A Corbyn government… hyperinflation… robots take all the jobs… and we all live to be 130 years old. What are investors to do? John Stepek chairs our Roundtable discussion.
John Stepek: This time last year, between Trump and Brexit and the potential for a Marine Le Pen victory in France, people were pretty worried. Now, everyone seems more relaxed. Is anything about the year ahead keeping you awake at night?
Steve Russell: Yes. Our whole market system is effectively predicated on zero interest rates. That carries the seeds of its own destruction. If we get strong growth, then rising rates will upset the applecart – but if growth isn’t strong, we can’t expect earnings growth to continue. So our view is that the downside will prevail, but it could take time to show. And until then, markets will keep going up. So it’s very difficult not to be in markets.
Lucy Macdonald: But don’t you think that central banks will lag the growth?
Steve: Yes, but they can only do that if inflationary pressures remain subdued – which is a problem for the UK, where they are not subdued at all.
Jim Mellon: I think we will see wage inflation very soon. The “precariat” (workers in precarious jobs) wants more money – quite rightly. Companies are making too much and the general population is making too little. Corbynism is a symptom of that.
Lucy: I can see inflation here in the UK, because it’s always here, just under the surface, but I struggle slightly with the idea of seeing too much of it in the US. Wage growth there, outside of a few pockets, has been very subdued. Perhaps it’s just lagging. But the firms we talk to aren’t talking about employing more people, but about how to use technology to boost the productivity of existing staff. We’re not seeing productivity growth at the moment because we’re only in the early stages of this new technology proliferating, but it would be amazing if that didn’t have some effect.
Steve: But what will drive inflation is the fact that for 30 years we’ve had ever-increasing returns to management, and that is now meeting with resistance. As Jim says, going back to the precariat, the political picture is shifting. In the UK, it’s Jeremy Corbyn; in the US, if Trump doesn’t deliver, Bernie Sanders is next. The people now want money to go to either government or workers, and that pressure will only grow. The more rapacious the internet businesses are, the more jobs that are put at risk by robotics, the more political pressure there will be to stop that.
Lucy: Will it be possible to stop it?
Steve: If workers and the government are aligned, then that’s a powerful force that can act to slow down the pace of innovation. It’s what the unions did in the 1970s. They were shrinking the cake by their actions – which is also what will happen now – but they were taking a bigger slice of it. And that’s all that mattered to them.
Lucy: But you can’t have an open, globalised economy and do that.
Steve: I think America could close its economy – and then that’s it for everyone.
John: Jim, in the late 1960s we had very low unemployment and very low inflation, but then it just took off. Could that happen now?
Jim Leaviss: The classic explanation for the double-digit inflation rates we saw back then is a demographic one. Obviously there was war in the Middle East and the impact on the oil price, but workers also became very scarce in the 1970s, partly due to the power of trade unions. They then became less scarce as baby-boomers entered the workforce in the 1980s. That explains why inflation was so high in the 1970s and came down subsequently. But that model has broken down. For example, in Japan, you should be seeing substantial inflation. But even though unemployment is sitting at 2.4%, Japan can’t generate any wage inflation whatsoever.
Tim Price: I read about Japanese wage negotiations this week. The unions wanted 2%. Prime Minister Shinzo Abe said: “Can you ask for four?” It’s a sign of just how far down the rabbit hole we are.
Jim L.: The argument goes that demographics may not impact on bond yields and inflation any more because we have an open economy – so if we don’t have enough workers in the UK, then Polish workers can come and fill the gap, or UK firms can open a factory in Vietnam, say, where the demographics are more favourable. But if we’re rolling back globalisation, then perhaps that rolls back too.
Steve: There are signs globally of all of those disinflationary forces running out. It’s getting harder to put a factory elsewhere – Chinese wages, for example, are rising so fast that it is less lucrative to do so. This goes hand in hand with the politics of anti-globalisation. Anti-globalisation isn’t: “We don’t like trade”. It’s: “We don’t like what trade does to our jobs”. People still want trade, but with higher wages. The problem is, we can’t have both. A connected point is this growing sense that tech firms such as Amazon and Google – as well as cryptocurrencies – eventually have to be regulated. As a result, we’ll see an increasing regulatory risk premium being applied to internet businesses rather than banks.
Jim M.: Yes – you can’t break them up because they’re “monopsonies”, not monopolies. If you try to break up Facebook so that you end up on one side of it, and I’m on the other, then you’ll just move across to me or I’ll move across to you. So you end up with the same situation. Hence you have to regulate them as utilities. You charge them for the data they exploit, or fine them for misconduct, as happened with the banks over the last ten years. That’s why I can’t see any upside in these things.
Jim L.: But why regulate Amazon? What a fantastic force for good for consumer prices. It acquired Whole Foods – suddenly, we get 30% price cuts. Pharmaceuticals are next.
Tim: If you’re a small, independent bookstore, you have a different take.
Jim L.: Yes, exactly. But as a consumer, Amazon’s delivered you a massive surplus. It’s kept inflation stable and below anyone’s wildest dreams – it’s almost like a great socialist experiment.
Tim: But one that actually works in the interests
Steve: But at some point there’s a conflict between Amazon benefiting consumers and putting jobs at risk – if you lose your job, you can’t use Amazon.
Lucy: Yes – the consumer is also a voter, which matters when it comes to issues such as tax avoidance. So the consumer is now slightly conflicted as to what to feel about all this.
Jim M.: I don’t think Amazon falls into the same category of data exploitation as Google or Facebook, but it is still going to come up against the forces of Schumpeterian destruction. Already, Walmart is fighting back extremely effectively online.
John: Do you think the whole “retail apocalypse” story for bricks-and-mortar chains is overdone then?
Jim M.: Not necessarily – the Westfield shopping centre group has just been sold. Frank Lowy, the chairman, is one of the smartest cookies out there. The fact that he’s selling tells you everything you need to know.
Charlie Morris: It doesn’t mean all retailers are doomed. Foot Locker was an early diver. But it’s staged a massive rally in the last few weeks. The things is, you don’t just sit there and die. You reduce your square footage, you improve the experience, you have your own website…
Tim: And you negotiate rents downwards.
Steve: Yes, in the end, if there’s less demand for space, it’s the rent that has to go. Individual bad retailers will fall off the cliff as they go along, and the ones that change – Foot Locker, Tesco – will succeed. But rents will have to fall. And that’s where the pain will come.
John: So where do you see the greatest value now?
Lucy: Financials are one of the few areas where you can still see some absolute value, as well as reasons why that value might start to be realised. Regulation and litigation risk are probably now past the worst. Rising interest rates are good for banks. Everyone is living longer, so we need to save and invest more, which means higher fees for asset managers. Technology presents interesting opportunities too. For example, some of the biggest developers of blockchain right now are financial institutions. I don’t think that’s really priced in yet.
Steve: Yes, financials are the clear value play, assuming that growth continues. By definition, banks are always at the epicentre of any financial crisis, so we’re always a bit wary of financials. But this time, we’re a bit more relaxed because: a) it’s quite rare for any crisis to mirror the last one exactly; and b) while there’s every chance that a bank you own might fall in half in a financial crisis, there’s also every chance that a bond-like equity – such as a consumer-staples company – would half too, given the ratings they’re currently on. If they’ve both got the same downside risk, then the cheaper one looks much more attractive.
Jim L.: Regionally, Europe and Japan have much stronger growth than anywhere else – I think they’re going to be the hot spots. From a bond-market point of view, look for positive real (after-inflation) yields. I’ve been sceptical about emerging markets for a long time, mainly because of Chinese worries. But you can get 4% real yields in plenty of parts of Latin America. Obviously, there’s political risk all over – Venezuela, Turkey, Brazil, Mexico, Trump, Nafta – but it’s priced for that. So I like local-currency, emerging-market bonds from the likes of Mexico, Brazil, and Colombia.
Steve: Yes, the worse Venezuela gets, the more it encourages the others to govern better. And yes, Japan’s been the best-performing major market for the last five years and it’s still looking good. Valuations are getting cheaper as firms grow rapidly. More specifically, if the Bank of Japan stops holding the ten-year government bond yield at 0%, it could be a game-changer for Japanese banks domestically, as they would earn more as the gap between longer-term and shorter-term interest rates increases.
Jim L.: Pegs always break when the fundamentals are no longer supportive. And Japanese fundamentals aren’t. It’s got to pop.
Steve: Yes, the market is already sniffing it. The Japanese banks are starting to move as if this was more than just a pipe dream.
Tim: Absolutely agree on Japan – still our favourite market. Vietnam is our second favourite. It’s the cheapest market in the world – the cash flow generation of many Vietnamese companies is off the charts. Yet while Vietnam is a surprisingly big market, big fund managers can’t play there as it’s a frontier market. But it’s certainly an opportunity for the unconstrained – ie, private – investor. There are two funds readers might want to look at. Saigon Securities offers the Vietnam Value and Income Portfolio. And there’s the Vietnam Opportunity Fund (LSE: VOF), run by VinaCapital.
Jim M.: I agree on Japan too. On more specific trends, in the nearer term the growth of the electric vehicle and energy storage market is going to be the most significant change in the next few years. Lithium is going to go through the roof. There’s a huge shortage of it. JP Morgan reckons that $1bn-worth of lithium carbonate was sold in 2016. By 2030, that’s expected to hit $50bn-$100bn. And that may be an underestimate because there’s still no alternative to lithium batteries. In terms of buying into lithium, I’ve just been in Australia where I listened to an interesting presentation by mining company Zenith Minerals (Sydney: ZNC), which has lithium projects around the US and in Australia.
But the most important shift is that life expectancy is about to take off. There’s been a hiatus in the last couple of years because of the opioid epidemic in the US. But I’m convinced that life expectancy in the UK will rise to 110 or 120 within 30 years. And that will change everything. It will transform financial services – for instance, the pension-fund model is finished. Consumption patterns will change too, because older people are not going to go to night clubs or bars as frequently.
Lucy: Maybe they will? When we think about everyone living longer, we assume they’re all going to be the same as old people are now. But is that really true? Are we not buying the same Adidas trainers now as we did in our 20s?
Jim M.: That’s a good point. People will be robust rather than frail in old age. But in any case, it throws up two main points. What do older people spend money on? Leisure and travel. So the big players in the cruise industry – Royal Caribbean, Norwegian Cruise Line, Carnival and the like – are great long-term investments. And the longevity industry itself will be huge. Biotech has seen major shifts in the last ten years, from small molecules to biologic drugs, and now cancer immunotherapies, which will be a $50bn industry within three to four years.
But the really big prize will be when a company can say: I can give you this drug and you will live for another ten, 20 or 30 years, and be in better health than you would have been in your grandparents’ or parents’ day, and it’s going to cost you 5% of your income. That’s where the real money will be. For now, most of those firms are private, but a slew of them will come to the public markets in the next few years. The best of the big drug companies in this area is Swiss giant Novartis (Zurich: NOVN), which has a reasonable dividend yield, a solid balance sheet and a very good suite of new products coming out. It’s a long-term keeper.
John: But how does all of this interact with people losing their jobs to robots, for example? Because these life-extension products will be expensive.
Jim M.: It gets back to what we were saying earlier. We will have to mandate a diversion of corporate profits to the general population. It could happen through a universal wage, or a significantly higher minimum wage, maybe – but it’s definitely going to happen, which is why I think you have to be bearish on the big internet platforms, because they’re such a juicy target. Sure, they may have the best lawyers in the world, and Washington doesn’t – but they’re going to get them, like they got the banks.
Steve: The thing is, the universal wage – assuming we go there, which I’m not certain of – carries the seeds of extreme inflation with it, because there is nothing to stop the majority of the people receiving it from voting for more.
Tim: You get into hyperinflation territory, don’t you?
Jim M.: Another good reason to own gold. Gold only went up by about $100 last year, but I don’t think that says anything about gold and inflation – I think it’s because there’s been displacement speculation in bitcoin.
John: On another topic, do you think the move towards passive as opposed to active funds will continue in 2018?
Lucy: I think we have to assume it will, because it’s cost-driven.
Charlie: But perhaps only until the momentum trade cracks. When the value trade comes back – which coincides with the rise of inflation – I think the rush towards indices will reverse.
Steve: Yes, one problem is that an index, by definition, maximises your holdings in any bubble assets right at the top of the bubble, because that’s the biggest bit of the stockmarket. They won’t underperform the market, obviously – they will just be the wrong place to be. The rise of index investing has also gone hand in hand with the selling of volatility. This is a fragility within the system that could come apparently out of nowhere and really hit markets, because so many investment strategies are now based on “low vol” (see page 10), which is pro-cyclical. In effect, as markets go up, you buy more, and as they go down, you sell more. It needs a trigger, and it’s difficult to see one. But that’s a risk.
Lucy: There are two things that should help active managers. Firstly, as interest rates go up balance sheets will matter again. If you do get some financial stress appearing then you will get more potential for differentiation and stock picking. Secondly, advancing technology is causing a huge dispersion of winners and losers – the winners grow to the sky and the others just die. So if you know what you’re doing, you ought to be able to add some value.
And what we’re discussing here is only really now seeping into the corporate sector. Researchers at McKinsey have done some interesting work on how far advanced each industry is on digitalisation. Overall, it looks as if we’re only about 20% of the way through. Yet even in the least digitalised industry, agriculture, we all know what’s happening with drones and tractors and seeing your way around fields remotely. So it’s all kicking off.
One way of getting exposure to that is to invest in a consultancy such as Accenture (NYSE: ACN) or Capgemini (Paris: CAP), which is right in the middle of this shift. Companies have spent the last few years offshoring and outsourcing everything IT-related. Now chief technology officers are being told: “We need to be digital, we need to get in the cloud!” But they’ve offshored everybody. So they are getting the likes of Accenture in, and giving them huge business-transformation projects. This process could sweep through every single industry in the years ahead. Meanwhile, Accenture has been investing in “digitally enabled” people – so they can do site security, cloud computing, blockchain, etc – and they are able to supply them to other corporations.
There aren’t many companies with all of that capability to hand who are also trusted to do this sort of business transformation, so the ones who are have really moved ahead of the pack. Accenture is now on 20 times earnings or so. Even so, it’s got a bit of yield, it’s got net cash, and it’s well managed. But of the two main players, Capgemini is cheaper and it’s catching up. It’s not going to grow at 30% a year, but it’s going to grow faster than average. And it’s not that cheap, but it’s cheapish. So I think it’s got a bit more runway to it.
Tim: Just on Steve’s volatility point, if you’re concerned about a spike in volatility, there is an answer – systematic trend-following funds. They can be tricky for private investors to buy, but there is one option – Montlake Dunn WMA – that readers might want to consider as part of their hedging portfolio.
Steve: Most of what I like right now, excluding index-linked bonds and Japanese banks, is stuff in the UK that’s been beaten up a bit. We know some stocks have been sold off because they’re part of the “Brexit basket”. Now, Brexit may be as bad, less bad or worse than we expect. So I don’t want to make a bet just on that. But if you’ve got some management changes or something else going on in a company that’s been sold off just because of Brexit, then it becomes attractive.
For example, I like what Dave Lewis is doing at Tesco (LSE: TSCO) with Charles Wilson from Booker. Even in a challenged supermarket environment, they could deliver something quite special. At Marks & Spencer (LSE: MKS), Archie Norman has taken over as chairman and is suggesting that they might stop spending so much money. M&S’s cash flow has always been great, but they’ve always spent it all. So if they did that, it could be a great business. You’re getting a 5%-6% yield too. Then there’s a housebuilder called Countryside (LSE: CSP). It’s not really a housebuilder – it generates a big proportion of its profits from being the preferred partner for local authorities. So in the drive to build more houses, it’s on the side of the angels, so that part of its business looks very undervalued.
Outside of the Brexit basket, we like Vivendi (Paris: VIV), specifically because of music streaming. I come from a generation that always paid for music, and then I stopped consuming it because it just wasn’t available, and I didn’t really move with the times. Then you get the next generation who never paid for music, and don’t understand the concept. Now we have the latest generation, who don’t understand the concept of not paying for something that you rent. So we think that Universal Music Group, part of Vivendi, is very attractive.
John: Last year you tipped IT recruiter FDM Group. That’s up 70% now. If somebody is still holding, what would you suggest?
Steve: I’d hold. It’s not cheap, but it’s similar to what Lucy talked about earlier – FDM trains graduates and ex-army people and mothers coming back into the workforce as IT workers, then puts them into banks and other big firms. In effect, it’s arbitraging the fact that our university courses aren’t teaching people the skills that companies want, predominantly IT-related ones. It’s expanding across the country and I think it will end up being a FTSE stock.
John: Thanks everyone.