November 2013

November 19, 2013

The panel flirted with various topics, and here is a taste of the key areas covered.

Inflation or deflation

We touched on this debate at the last panel with the conversation on Japanese quantitative easing, and the fact that the lower yen exchange rate has increased deflationary pressures as foreign countries import cheaper goods from Japan. We are now observing other deflationary pressures that are not getting the headlines they perhaps deserve. Large consumer brand companies’ recent results are confirming pressure on average selling prices. The prevailing opinion has been that brand strength allows these companies to retain prices even in difficult economic environments. This is why these companies are viewed as defensive, and command higher valuations (notably PE multiples approaching or now exceeding 20x trailing earnings). The reality over the next few years appears to be that lowering prices is the only way of defending market share (with Nestle’s European operations perhaps being the most notable current example). This would be deflationary.

The big potential countervailing force is increased bank lending. This was, after all, the point of QE – to refinance the banks so that they were able to lend. QE hasn’t had that effect (yet), and in fact we are increasingly seeing governments taking other initiatives to increase bank lending. “Help to buy”, however ill-conceived it seems from the perspective of the sustainability/affordability of house prices, is an example of the government encouraging bank-lending by underwriting the more risky loans. In addition, the UK has the Financial Policy Committee (FPC) that has the express purpose of controlling credit out with the usual channel of adjusting the base interest rate. The increase in government policies to create bank lending and inflationary pressures might be a sign of increased desperation (and a sign of increased government involvement in the economy), and a tacit acknowledgement that QE hasn’t fulfilled that purpose on its own. Until we see evidence of these policies working, the future looks deflationary.

There is a question as to whether deflation is actually a bad thing, either for the economy, or for equities directly. The reality is that for an indebted environment – and we should remember that debt levels are almost universally high across the globe, especially for governments – deflation will be painful.

Other topics

The debate as to the future of China also continues. We are seeing smaller companies in China facing a very difficult environment. Margins are being squeezed from several angles. The steady strengthening of the renminbi, the severe increase in wages and the impact of price pressure from Japanese competitors are all playing a part. Since January 2009, wages are up over 70% in China against export prices that are up only 4%. Until these movements stabilise, it will remain difficult to predict the future for Chinese manufacturers.

The investment environment remains extreme, and market sentiment seems to be overwhelmingly positive on equities. An example would be James Mackintosh’s comments in his Short View in the Financial Times on November 12th, noting that broker’s margin accounts are at record levels (i.e. people are borrowing more money to buy equities than ever before) and investors are more overweight equities (in just about all geographies) than at any point in the last decade, with the offset being that they are equally underweight bonds. All this has forced equity prices ever higher, and expected long term returns from equities ever lower.

The challenge for investor seeking value remains, the panel noted that the interquartile range in PE ratios (i.e. the gap between upper quartile PE ratios and lower quartile PE ratios) has compressed, meaning that relatively speaking, cheap companies have become more expensive and vice versa. The scarcity of good quality companies trading at attractive valuations continues.

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

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