Markets are in an intriguing situation. They have performed well over the summer months, and volatility is at historically low levels. Much of this can be attributed to more resilient macro data, ever-easing monetary conditions and strong corporate earnings on both sides of the Atlantic – albeit from low re-based levels.
This, however, does not seem to be a no-brainer. Corporate America does not necessarily agree – last month saw the highest level of debt issuance in any August in history – could CEOs be sensing that this window of cheap money may be about to close?
Interestingly, lending conditions for smaller companies are easing dramatically; we recently met with Faurecia, which refinanced bonds from 9.4% to 3.6%. It is almost impossible to know when interest rates will start to rise, and only a fool would position his portfolio accordingly.
There are, however, nascent signs of inflation reappearing. My best guess is that markets will continue to move forward until interest rates start to rise, when things could become very turbulent.
Some commentators are now trying to justify higher targets for markets based on an anticipated wave of fiscal stimulus now that all the monetary bullets have been shot and investors are showing signs of fatigue from monetary stimulus. This fatigue is apparent in the growing awareness of the unintended consequences of a Zero Interest Rate Policy (ZIRP) – such as banks not being profitable and thus not increasing lending, meaning ‘cheap money’ is not feeding into the real economy and social inequalities are appearing.
Central banks seem to be more modest in their ambitions now, acknowledging policies will have less effect on financial and economic conditions. The effectiveness of hyper-active monetary policy is diminishing, while many of its side effects are becoming more and more dysfunctional. If markets are less addicted to QE, ‘stock-picking’ could return to vogue.
Equally, we are more and more inclined to discount the arguments for higher markets based on an elevated equity risk premium (ERP); this only looks elevated if we model in historic growth levels; using current economic growth forecasts the ERP looks, if anything, quite low.
Three strategy questions are key to framing our ‘big picture’ thinking for the rest of the year:
- Are we nearing the end of this obsession with /addiction to monetary policy?
- Are there signs that inflation may be on the horizon?
- Could this be the turning point for rates?
As ever, our day jobs will be all about finding value in individual stock names, both long and short.
An example of an attractive recent opportunity can be seen in our recent participation in the refinancing of Kenmare Resources, an ilmenite producer. The company has been rescued from a ‘near-death’ experience – where operational issues, collapsing commodity prices and a lack of short-term liquidity combined to bring it to its knees. The company has a wonderful mine, which is now producing at 50% greater capacity and at a much lower cost. The P&L will also be boosted by the rapid rise in ilmenite, the key commodity that it produces.
Finally it is now almost debt free. While we rarely invest in this sector, we do believe the special situation thrown up by this rescue is highly compelling even if we assume no rise in commodity prices.
Jamie Carter is manager of the SWMC Small Cap European Fund