Favour Needs not Wants?

Most risk assets have had a decent fall this year. Long overdue and somewhat predictable perhaps but as ever it’s the most popular stocks and styles that have been hit hardest.

Along with the Ukraine invasion and continued Covid induced lock downs in Asia, the rise in the US 10 year note yield has been responsible for this reappraisal of risk.

The US 10 year note yield is fast approaching 3% and the whole curve has occasionally inverted which to some ‘scribblers’ portends a recession. To put this rise in perspective the US 10 year note yield was 0.5% in July 2020 and started this year at about 1.6%. That’s quite a loss of capital given the long duration at such low yields. Over that same 21-month period, US equities are up about 30%! Too late, the ‘inflation is transitory’ narrative has been removed, and we now perhaps have a more aggressive tightening to endure than we would have had if action had been taken sooner? “A stitch in time saves nine” is a useful refrain to remember.

https://www.delftpartners.com/news/views/a-fictitious-memo-to-jay-powell-from-a-staffer-at-the-fed

We have been told that ‘tightening’ is an imminent rise of 50 basis points in the Fed Funds rate (the short end) but also need to bear in mind that the size of the Fed balance sheet is going to be reduced. This represents an additional source of tighter monetary policy and so the effective tightening of policy is greater and quicker than most realise. This has consequences for the kinds of risk factors one should favour; put another way a different kind of stock will do better in the next five years than in the last 10. The 30% rise of US equities compared with a 15+% fall in the value of ‘safe’ government fixed income is unlikely to continue.

We call it investing in stocks that meet needs rather than wants.

https://www.delftpartners.com/news/views/Investing-during-this-new-paradigm

To repeat - new emerging investable themes will be –

1. Defence food and energy security are all now clearly priorities and are not wants but needs – the green transition couldn’t have been handled worse as we detailed in our presentations (“All revolutions eat their young”). Nuclear power should be on the agenda. All this is investable. https://www.delftpartners.com/news/views/quanta_services-a_way_to_play_the_us_industrial_revival
2. De-globalisation or National Industrial Policy is on the rise as we suspected it would be. This means both a need for an increase in domestic capital investment and the involvement of government in ‘helping’ revitalise and protect strategic industries. The Semi-conductor industry in the USA is one such example.
3. Buy backs have to give way to capital investment incentives. This increase in capital expenditure in the name of National Industrial Policy is much needed. This inflation is different from that of the 1970s when the labour force was very powerful and not very productive – at least in The West. Then wage increases were way above inflation and fed the beast with expectations of price increases driving the next round of higher wage demands. This time it’s a dearth of supply side competition that is causing the price pressures and misguided legislation against oil companies, pipeline companies, lobbying to prevent break ups of monopolies, the shedding of defined benefit obligations the introduction of zero hour work contracts has allowed Capital to place its foot firmly on the throat of Labour has been disincentivised and buy backs rewarded. This has to shift back.
4. In an era of inflation and rising mortgage rates, the consumer will become more discerning about where they spend their money since inflation has been eroding income for a long time and personal debt is high already. This again means the extrapolation of subscriber growth and price increases is naïve. Anyone for Netflix?

This means to us one should favour Basic Materials, Energy (pipelines are probably a better position than ‘evil’ oil?), Industrials, Defence, infrastructure and, increasingly, banks especially US regional banks.

https://www.delftpartners.com/news/views/Investing-during-this-new-paradigm

One area needs a mea culpa - which has hurt our returns and surprised us - Japan. Japan and especially the Yen are getting sold harder than Europe and the Euro. We have been roughly benchmark weight the US and the US$ and overweight Japan, the Yen, and underweight Europe and the Euro. We understand that the Bank of Japan, the central bank has signalled it won’t tighten policy and thus makes the rising yield on the US$ attractive relative to the Yen, but Japan remains a massive net creditor nation and has not (yet?) displayed any excessive inflation.

Moreover when adding up the fundamental performance of Japanese companies in the last decade, on the basis of sales growth, gross profits, book value and excess return on equity, they have produced better outcomes than the US ones. It is only P/E expansion (now over?) that has produced better US equity index returns.

Meanwhile the ECB cannot raise rates for fear of sparking a new crisis in the Euro still held together by smoke and mirrors. Inflation even in Germany is getting serious, and at over 7% p.a. as of March 2021 is the highest since 1981.

We’ll continue with our positioning.

There is still plenty of risk and lots can go wrong with the attempt to create a soft landing. It’s not our expectation but it’s worth bearing in mind we can see a whole lot more intervention and confiscation. https://www.delftpartners.com/news/views/future-tense-or-past-imperfect

So be aware of risk and portfolio construction even if you wish to focus on only a few markets and sectors – we can help with this. https://www.delftpartners.com/news/views/some-stuff-you-dont-want-to-think-about-but-should

Your portfolio should comprise more than a few favourite stocks. 10 companies isn’t a diversified portfolio, nor is 20. Probably not even 30. Combine managers who do different things and invest in different kinds of stocks with perhaps different holding periods – time diversification. Prepare to be content with 8% pa and there is still time to position away from the ‘growth at any price’ style!

Delft Partners April 2022