February 2024 Update

February, 2024

A Debt Reckoning?

Equity markets were more subdued in January than the back end of 2023 although in A$ the global indices rose 3-4% as the A$ declined. Large beat small and Tech won again although Tesla (not and never owned to be fair) declined almost 25%. Growth beat Value. In a rotation we have been backing for a few months now, the indebted US Real Estate sector fell almost 5% in US$ and the boring but stable Telecom sector rose by approximately the same amount. The US Markets' earnings growth is currently driven almost solely by tech stocks so the increasing concentration in these companies is logical, or worrying and illogical, depending on how you think about the principles of capitalism and a long standing 'reversion to the mean' effect in markets and economies. Trees don't grow to the sky.

All our strategies outperformed in January.

We see the US fiscal funding deficit now requiring over $10 trillion of paper sales/Treasury auctions this year. Not all of this spending is bad of course and we're delighted to see the power transmission grid now getting the attention it needs. Our investments in Quanta, EMCOR, Atkore and so on have proved remunerative. More to come we think. On the other hand, at some point this profligacy will cause a reckoning because debt servicing costs will begin to grow larger than defense spending and other essential programmes.

Meanwhile, rather than grow export earnings to help pay for fiscal programmes at home, and improve the geopolitical situation, the Biden Energy Department announced a likely new export permit ban on LNG exports. This can only be described as "misguided" and probably borders on irresponsible. It stymies trust in making the long-term capital investment required given the length and cost of these projects and also increases European reliance on more volatile sources of energy. Oh well. Not long to go now and we'll have a more stable set of decision-making processes in the White House (sic).

The long-term Chinese residential and US commercial property excesses are now front-page news but that doesn't mean their parlous position is discounted by equity or bond holders. Regional US banks got smacked a week or so ago (The KBW Regional Banking index fell 6% on Jan 31st) and New York Community Bank fell 38% and as we surmised in our January note, this regional banks real estate connection was possibly behind the apparent U turn in Fed Chair Powell's rhetoric in December?

The data do not indicate a weakening US economy, so the statement by Chair Powell appears strange unless something is worrying the Fed which markets do not wish to address, or do not yet see? If so, our guess would be that it's the regulatory capital buffers and balance sheets of mid and small banks which alarm policy makers. These are/were burdened both with carrying value losses on bond holdings and a deteriorating commercial real estate market.

We're itching to invest more in banks and close our large underweight but for now hold insurance companies, financial advisory services, and stock exchanges. Other news on listed fund managers has us thinking that M&A might be required there to reduce the cost base in the face of fee pressure. We'll probably invest there before the banks.

Chinese property company Evergrande got declared insolvent which will put pressure on that financial system and perhaps demand for building materials. The liquidator may find viable buyers who can complete projects. Other residential development companies such as Country Garden remain in trouble. Estimates range up to an excess supply in China of c.50m apartments, enough for c.150 m people, or 5 years of supply. That will be precisely wrong but approximately right. If ever a country needs to embrace private enterprise again, and quickly, it's China….We sold the last remnant of Ping An which was an investment mistake by dint of hanging in too long.

Europe just avoids recession, but companies are struggling with debt loads. European companies and banks are not immune from the debt reckoning. Signa an Austrian property company finally went under, and apparently Korean and Hong Kong pension fund companies have exposure. Julius Baer will try to exit private debt as a consequence of reputational and monetary losses from its involvement with Signa. Private Credit has seen a stellar growth in allocations. The butterfly flapping its wings in China, or the USA has consequences in Europe and maybe Australia? Just saying that locking up your money is to lose flexibility and that risk is not price volatility.

So, although early, here's how 2024 looks; and it's a veritable conundrum - rates at even these levels are causing pain to shareholders and investors in industries and companies which have way too much debt and were only viable by ZIRP. So, rates can and should fall right, because we're going to see a slowdown and we've always been bailed? On the other hand, US fiscal profligacy is creating (low level) jobs and strong demand in an economy being denied supply side benefits of capital investment. To cut rates now would be premature and likely underpin inflation which is only currently falling due to base effects. This is a tough backdrop and volatility is likely to rise. Our stance is to be diversified and to take our tech exposure through true tech companies rather than digital advertising platforms. This means we have a large overweight to Japanese technology and only selective US companies such as KLA, LAM Research and Applied Materials. We also like Quality exposure (one of our main quant factors) and love dividends.

A final word on risk control

Even though we effectively got 2023 entirely wrong - we expected the market to either fall (hence our defensive positioning) or to broaden out in a recovery for all stocks with good balance sheets, defendable margins and inexpensive valuations - and the opposite happened. However, our longer-term performance is sound due to risk control. What has saved our global equity portfolios in the last couple of years is sound risk control which means respect for the external benchmark as a relevant hurdle and the ability to quantify and manage active risk away from that benchmark; viz - No overly concentrated 'bet' against sectors regions or stocks that may jeopardise the whole portfolio. Be the tortoise against the hare!

Delft Partners February 2024