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Diary of a Fund Manager - Light Brigade

Date: 13 December 2021

In this week’s Diary, Omicron, Evergrande, US debt, company earnings forecasts, interest rates, inflation and pay rises, together with whether value or growth stocks are the place to be. Finally, another Charge of the Light Brigade.

The tentative recovery from the Omicron shock gathered pace last week, with equities reversing the losses of a fortnight ago and bonds reversing the gains. Currencies were quiet as was gold. Oil and industrial commodities moved higher. Omicron has now made it to 57 countries, the same as these Diaries, making a nonsense of the travel bans. The slow motion Evergrande car crash continues, but financial markets now seem less concerned. The Chinese authorities have now pumped $188 billion into the banking system just to be sure. After Omicron and Evergrande, US debt ceiling negotiations, the third major concern of the last month, have also become less intense showing once again that worries don’t always turn into reality.

Last week I wrote about portfolio construction, noting as an aside that picking winners was important. With hindsight, rather an understatement. Taking account of all the known concerns, analysts are optimistic about next years company earnings; US +14%, EU +20% and emerging markets +17%. As higher input prices ranging from energy to raw materials and now wages have an effect, pricing power, the ability to charge customers more, will be the key differentiator between the winners and the losers. Higher interest rates won’t help, but only at the margin.

Remaining with interest rates, central banks are making a lot of noise at the moment, including the Federal Reserve which is meeting in the next few days. Markets expect to hear that there will be less support for the US economy next year and that the first interest rate rise could be as soon as June with three in total during 2022. All very incremental and, therefore, unconcerning. The risk is that inflation will continue to rise and that central banks will react to the perception that they are following rather than leading and, as a result, raise rates at a more rapid rate.

As I have been a part of financial markets for 41 years, the news that US inflation is now 6.8%, the highest for 40 years, brought home the materiality of the move seen in recent months. Back in the 1980s we worried that low inflation was a temporary phenomenon, but low forever became the accepted wisdom as the years passed. The lack of reaction to zero interest rates and massive quantitative easing served to reinforce this sense of complacency. Fortunately, underreacting to the inflation surge this year hasn’t damaged investment returns. The only clear losers are those holding cash who are a lot worse off in real terms than they were last Christmas.

As ever, questions outnumber answers, but as next year unfolds we will know what to look for.

Below the surface, the US inflation report from November provides some grounds for optimism. Higher energy prices over the last year account for 3% of the 6.8% increase and as we look forward to 2022, the year on year increase in fuel prices will moderate to the extent that a decrease in inflation back to 3% is entirely possible. In addition, supply chain problems are moderating and so another source of inflation this year could be less intense next. Wages are the most important unknown. Household income for the lowest third of the US population measured by wealth is rising strongly, but the remaining two thirds have experienced a decline. Those in the upper third have been insulated from lack of wage growth by higher asset prices, both houses and investments, but the squeezed middle must be feeling the pain as money ‘doesn’t go as far as it used to’. Whether wage rises for the lowest paid subside as supply and demand imbalances are resolved or whether we will come to realise that these basic jobs have been under-priced for years is to be seen. Another unknown is whether the better paid will find that they have bargaining power when it comes to pay negotiations. As ever, questions outnumber answers, but as next year unfolds we will know what to look for.

Something else that caught my attention, courtesy of Paul Krake of View from the Peak, was the observation that a lot of the excesses seen earlier in the year have already evaporated, particularly in the US technology sector. The top five members of the NASDAQ 100 Index, formerly known as the FAANGs continue to perform very well, although name changes have made this particular acronym redundant, but the remaining 95 are down on average by over 20%. At the outer extreme, stocks that wouldn’t have looked out of place in the tech bubble of 2000/2001, are 60% lower on average than earlier in the year. Chinese technology companies are down a similar amount but for different reasons. The growth to value rotation still being trotted out by one trick pony strategists looks like it might already have happened.

Away from day to day investment, the highlight of my week was a question and answer session with a group of London Business School students facilitated by Professor Bob Jenkins who has been in the investment game even longer than me. The questions were as challenging as ever, emphasising the importance of looking forward 40 years rather than back. And in closing, an update from Putin’s People by Catherine Belton which I mentioned last week. I have now reached the chapter dealing with the annexation of Crimea in 2014. The economic sanctions imposed on Russia by the West then are almost identical to those threatened now, begging the question as to why they should be regarded as a deterrent having failed to work in practice not that long ago. Power and the wealth of the nation may be concentrated in the Kremlin, but the financial system is much more diverse and, therefore, resilient than either Washington or Brussels seem to believe.

As this is the last Diary of the year may I wish all a Happy Christmas and prosperous New Year. Back in January.

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