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Private Client Letter - April 2014
Tapering is on track!
The US Federal Reserve (‘the Fed’) has expressed its confidence in America’s recovery by reducing its bond buying programme by $10 billion per month, starting in January 2014. Recent economic data support their confidence. The Purchasing Managers’ Index is increasing, while payrolls, consumer confidence and the Case-Shiller home price index surprised on the upside.
U.S. CONSUMER CONFIDENCE
Over the coming quarters the upturn is expected to be underpinned both by a rise in federal government expenditure (after a 4.7% contraction last year) and by higher personal consumption as the labour market improves. A cyclical rebound in business investment is forecast to follow, with companies sitting on record amounts of cash.
Can the Fed take the ‘quantitative easing’ punch bowl away without killing the party?
The US economy is in a sweet spot where activity is picking up but liquidity is still abundant and there is as yet no sign of inflation. Competitiveness has been boosted by low energy prices on the back of shale gas and oil, the dollar is weak and some manufacturing is returning to the US from Asia.
Interestingly, the combination of subdued inflation and bonds selling off last year on the announcement of tapering has resulted in real yields again being available.
Whether or not tapering becomes an issue for investors will substantially depend upon whether the ‘helicopter money’ dropped from the Fed’s printing presses leads to significant inflation and restrictive interest rate rises.
There are powerful structural reasons for believing that this may well not happen.
Significant inflation would require robust demand. Although a cyclical boost to demand is in prospect, the longer term outlook is less certain. One reason is the negative impact of technology on employment. Carl Frey and Michael Osborne at Oxford University believe that 47% of jobs in the US are now at risk from computerisation, reflecting the relentless fall in the cost of computing power and new ways of interacting with computers, making it easier for non-technical humans to work with machines on complex tasks. McKinsey opines that even in fields such as law and
medicine, machines are likely to produce ‘generally better answers’ than humans – because people struggle to keep up with the latest knowledge in their fields.
The more immediate threat to employment is of course to blue collar workers. The numbers may be dramatic if history is any guide: in the century leading up to 1910, the automation of agriculture reduced the proportion of workers engaged in the sector from 90% to 2%. Now a machine called Baxter, costing only $25,000 and with a tablet computer for a face, is an all-purpose robot designed to move around and handle a range of tasks, thanks to a collapse in the price of sensors. For now Baxter is most likely to be found moving bulky packages in a warehouse or loading a truck, but digging ditches, laying pipes, directing traffic are all in his sights.
The trouble is that robots are not consumers. These technological advances, by restraining employment, will dampen long term levels of demand.
Structural demand is also driven by demographics. Birth rates have been falling for over 40 years, the baby boomers are retiring and life expectancy is increasing. These forces are resulting in the proportion of the population in the over-55 age group increasing rapidly. Spending inevitably declines beyond the age of 55 as people already own most of what they need, plus their incomes shrink as they retire.
The situation is exacerbated by the fact that the baby boomers did not save as they approached retirement; they borrowed.
FUNDING OF U.S. HOUSEHOLD ASSET ACQUISITION
The combination of technology, high leverage and an ageing population portend relatively weak demand, creating sustained disinflationary pressures. Extraordinary policy exertions have delayed the full impact of this, but, given that household spending is over 60% of GDP, policy makers can do little to reverse this in the longer term. Deflation is a possibility.
Deflation is widely regarded as an ogre. Yet deflation rewards savers - your savings can buy a little more next year than this - and penalises debtors, for whom the burden of re-payment rises each year in real terms. Deflation would help to create a more sustainable world as people pay down debt instead of borrowing to buy the latest ‘trendy’ thing. However, that would delay consumption and slow growth, which is not politically acceptable in Western democratic societies to the ‘now’ generation. Nor is it
helpful to heavily indebted governments, especially those that took on the burden of the private sector’s excessive debt in the aftermath of the credit crisis.
Elsewhere in the world the economic backdrop faced by investors varies. In the UK, the new Governor of the Bank of England, Mark Carney, is already having to eat his initial conservative forecasts as the recovery gathers momentum, led by an exuberant housing sector. The €urozone’s manufacturing and services activity is the strongest in almost three years, attracting a sharp rise in American investment, with inflows into Spain up by +59% this year on last and into Greece by +75%.
In China the government is determinedly continuing its programme to cool the economy and deal with its imbalances. A year ago, the then-new President, Xi Jinping, proclaimed ‘the great rejuvenation of the Chinese nation’ as the Chinese Dream. He held a forum bringing together scholars and officials from China and abroad to discuss what the Chinese Dream is, what it should be and what it should not be. Rather like a corporate strategy ‘away day’. Can you imagine the UK government organising that? What is the British Dream?
Beijing fully recognises the challenges of transitioning to slower and more balanced growth. The China Development Forum met recently in Beijing, again bringing Western and Chinese business leaders and academics together to study the issues. The best brains from diverse backgrounds all contributed to the analysis and planning process.
Gradual deleveraging without over-damping growth will be tricky and there will be rough patches. However, the underlying drivers - urbanisation, growth in domestic consumption - remain strong.
CHINA URBANISATION RATES
Whatever the hazards facing the Chinese economy, they appear not to be affecting the art market. At a Christie’s auction last November Wang Jianlin, China’s richest man, paid US$ 28 million for Picasso’s “Claude et Paloma” - double the high-end estimate. Stradivari’s ‘Macdonald’ Viola, created in 1719, is viewed as the greatest viola in existence. It is one of only ten complete violas made by
Stradivari during his lifetime and the only one in private hands. It will be offered by Sotheby’s via sealed bid - in Hong Kong.
The Japanese government’s planning to resolve their economy’s perceived problem of deflation seems rather more tenuous than China’s. Their massive fiscal and monetary stimulus has succeeded in lifting the stock market, growth and inflation – although most of the price rises are of imported goods, particularly energy, as a result of the policy-induced depreciation of the ¥en. The hurdle of the increase in VAT on 1st April must be navigated, and, with structural reform still awaited, more quantitative easing will be needed to depreciate the ¥en further to maintain momentum.
Thus the global backdrop seems broadly benign for investors: Western economies are recovering, albeit to different degrees, and the major Far Eastern economies are tackling their problems.
“It was the best of times…
It was the worst of times…”
The best and the worst? Our front cover quote from Charles Dickens is a reminder that the landscape is not without risks. Inter alia, debt is creeping back into the system rather more rapidly than one would wish.
The demand for higher yielding securities has moved Wall Street’s securitisation machine into a higher gear, while sales of junk-rated bonds have surged. Bank for International Settlements figures show that between the bubble peak in 2007 and mid-2013 global debt surged from $70 trillion to $100 trillion, and global debt to equity rose from 1.2 times to 1.9 times.
Equity market valuations are elevated, buoyed by quantitative easing and now anticipating earnings growth on the back of the economic upturn.
A time of structural growth
At Veritas, with our focus on both the protection of capital as well as its growth, we continue to pick our way across the investment landscape with care. However, there are still opportunities for those seeking ‘real returns’, ahead of inflation, on a five year+ view. We use themes as a filter, and our attention is directed to two at present, ‘Rising Tide 2020 Winners’ (structural growth) and ‘Scarcity’ (assets or networks that cannot be replaced economically).
For example, ‘Big Data’ (BD) will be a powerful structual growth force across virtually every sector, we believe a clear ‘2020 winner’. It refers to the enormous expansion in the volume, velocity and variety of information available about people and their habits, devised as people create their digital footprint online. BD gives companies the ability to forecast, plan more accurately and gain valuable insights into the behaviour of suppliers and customers. It can drive efficiencies and cost savings in resource allocation. In transport, BD enables minimising distances and travel times based on weather and congestion – and hence costs.
Internet traffic increased four-fold in the five years to 2012, and is forecast to grow by 23% p.a. in the next five years.
In biotechnology, BD has enabled mass sequencing of human genes. A detailed diagnosis of cancer calls for sequencing hundreds of thousands of cancer genomes. Five years ago, it cost circa $1 million to sequence a genome. Today, thanks to BD, the cost is close to $1,000.
THE SEQUENCING EXPLOSION
As a consequence, DNA sequencing is moving from being an expensive luxury to becoming an affordable procedure, facilitating personalised medicine. This could result in growth from the 10,000 tests administered in the US in 2013 to over 400,000 tests p.a. in ten years’ time (source: Bernstein).
The share prices of many technology companies have risen geometrically in anticipation of revenues, reminiscent of the ‘tech bubble’ in the late 1990s. In February Facebook paid $19bn to acquire WhatsApp, a company founded in 2009 and with only 55 employees.
At Veritas, with our philosophy of investing in sound businesses but only at a sensible valuation, we have foregone the rises in Facebook, Netflix, Tesla and Twitter. We have nonetheless found attractive companies for investment, including a few providing exposure to BD.
One is Oracle, the world’s largest enterprise software provider with a c.50% market share in database software. Their software is critical infrastructure for companies and carries high switching costs. Consequently a material proportion of revenues is recurring - and highly profitable. This ‘maintenance’ revenue stream accounts for the overwhelming majority of cash flows and is very resilient, even during economic downturns.
Concerns around competition from alternative databases resulted in material underperformance of the stock. We believe the competitive concerns are over-stated. Cash flow is prodigious and the company bought back shares equivalent to 5% of issued capital last year. A 9% free cash flow yield afforded us an attractive entry point into this resilient earnings stream with the expectation of modest future growth in revenues driven by several tailwinds, most notably the continuing rise in ‘Big Data’.
9th April, 2014