that is a real conundrum. And the question is why are they so low?

So maybe if I put some numbers on this. If I buy a UK government gilt, a blue chip investment if there ever was one, with a 50 year time horizon, I’m getting an interest for return of less than 1%, it’s actually 0.3% at the moment. Why? Why is that when inflation is running at 2.5% at the moment, and the Bank of England has a long-term target of 2%. In other words, the interest yield I’m getting on this is actually negative. So it’s a negative real yield.

Again, just trying to put that into numbers. If I invest £100,000 in that 50 year government bond now, it’s going to be worth £55,500 in 2071, and that is only a rational investment decision if prices are going to fall. And do we really think prices are going to fall to that extent? So perhaps I should be looking for a more pertinent example? I was looking at house prices. The current UK average house price is somewhere around £250,000. If you presume that sort of deflation that is implied by that bond yield, you’re saying that the average house price in the UK in 2071 is going to be £139,000. Do we really think that makes sense?

CS: You’d hope not.

[laughing]

[6:41]

CS: Just to turn to another couple of things. So there’s sort of two sides to the coin. Firstly, the worry is that perhaps it’s slightly more endemic, that inflation is more endemic, than perhaps we thought at the start of the year. The other side is how central banks react to this.

I’m going to go back to another one of your market commentaries now from more recently, where you said the Federal Reserve will start tapering its bond buying program in the final quarter of this year, how do you think markets will react to that? And how do you think you will position your fund as well to react to that? And maybe give us a bit of a longer-term view, there’s been talk of more tinkering with interest rates in 2023, perhaps more recently than perhaps has been seen. Just give us a slight overview on that as well, please.

JM: Okay. Well I think, the US Federal Reserve has a dual mandate, so it has this, they aim to keep inflation at around this 2% level. But they also aim for full employment. So you have to consider those two aspects to it and what the implication or what they’re actually saying now is that maybe, they’re going to have to raise interest rates slightly earlier than they’d previously thought. They have this awful thing called a dot plot, which is the level of interest rates expected by all the different people on the federal open market committee, but the point is, they’re expecting them perhaps to be a bit higher. And I think it’s certainly true that the Fed will not be comfortable allowing too much of an inflationary over shoot. They don’t like that.

And at a time when the employment figures have been getting better, and I think the employment figures are going to get a lot better over the last couple of months. So it’s going to be increasingly difficult for the Federal Reserve to keep rates down. The first thing they have to do is this awful thing called taper. Otherwise as they cut back on the amount of bonds they buy. And obviously if a big buyer backs away from the market, there’s probably a tendency for rates to go up. And we saw, again to go back to the first quarter of this year, when we saw long-term interest rates jump, what you see of course is the capital value of the long-term bonds go down quite sharply. And that’s going to be the bit that the Fed has to be very careful about. I expect these long-term rates to reprice at some stage. Re-price is a funny word for fall. In other words, I think long term bonds are going to go down.

[9:35]

CS: And the impact on the fund? I know it’s early days but how would you expect that to…

JM: The impact on the fund is that we don’t hold any long-term interest rate paper. We just think that’s, it’s just not interesting at all for us.

We have a lot of floating rate paper, so this is bonds issued with a, literally, a floating interest rate. So if interest rates go up, these rates on these bonds go up in line with those rates, therefore the capital is protected and that otherwise we just hold short term interest, fixed interest debt. So nothing, nothing long. So that’s how we protect against that sort of move.

I have to say that there’s not a lot of conviction in the market place, however there is a lot of confusion over this particular conundrum and lots of the big banks are sending around surveys of all their clients saying, well, why do you think bonds are this low? And there certain is a lot of confusion. And I think what we’ll see as a result of that is quite a lot of bouts of volatility.

[10:40]

CS: James, ‘Freedom Day’ has come and gone supposedly. Do you think this will give another boost to the economy and is the fund positioned to reflect this in any way?

JM: Yes. Tiresome word isn’t that, Freedom Day, tiresome expression. I do think the UK economy is on a recovery curve and I think that’s going to be protracted. I am optimistic for the economy with of course again, that caveat of new variants of COVID. It would appear that the amount of vaccinations that are taking place are sufficient to contain this, but we will see.

And the fact that we’ve got this inflation and the supply bottlenecks, well it actually doesn’t stop the demand, it simply spreads it further forward. So I think actually the economy will carry on recovering. And as rough numbers, I would say the economy is running at about 92% of pre-COVID levels. But that’s hugely varied. So airplane traffic is running at about 25% of pre-COVID levels, but searches on housing sites are running at 165% of pre-COVID level. So it’s very varied, but overall it is picking up and getting there. America is running just about where it was pre-COVID, Europe I think is roundabout 88% but gathering pace.

[12:15]

CS: So shifting gears to look a bit more at the fund in detail. One of the benefits of the fund is it can invest beyond some of the traditional asset classes, the likes of equities, fixed income and property. Among those sort of asset classes is hedge funds, an area that you have had a little foray into and have since reduced your allocation. Could you maybe tell us what the attraction was?

JM: Okay. Hedge funds should be a very interesting asset class for us because we’re seeking absolute returns, so steady and consistent returns, which is a similar objective to most, most hedge funds. The problem we found is that alarmingly few of them actually achieved these steady and consistent returns, and they do frequently take on a lot more risks than is immediately apparent and both myself and my co-manager Jerry Wharton have run hedge funds in the past. So when we hear the sort of positioning they have it rings alarm bells for us. So that has tended to put us off. And the other aspect of it is a number of hedge funds consider themselves to be so immensely covered that they won’t show us what they’re doing, in which case we won’t invest anyway. So at the moment, yes, it’s a very low figure. We will happily change that if we see something that interests us, but not at the moment.

[13:42]

CS: And another two sort of alternative asset classes that you have invested in previously are infrastructure and property. You’ve sort of trimmed back your exposure to both of them slightly, could you explain why you’ve done that?

JM: Okay. It’s slightly more perception than reality. Infrastructure we have pared-back a bit, largely because valuations had got quite stretched, and what tends to happen with those infrastructure funds is if valuations get stretched (in other words, they move a long way from their underlying asset values) they issue more shares, so you’ve got more supply of shares and that was true of a number of them. So we have pared back a bit there, they just simply weren’t looking as attractive. Having said that we have taken up one or two offers of new stock recently. So infrastructure, yes, back a bit.

Property it’s more of an adjustment. Lots of sub-classes within property, as you know. The area of property investment that’s been doing the best has been that in warehousing, particularly big, big warehousing, and companies in that area have done tremendously well, and so we have been reducing them because they’re just no longer, really very attractively priced to us. We’ve been moving into what would probably be thought of rather more sharp end – so London office and London retail, that sort of area, so I think perhaps it’s not so much a trimming, more of an adjustment that maybe looked like a trimming at the time that last document was produced.

CS: That’s great, James, thank you very much for joining us today.

JM: Not at all.

CS: And if you’d like to learn more about the Church House Tenax Absolute Return Strategies fund, please visit fundcalibre.com and remember to subscribe to the podcast.