219. Currencies, corrections … and inflation!

27 October 2022 (pre-recorded 18 October 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Darius McDermott (DM):

I’m Darius McDermott from FundCalibre. This is the ‘Investing on the Go’ podcast. Today I’m joined by James Mahon, co-manager of the [SVS] Church House Tenax Absolute Return [Strategies] fund. James, good morning. 

James Mahon (JM):

Yes, good morning, Darius

(DM):

Well, we live in interesting times! We were having a quick chat off air, and it’s certainly interesting, but I’ve always thought of you as a sort of fairly calm, collected investor. What’s your view on what’s happening in [the] markets? We can go wherever you want [to] go, whether you want to go [to] bonds or equities or UK, or beyond. What’s it feel[ing] like out there at the moment?

(JM):

[0:44] Ok, well thank you for the compliment, Darius. Really, we have to sort of stand back and reflect that it is all about inflation. It is still all about inflation, and that holds the key to it. What we have found is that we’ve had a little local difficulty in the UK, which has rather thrown a spanner in the works, but on the other hand, it has meant that an awful lot of things that needed to be corrected, have corrected very, very quickly. And we have to be [a] bit careful with inflation because it’s a lagging indicator, and it certainly is lagging at the moment.

 So many of the components are actually going our way. I mean, the oil price has come off really quite significantly. It’s now trading around the $90-92 [US] dollar area, having been up closer to 130 [USD] in March.

[01:44] Possibly locally more interesting, is the European gas prices, which have really collapsed. And having hit that around 339 euro[s], I think it was in August when Putin got his gas attack underway, we’re now back down at about 120 euros, there’s been a very significant turnaround there. So, that’s got to be encouraging. And actually, it’s also got to be a big help from the point view of the chancellor and trying to change his policies on the energy support.

We’ve also seen the metal markets; copper’s a long way back down from peak, about 30% off. We’ve seen freight rates are way down, and crucially China is slowing. China is slowing, the covid policies are slowing the economy there, and the Chinese property market is really weighing on their economy.

So, what we’re seeing is actually a lot of deflationary forces at work. So, I am expecting that inflation will peak out in the next few months. And I know we’ve felt this for a little while, but it does feel like that’s the direction of travel, and it really is that inflation that’s key.

(DM):

Do you expect, I mean, are you in the ‘back to 2% inflation’ camp anytime in the next say 24 months? Or do you just think it needs to stop going up firstly, and then potentially start coming down, even if it only comes down, I mean with, let’s approximate and call it 10% across Europe? Obviously, 6% is far more agreeable, or do you just see that energy price part of inflation being so vast, that actually we could be back to four or five [%] within a year or so?

(JM):

[03:37] I think we come back down. I think hoping it’s coming back down to 2[%] is a little ambitious at the moment. I think we’ve got to expect the, if it gets back down to 3-4[%], we’re going to be very pleased about it. And just as it’s surprised on the upside, it might well surprise when it comes back down again, but I think that’s the way of it. And it does lag. And clearly the central banks are playing catch up in a big way.

And history tells us – and I’ve done quite a lot of looking back at previous periods of inflation -and what really the market is looking for, in the broadest sense of ‘market’, is that time when it really feels that the Federal Reserve has got a grip on things again. And I suspect we’re quite close to that now. There’s no doubt that J Powell is tightening quite aggressively, and people are beginning to believe him. You know, we’re going to see US rates up another leg or two yet. Whether or not they’ll get right up on US rates – the base there is at 3.25% percent – I guess we can get it up to 4.5[%], 4.75[%], that sort of area, but at that stage, I think we’re going to see a pretty steeply downward sloping yield curve. Sorry, that sounds a bit weirdly technical, but with US short rates that high, I don’t think US long rates are going to be that high. So, that points towards some sort of recession in the States.

(DM):

So, let’s just explain that then for our listeners. What that means is: on the chart of yield on the y axis and duration by length of time, is that you’re getting paid more tomorrow at the short end. So, if I loan to you for two years, you’ll pay me more than if I loan to you for 10 years. That is counterintuitive, isn’t it? And a signal of recession historically.

(JM):

[05:46] It is counterintuitive, and what’s been quite interesting in the last week, as we’ve had all this chaos in UK markets, is that the UK yield curve has actually gone back to what might be called the correct area. So, we’ve now got short rates in the UK, trading – this is two-year rates in the UK – trading around 3.5%, and 30-year rates, at 4.5%, pivoting around a 10-year at 4%, which is the same level in the States – US 10-year rates are at 4%.

[In the]UK, we’re going to get base rates up – they’re still at 2.25[%]; they’re lagging a bit, to be fair to the bank – and I want to be fair to the bank at the moment, because I think they’ve behaved well in the last couple of weeks – their previous rate setting meeting was just before that fiscal event, so, I think one can forgive them for only putting rates up 50 basis points [0.5%] at that time. So, UK base rate [is] 2.25[%] now, I think we’d be expecting 75 basis points [0.75%], so up to 3% in November. I don’t think we’re going to get as far as 4[%], I think UK rates can probably get to 3.5[%] but it is actually now a healthier shape, than in the US.

(DM):

Yeah. So, we’ve touched briefly on the mini-budget – we are recording a day after the massive U-turn – and one of the outputs of that mini-budget was, of course, a massive run on our currency versus pretty much all the other major currencies – something that you highlighted as a potential in your last monthly update. Were you privy to the then chancellor’s crazy suggestions, or was there something else behind your thinking?

(JM):

[07:47] <laugh> I’m always delighted to hear that someone’s been reading my updates Darius! I think we have to, I mean, sterling has been a bit of a whipping boy and it is a bit of a, I have to say, it is a bit of a sideshow really. It’s all about the [US] dollar.

(DM):

Yes, exactly, the dollar’s been dominating [the] yen and euro and everything. It’s not just us.

(JM):

[08:09] Exactly. Exactly so. And the dollar is right back up at the top of the range, and it feels to me as if the dollar’s probably gone far enough and that, at this stage, sterling is probably going to steady, but the actual move on sterling’s trade-weighted index is not very big. It’s only a few percentage points and it’s a freely floating currency. So, I think all the focus on sterling was slightly the BBC, and the really important bit was what was going on in the gilt market. It was gilt markets saying “no”.

I think, I mean, it’s also worth just pointing out that quite extraordinary move in the index-linked market, is that the index-linked gilt market isn’t a very liquid market at the best of times. But, to take an example though, there was a new index-linked issue came out last November. It’s a very long dated one: 2073. So, it works for people with long-dated liabilities, like pension funds, and it was issued at a price – this is an index price – of £3.56. And in mid-September that fell to 50 pence. And it is the most extraordinary move. And for an illiquid market, but nonetheless, a gilt market to move that dramatically, it is a staggering re-pricing of long-term interest rates. Not, I mean, you and I have spoken about this lots in the past – we’ve long thought that long-term rates were way too low, but it’s been corrected in a trice, in [an] absolute trice, and suddenly they’re interesting again.

(DM):

So, I think that brings me then swiftly on to what opportunities are these incredible market conditions offering you, as a long-term investor? But yourself and Jerry, you do a lot with fixed income, gilts and, and other fixed income, which maybe we’ll touch on [in] a little bit. Are bonds now attractive having been, sort of, not super yielding for quite a long period of time, both government and investment grade?

(JM):

[10:33] Well [the] short answer is yes, they are. I mean, they have moved so quickly that yes, they are. We’re still going to add the caveat, that there’s not much point in going long, because short-dated bonds now offer so much potential for return, that they are very attractive.

Within Tenax [this fund], I can say that we have our book of corporate bonds, that have a duration of less than four [years] – sorry, perhaps [I] shouldn’t go into duration and time periods – but anyway, they’re short-dated bonds, but the average price of these bonds is close to 80 pence in the pound.

So, my point is the very simple one, that these are short-dated bonds, these are investment grade bonds. They’re going to repay at par, at a hundred. So, there is [DM: a capital opportunity], well, there’s a near 25% capital return in there, beside the fact that they’ve got very high yields too.

So, that suddenly to me is a great opportunity, and it’s a much more reliable opportunity than moving out to longer-dated yields; and albeit longer-dated yields have snapped back to the very long-term averages – and they’ve snapped back to the yields that were around before the financial crisis – so, yes, they’re much more interesting, but I’m [not] quite sure we see the point in taking a risk at the moment, when we have these phenomenal opportunities at the short end of the market.

(DM):

So, you’ve always said that the Tenax fund looks to exploit mispricing opportunities that arise at these extreme periods of volatility. Outside of the gilt and the bond markets, where else [are] you seeing those opportunities? Are equities offering good value, or some of the alternatives, which I know that you like historically?

(JM):

[12:41] Equities possibly are, yes. The correction vis-a-vis gilts, I mean it’s interesting to see that – again, if we focus on the UK – UK equity yields are now the same as long-term gilt yields. So, we’re back to one for one in terms of yields. And that’s been a ratio that’s been distorted for a long time. So, it’s good to see that, and relatively speaking, it makes the gilt actually look slightly more attractive than the equity.

But equities have derated very significantly, particularly in the UK though, they derated so much. And of course, the weak pound tends to help UK equities. We can export more easily. And of course, we have a lot of, well, at the bigger end of the market, we have a lot of big dollar earners. But the really, if you like, cheap area of the market, looks to be in the FTSE 250 and below, where prices have fallen a very, very long way.

And interestingly, we’ve got cropping up across the board, one of those funny little old indicators of yield exceeding price earnings ratio, is popping up again in lots of mid-and small-cap companies. And it does seem to us that yep, maybe this is looking a little bit overdone in some areas, the equity market. So yes, I feel more constructive on, if you like, risk assets – to use the awful term – than I have for a while because we’ve had this extraordinary, we’ve had this blowout.

(DM):

Yeah.

(JM):

[14:28] I can’t say the same about the conservative party <Laugh>

(DM):

<Laugh> Yes. Well, maybe there’s a correlation there, that wasn’t previously obvious! Let’s go back into fixed income. And I know an area that you guys are expert in, and do use a lot, is floating rate notes [FRNs]. Would you be as good as to give us a fairly layman’s explanation as to what they are, and how they differ when rates go up or go down, than a conventional bond, which is extremely sensitive to interest rate rises and falls?

(JM):

[15:05] Yes. Okay. These tend to be issued by big banks and financial institutions. And the interesting part to us, is literally that floating rate. So, the interest rate that is paid on these bonds, floats up with short-term interest rates – or down as the case may be. So, if one goes back a year or so ago, these bonds would’ve been paying interest rates of perhaps 50[basis points] – 0.5% or so – more than whatever the base rate was at the time. But as interest rates have gone up in the market, so the interest rate on these bonds go up. The joy of that is, it means that the capital values of these bonds stays steady. And that’s what’s happened over the course of this pretty grim first three quarters of the year.

(DM):

Yeah.

(JM):

[16:04] So, floating rate notes have stayed steady throughout, and the interest rates we’re getting off them, go up and up, and that’s great. We like that.

(DM):

Well, James, thank you very much for running us through a fairly interesting, if not topsy-turvy market, both with respect to equities and bonds, but particularly the gilt market, which I know you and Jerry follow very closely. If you’d like more information on the [SVS] Church House Tenax Absolute Return [Strategies] fund, please do visit fundcalibre.com. And don’t forget to subscribe to the ‘Investing on the Go’ podcast.

(Outro)

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.