So much has happened since our last update just over a month ago that it has been hard to keep up to date. This month therefore we will attempt to discuss some of the bigger issues influencing markets and put them in an investment context.
This update is a little longer than usual, so please bear with us. As always, there are no certainties, just probabilities and any views we have must be seen in this context.
As we have often said, the most important risks are the ones no one comprehends. Once something is widely discussed it can be assumed to be largely discounted in market prices, something which is very important to remember given recent market turbulence. Even two weeks ago there was no talk of a global energy crisis, which now seems to have engulfed us. How can we go from having enough energy to soaring prices in two weeks?
As always, commodities are a tale of supply and demand. Looking at the total amount of gas, oil and renewable reserves globally there is clearly enough energy. Indeed, we maintain that in the long term, some of the existing reserves of carbon-based fuels may never be used. What we are seeing here is not fundamentally a shortage of energy. What we are seeing however is a rapid economic recovery combined with geopolitical tensions. On the former, energy demand plummeted last year during the pandemic and the price of oil went negative.
"What we are seeing here is not fundamentally a shortage of energy."
The current environment is the inverse, where despite the pandemic remaining with us the global economy has recovered far quicker than expected and has created a surge in demand for energy. This has been mixed with a complex geopolitical environment, whereby Russia is refusing to supply more gas as leverage for goals it has for its relationship with Europe, and The Organization of the Petroleum Exporting Countries (OPEC), the entity representing a number of major oil producing countries, is refusing to pump more oil than previously planned as it seeks to benefit from higher prices.
We have also seen the argument that the increasing focus on climate and ESG has created a significant dis-incentive to invest in carbon-based energy, which is causing higher prices. This is a fascinating argument and one that must be considered. There is a reason why we talk about energy transition and not energy dislocation. What is needed is a rapid decarbonisation of the energy mix, but it must be orderly. High energy prices hit those least able to afford them the most. Somewhere and somehow carbon will be part of the energy mix for many years to come and as a society we must engage with that issue thoughtfully as we build out renewable energy.
Overall, we see an energy crisis such as those that appeared regularly in the 1970s to be unlikely. This is a problem that policy and politics can resolve. Once a combination of Russia and OPEC restore previous behaviours, which it likely remains in their interest to do, it seems probable energy prices will return to more normal levels.
If an energy crisis weren’t enough, since our last update there has been a property crisis brewing in China. We must confess to having not heard of Evergrande, the real estate company close to bankruptcy which may prove a systemic risk to the Chinese property market. Again, as a general investment observation, it is remarkable how quickly issues are assessed and discounted by markets, as within a few days of the news breaking about the precarious position of Evergrande, the availability of in-depth analysis and the discounting of the associated risk was priced into markets. Markets happen fast, these days, which is a new challenge for all investors.
At its core Evergrande is another manifestation of the social equality agenda the Chinese government is enacting, which up until now has primarily impacted the technology sector. The message from the government is that property is for living in, not for speculation. As such, it is seeking to reign in some of the more aggressive property developers as they are seen as the conduit for investors to speculate on property prices.
If we take a step back, China is enacting a social equality agenda as it believes it will ultimately improve the long-term growth prospects of the economy. This is not intended to be an act of self-harm. Having seen bubbles and speculation end badly in western economies, it believes early preventative action will result in higher quality and more stable growth rather than a boom bust cycle. Whether or not this proves to be correct remains to be seen, but the adage that the US economy is run by the S&P 500 and China by politicians is very true. Which gives a better long-term outcome is a philosophically interesting debate!
"China is enacting a social equality agenda as it believes it will ultimately improve the long-term growth prospects of the economy."
The best analysis available to us suggests that there is no incentive for China to let Evergrande become a systemic problem, nor is Evergrande big enough to be so. Equally, despite continued and well thought out views that China has been over building for years, there are equally compelling arguments that China did not invest in its infrastructure for a century and therefore is still catching up.
We are not minded to side with those that believe Evergrande, or indeed the social equality agenda, is a watershed for China. We think it is more of a continuation, and perhaps acceleration, of existing policies. China will inevitably slow in the coming years due to weak demographics, so we may have to get used to it being less of a driver of global growth than in the past. But in the spirit of probabilities not certainties, we think it unlikely Evergrande or the social equality agenda is an inflection point for China.
So having concluded that the energy and property crises will probably pass, the next issue to understand is inflation. We have said consistently that we are not inflationists at heart. Maybe this is because we are not scarred by the Volker years of high inflation in the 1980s, or that throughout our careers we have only ever had a trend of declining levels of inflation. Or it could be that the economy is fundamentally deflationary as technology becomes pervasive and we can do more with less. Whatever our view, the debate on inflation being transitory or cyclical is front and centre in our minds, with rising energy prices adding more fuel to the inflation fire.
We have read some very interesting research recently from Gavekal, a macro research provider we subscribe to, about moving from an age of plenty to an age of scarcity. Food, energy and capital have been so cheap in recent times that we have feasted on them, forming a habit it will be expensive to kick.
Think about food. For most of the history of the human race, people died from starvation and a shortage of food, and in certain countries still do. This generation however is the first that will see more deaths from eating too much, as diabetes and obesity become prevalent. Equally with respect to energy, why does a grande Starbucks coffee cost three times more than a litre of fuel? No wonder we have climate change! Finally, capital has become so cheap, even free, that the amount corporates and consumers can borrow is way in excess of historical levels. What happens if energy, food and capital become scarcer? Well in the first instance it will be inflationary, something we are maybe seeing now, and the same amount of demand fights over the decreasing level of supply. Thereafter it will become demand destructive as consumers of energy, food and capital have to adjust their behaviours which in some instances maybe no bad thing. As the saying goes, the cure for high oil prices is high oil prices.
"Why does a grande Starbucks coffee cost three times more than a litre of fuel?"
Our point is that there is a credible argument that key commodities should be priced somewhat higher, in part so the world adjusts to consume less of them, which in turn should see prices fall again. This, combined with productivity improvements, keeps us in the camp that inflation will not be a dominant driver of investment returns in the coming years. However, relative to China and energy, this is the issue where our conviction is perhaps the lowest and we will manage risk of being wrong accordingly.
So, putting all this together where does it leave us? In our view, what we are seeing currently is more likely than not a market pull back of the nature we get once a year (that we haven’t had this year so far) where a number of issues aggregate to create a correction of c10%, rather than a new bear market of c20%, or full-blown panic of c50% fall in prices. For context, Ed Yardeni, another research provider we use, notes that we have had 70 (including this one) corrections in this bull market which started in 2009. It should also be noted that September and October are seasonally weak months for markets. It seems more likely than not to us that the previously mentioned concerns will pass and in time markets will make new highs, maybe before the end of the year.
It should be noted that uncertainty is the friend, not foe, of investors. Long-term returns are always improved by buying at times of uncertainty, with the pandemic last year being the latest example of this. It is impossible to know when the current uncertainties will lift, but they surely will and that will be the catalyst for those investing into market corrections to see a good return on their investments.
What a difference two weeks make! In the middle of September our relative performance had hit new highs for the year, capping off a very strong six months and resulting in strong year to date performance. While we are still ahead of our benchmarks, we have certainly given some of our performance back as oil companies have seen their share prices bounce by up to 20%. These are companies we don’t invest in due to their environmental issues. Equally, as inflation concerns have risen, ‘growth’ stocks have underperformed ‘value’. While we continue to dislike this categorisation we are certainly in the ‘growth’ camp.
With an ever-declining number of weeks left in the year the outcome for 2021 is still not certain for us. We do however note and take confidence in the strong operational performance of the companies we own and believe this will determine our ultimate success in long run.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.