Thoughts on European Macro Q4
I woke up one morning a fortnight ago with the word “Deflation” ringing in my ears wondering what that might mean for our portfolio? When the figures subsequently came in for the Eurozone at -0.3%, markets seemed to shrug it off. But negative CPI is actually a very bad thing if prices are falling, because people defer purchases, which lowers the overall level of demand, which results in falling production with a knock-on effect on employment, resulting in a downward deflationary spiral with potentially lost decades for stocks, as in the case of Japan. The range within the reported Eurozone CPI was wide, with Greece, the worst affected at -2.3% and France at 0.0%, the best. Germany was -0.4% and Italy -1.0%. Oil was a big negative contributor, for obvious Covid 19 related reasons. Clothing was negative, food positive but services were barely positive.
My mood was not lightened when I read that the ECB, having failed miserably over the last decade to keep inflation “below but close to 2%”, is now looking to change that target. It reminds me of John Maynard Keynes who purportedly said, “when the facts change, I change my mind”. Christine Lagarde has announced a round of consultation allowing various public bodies to engage with the ECB to help them decide how policy should be set. No one ever thought managing a monetary system was easy, but heaven help us when the ECB, which one might be forgiven for thinking should be comprised of some of the best minds, has to enter rounds of public consultations to set policy. It could be, though, that the point of this is more to encourage other entities, including governments, to provide extra stimulus, such as infrastructure spending, pay rises, tax breaks etc., since the ECB appears to be rapidly running out of ammunition. Either way, it is less than encouraging.
On Tuesday 20th October there was a bond auction in Europe. The European Commission issued €17bn of bonds described as social-linked and known as SURE at 10 and 20 year maturities. The 10 year at negative yield was, according to HSBC, 14.5x oversubscribed (EUR10bn offered vs EUR145bn demand), a record for a ‘social transaction’. Also, a 20-year bond of EUR7bn at barely positive rates saw EUR88bn of demand – 12.5x oversubscribed. A whopping EUR233bn total demand. The EU expects to issue up to EUR100bn under the SURE programme until mid-2021, almost doubling the outstanding social bond volume.
Can EUR233bn truly be the level of demand for this latest tranche? Why would institutions be willing to place so much money at a negative yield over 10 years and barely positive over 20 years? Our friends at HSBC suggest that a lot of this demand was what they deem ‘fast money’ (high frequency and trading accounts). They say it is hard to determine the exact amount of that but as a rule, for a sovereign Euro deal, around 70% of the demand comes from these types of accounts. It is also safe to say these accounts never get allocated their full amount and it could be that they got zero allocations in this latest placing. So, HSBC’s conclusion is that the bulk of this transaction was placed with ‘real money’ demand as many central banks still buy Euros and bank treasury accounts are obliged to from a regulatory perspective.
Could it also be that those institutions believe interest rates are going even lower and they will be able to sell those bonds on at a profit? The EU has been tasked to finance the ‘Next Generation fund’ which will be a total of EUR750bn (even higher if you consider refinancing). This includes a mixture of grants (EUR390bn) and loans (EUR360bn) to member countries. The anticipation currently is that this will be funded from 2021-26. The expectation is that the EU will likely fund a total of EUR900bn over the next 5-6yrs. Estimations for next year are in the region of EUR150bn.
Are those same institutions going to oblige? Probably, yes. So rather than this demand being a feature of risk aversion, it is more likely a combination of systemic necessity and possibly also the expectation that rates are going to go even more negative than they are at present. Do we really trust the ECB or any government to spend this money wisely? If it succeeds in providing a multiplier effect in the economy and gets Europe back on track that would be one thing. But if the bureaucratic waste and inefficiencies of these large institutions are any guide, there must be a few doubts. That said, the sums are extremely large. As a humble stock picker, it is quite difficult for me to get my head around the European monetary system, still less the concept of investing in eroding bonds. To me it seems like burying your talent in the ground, to use a biblical analogy, and paying for the privilege.
Our European equity fund over the last 10 years has delivered a 12% compound annual return, and we are hoping to deliver at least as good a return for our clients over the next 10 years. From the point of view of our own growth equity investment style, all this activity in the bond market is unreservedly a bullish signal. If bonds continue to go up, so will equities and negative yields justify much more headroom in terms of valuation. However, in the equity markets, given the economic backdrop, it will be more critical than ever to invest in those companies and sectors which are holding up in terms of end demand, pricing and earnings growth. Sectors such as technology and others which benefit from online commerce come particularly to mind. There are profound structural changes taking place in our economies and there will doubtless be winners and losers. Deflation will only hasten the process. If new rounds of QE send even more liquidity into the system, and capital allocation is anywhere near efficient, it is likely to gravitate towards growth sectors, that can give investors positive returns and dividends. It is logical therefore that growth should trade at a premium
Of course, investing in bonds with negative yields looks like a terrible way to invest people’s hard-earned savings, but in a deflationary world it is hard for companies to grow. What we do at Aubrey, seeking out the very best companies that are continuing to grow, despite the environment, is the only way to go, and we will need to be as discriminating as ever in our stock selection. Technology as a sector has done well, but not all companies are firing on all cylinders: you only have to look at Intel’s and SAP’s latest results to see that. There are deflationary forces at work even within tech. The world has become immensely good at producing things in large quantities. In the 1970s when inflation was the major concern of the day it was sometimes defined in layman’s terms as “too much money chasing too few goods”. Now the reverse is probably true, “too many goods, being chased by too little money”. So, at Aubrey we are attracted by leading-edge companies with dominant market shares, where competitors are unlikely to flood the market with competing products or services. This might include large companies within oligopolistic industry structures or smaller ones providing very niche, specialist products or components.
Finding growth in this environment is getting harder, but paradoxically, picking the winners might just get easier.
Please click here for a pdf version
This document has been issued by Aubrey Capital Management Limited which is authorised and regulated in the UK by the Financial Conduct Authority and is registered as an Investment Adviser with the US Securities & Exchange Commission. You should be aware that the regulatory regime applicable in the UK may well be different in your home jurisdiction. This document has been prepared solely for the intended recipient for information purposes and is not a solicitation, or an offer to buy or sell any security. The information on which the document is based has been obtained from sources that we believe to be reliable, and in good faith, but we have not independently verified such information and no representation or warranty, express or implied, is made as to their accuracy. All expressions of opinion are subject to change without notice. Any comments expressed in this presentation should not be taken as a recommendation or advice.
Please note that the prices of shares and the income from them can fall as well as rise and you may not get back the amount originally invested. This can be as a result of market movements and of variations in the exchange rates between currencies. Past performance is not a guide to future returns and may not be repeated.
Aubrey Capital Management Limited accepts no liability or responsibility whatsoever for any consequential loss of any kind arising out of the use of this document or any part of its contents. This document does not in any way constitute investment advice or an offer or invitation to deal in securities. Recipients should always seek the advice of a qualified investment professional before making any investment decisions.