286. Will 2024 be the year of the polarised recession?

31 October 2023 (pre-recorded 18 October 2023)

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.

[NTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast, brought to you by FundCalibre. We cover a lot of ground in today’s interview, including the outlook for inflation and the impact this is having on the UK mortgage market. We also delve into the substantial discounts available in the investment trust world and why government bonds, despite their growing popularity, are actually giving you negative real returns.

Darius McDermott (DM): I am Darius McDermott from FundCalibre, and today I’m delighted to be joined by Dr. Niall O’Connor, who is the manager of the Brooks McDonald Defensive Capital fund. Niall, good morning.

Dr Niall O’Connor (NO): Good morning.

[INTERVIEW]

DM: So, it’s been a tricky couple of years. Investing isn’t easy, otherwise everybody would be rich, wouldn’t they? But the one key figure that I think we all look for now on a monthly basis, is the inflation print, because naturally it will lead to what we think the Bank of England or the Fed may do.

You’ve recently said that you believe the Bank of England will raise that target inflation from 2% to 4% going forward. Why do you think that will happen and what sort of impact do you think that will mean for investors?

NO: Sure. I actually think it’s a necessity. But I think it’s slightly more nuanced than that because it’ll be quite difficult for the Bank [of England] or the Federal Reserve in the US, or whoever’s setting the targets, to actually agree that the 2% target can’t work anymore and it’s got to be 4%.

I actually think that the target won’t be explicitly raised; there’s all sorts of terms like anchoring that central bankers like using, and credibility, and I’m not sure the central banks have much credibility, but they certainly don’t want to lose anymore. So, I don’t think the target will be explicitly raised, but I think it’ll be done in a soft way. And particularly, if you look at today’s CPI print, which came out at 6.7% in the UK and that’s unchanged on the previous month, that’s such a long way away from 2%. I think it’s going to be very difficult for banks to get back down to 2% and I think they’d be more comfortable if inflation could settle around 4%. So, I don’t think it’s going to be an explicit reduction, but I think it’s sort of baked into the cake, both in the UK and in the US, to be honest.

DM: Where do you think the terminal rate – let’s stick with the UK – might end up, because obviously it’s a key question? We had our first non-rate rise at the last possible opportunity after seeing 13 or 14 consecutive rises. Do you think – now that that inflation is sort of flat today – that I’m afraid we’re returning to another rate rise this year from the Bank of England?

NO: It’s difficult to call, isn’t it? But I think the Bank of England’s probably going to be in a ‘wait and see’ type of environment. Generally speaking, rate rises take 12 to 18 months to filter through to the real economy. Maybe we’ll talk about UK mortgages later on, but certainly not everyone has felt the increase in their mortgage rates yet. So, the economy is going to slow down a bit as a consequence of these rate rises, and that slow down is going to carry on for quite some time so, I can’t see the Bank of England raising rates anytime soon. But, by the same token – and certainly given today’s CPI print – it’s hard to see them cutting rates anytime in the near future.

DM: Well, maybe we should just touch on that, about a) the lag in monetary policy and the fact of UK mortgage rates; lots of people have been on fixed, but almost everybody I know who is on a fixed is not looking forward to 2024 because that’s tending to be when a lot of them roll over. What sort of impact do you think will happen there?

NO: You’re absolutely right. People aren’t looking forward to it, but what’s been really interesting is we haven’t actually seen the response that you would’ve thought. So, I know someone who is the finance director of a small company and his mortgage was due to be refinanced or is being refinanced in December. Now, as of last September, it was pretty obvious that fixed rates are going up from around 2% to around 6%. That increases your monthly mortgage payments by around 60%. And he’s a finance director, he must have known this, but it’s only been in the last month or so [that] the realisation has suddenly come in, oh, wait a minute, we’re a thousand pounds a month worse off, we need to start saving money.

So, although effectively this mortgage rate increase has been baked into the cake for a while, we haven’t really yet seen the economic impact of it. People whose mortgage will be refinanced towards the end of next year, I don’t think their spending patterns will really change until maybe the middle of next year. So, the economy hasn’t slowed as much as you might have expected it to yet. And that’s really where we see the lags come through.

Likewise with companies refinancing debt, a lot of companies with fixed rate debt – if you’ve got five year fixed rate debt, you know you’ve got a problem in the future, but it’s not really showing up in profits for now, for instance.

DM: Right. So, we’ve touched on the macro and the potential for some nice doom and gloom in 2024 as the rate rises we’ve seen behind us potentially kick in, particularly hurting those with mortgages, leading to that sort of inevitable slowdown.

Let’s get into a couple of companies and a couple of stocks. Round Hill Music [Royalty Fund Limited] was your stock of the month for both April and August of this year, and recently was subject to a bid. Maybe you could tell our listeners in best as you can layman’s terms a little bit about music streaming royalties. And then whether or not you think we may see more M&A particularly in the investment trust sector, which has this ability to trade at a premium to the net asset value, but more importantly today to a very substantial discount [that] most of the market is on today.

NO: Yeah, so about Round Hill Music first.

It’s one of the two investment companies in the UK that invests in music rights, writers’ music rights. The other one is Hypnosis Songs fund. So Round Hill is the smaller one. We preferred it from a quality perspective. The catalog is an older catalog, so it’s got songs like What a Wonderful World. And the nice thing about that song is that you hear it week in, week out, on adverts and so on, so the revenue stream there is pretty constant. And as the economy grows and as more people consume music – global music consumption goes about up about 8% each year at the moment – you’ve got a rising revenue stream.

Hypnosis Songs fund by contrast, have things like Rihanna’s Umbrella and Shape of You, which are sort of trendy, but you don’t really hear that much of those songs anymore so you’ve got a declining revenue stream. So, we just preferred Round Hill for the more consistent music. And it traded to a very, very big discount. [DM: Certainly did!] <laugh>

Yeah, I think it got to 51% discount at one point because what we’ve really got in the investment trust space at the moment is a buyer strike. People are just buying government bonds – and maybe we can talk about negative real returns on government bonds in a bit – but people are really keen on buying government bonds because they’re looking at a government bond and saying, I get 5% risk free and I lost a lot of money last year, I don’t want to take any risk. So, as a result of that, you’ve seen redemptions, outflows from open-ended funds that hold investment trusts.

Nobody really wanted to own an investment trust and hence it went to a 51% discount. And then it got bid for at a 67% premium to the previous day’s close – that was still an 11% discount to its net asset value so, I think sort of everyone’s a bit of a winner there; the shareholders get a 67% uplift; the IPO price was a dollar and we’re being bought out at $1.15 and a half, and we’ve had dividends along the way, the shareholders are happy and the acquirers are happy as well because they’re buying some assets at a slight discount to net asset value. And you know, it was our third biggest holding. So, it’s been a real win for us and vindication of our investment process and philosophy as well, I think.

DM: And broadly, I mean on some of the funds that we advise on, we buy some of the investment trusts as well, so, very familiar with the pain of the widening discounts and the buyer strike. But do you suspect we might get a bit more M&A?

There are, as you say, some really hefty discounts on real assets and real future incomes. I wonder whether we might not see a bit more of this, maybe some American PE money – private equity money – stuff like that coming and taking some of these assets at fair discounts?

NO: Yeah, it would be very odd if we didn’t, to be honest. We’ve had four UK real estate investment trusts – four REITs – being acquired in the last year or so. Round Hill Music is the first alternative investment trust, if you want to call it that. But you know, I was just having a look through our holdings and the discounts are, I mean, I’ve never seen them so wide to be honest. So, I looked through our fund and if you looked at investment trusts where you could pay a 30% premium to the current share price and still end up paying less than NAV – and a 30% premium is a sort of typical buyout premium – but you still get them at less than net asset value ie. less than the actual value of the company, then 30 of our holdings fall into that category. That’s 30% of our whole fund you could have takeover of. And I think you’re absolutely right, you know, US private equity must be having a look, particularly with the strength of the dollar recently. It makes UK assets look very cheap. But I’ve never seen a situation where we’ve got so much of the fund you could bid for.

DM: So, another alternative asset that I know an area that you like is student accommodation. Maybe tell us a little bit how that works and what it is you like about about that particular alternative sector.

NO: Sure. The main holding we’ve got here is Empiric Student Property [Plc] and it invests in top end premium student accommodations. This is very different to probably the accommodation that you and I had when we were at university.

DM: Almost definitely, almost definitely! <Laugh>

NO: This is all sort of luxury high-end en suite which I certainly didn’t have when I was at university. And what we’ve got at the moment is a very interesting demographic bubble. The number of people going to university in the UK is pretty much an all-time high so there’s a real shortage of student accommodation, and particularly at the top end. Now what’s really interesting, because of course property is not really a very popular area at the moment [DM: No.] …but what’s very interesting about the student accommodation is that you’ve got effectively uncapped rental growth because your rooms are re-let every single year.

So, every single year you can decide as the landlord what price you charge and what price the market can bear. And that’s very different to most commercial property in the UK. Most commercial property in the UK is capped at 4% per year. So, even if inflation runs at 15%, you can only put through a 4% increase. The nice thing about student accommodation is you are uncapped and Empiric is guiding to at least 7% growth this year and could even be as high as 10% to be honest, particularly with higher CPI numbers.

What you’ve got is a revenue stream there which is growing very quickly. And what we really like about this is clearly with rates higher, the cost of debt is higher and also you’ve got a negative effect because as the cost of debt gets higher, your what’s called your net initial yield goes up and that decreases the value of property. But that’s offset by the rental growth – if you can actually impose the rental growth which you’ve got here. So, this is a real situation where – and I think a lot of the market hasn’t really woken up to this – that real is not the same as nominal anymore. So, if you’ve got 7% rental growth, that offsets an awful lot of your increase in cost of debt.

So, we really like this one because you’ve got a proper growing, a real rental stream growing at least 7% a year. The stock’s also on a 24% discount at the moment. And going back to the M&A theme, Duncan Garrood, the CEO, the last two businesses he ran, he turned them around, which he’s also done for Empiric, and then he ended up selling them. So, I think this is a really interesting candidate to be bought.

You know, again, maybe you could look at American infrastructure funds or Canadian infrastructure funds might be quite interesting and their peer GCP Student Living [Ltd] actually was sold a couple of years ago. So, yeah, it’s got a very cheap, growing rental stream and [is] an acquisition candidate.

DM: And also, the supply and demand for those beds is also a nice supporting factor to drive that rental growth.

NO: Yes. It’s full occupancy, which is why you’re seeing such strong rental growth. Yeah.

DM: And a bit about government bonds then you mentioned earlier and how you’re tying in negative real rates. What does that mean?

NO: Sure. So the thing is, if you’re buying a government bond at the moment, you’re getting around 5% return. And that’s guaranteed, as long as the UK government doesn’t go bust and it’s, you know, very unlikely to go bust in the next year.

So, if you’re buying a one year government bond, you’re going to get 5% come hell or high water. The problem is, as we mentioned earlier, CPI is 6.7%, so it is all very well if you invest £100 in a government bond, now you’re going to get £105 in a year’s time, but the price of everything will be £106.7. So, in real terms, you’ve lost money, you’re actually walking backwards here. And I find it a bit strange. I think people just haven’t got acclimatised to the fact that the price of everything is going up and hence your required returns are higher.

If you look through a lot of our investment trusts now, the dividend yields are sort of 11% or 12%, whereas, you know, they would’ve been 6% or 7% before because everything has gone up 5%. And, as a result, we haven’t invested in government bonds.

We have invested in short-dated, index-linked government bonds because they yield around 2% higher than the normal gilts, the nominal normal government bonds. And actually today, a good example where we have a high CPI print – where CPI comes in higher than expected – government bonds have sold off, whereas linkers – our index-linked bonds – have actually gone up. So, you know, we’re hedging …

DM: Yeah, index-linked bonds have not been a good investment over the last 24 months.

NO: That’s absolutely right. Because the problem is what you are talking about is the longer-dated, index-linked bonds and they have a really interesting mix, a complex mix of a nominal element so when rates go up, they sell off, and also an inflation-linked element, I think that’s caught a lot of people by surprise. But yeah, the linkers we invest in are one year or six month linkers. So, we’re really short [DM: Short duration, short dated, yes.] So we’re effectively getting 7% or 8% on a short-dated linker which I think is a much better bet than 5% on a government bond.

DM: And does that mean when you are looking, you are generally looking for yields above inflation? You know, that sort of anything above 6.7% is attractive to you because it gives you that positive real return?

NO: I suppose there’s two different ways of looking at things. Everything’s on a risk versus return basis. [DM: Of course] On one end of the spectrum, we’ve got things like Empiric Student Property where there’s a reasonable amount of volatility. It’s like a real estate investment trust, it’s an equity effectively, but we just think where you’ve got that kind of discount and that kind of upside, that that’s one way of doing things.

At the other end of the spectrum, we’ve got our short-dated index-linked bonds where I just think you’re being given free money, you’re being given 2% or 3% above the government bonds without taking any risk. So, everything’s risk versus reward for me.

DM: Yeah. So, maybe then, if we could, and I know we’ve already touched on this, but a bit of an outlook because we’re coming to the end of ’23. Your job and mine often is to try and have a prediction of the future and then what that might mean for assets. And as obviously a fund manager, you have to think about the world ahead and what investments you might have coming into the fund.

NO: Well, I mean, just in terms of outlook, we’ve already talked a little bit about rates. [The] Bank of England I don’t think is going to put rates up. I think the next move’s probably going to be downwards, but when’s that going to be? We don’t know.

The US Federal Reserve probably the same. Some people sort of talk about Table Mountain, where rates have gone up a lot and they’re now going to plateau and flatten out. I think that’s probably about right. So, I don’t think we’re going to get any tailwind from falling rates and you know, we don’t need a tailwind in the fund given how big discounts are and how high the dividend yields are at the moment.

I think the other question everyone’s asking at the moment, still asking actually, is is there going to be a recession? Because a year ago, everybody was calling for a recession. We thought there wasn’t going to be one. And I think I’m still in that camp at the moment actually.

DM: Right. Even with those rate rises starting and mortgages coming off like we discussed earlier?

NO: Yeah. Because only about a third of people have mortgages and it’s, I think this recession, let’s call it, there kind of will be a recession, but it’s going to be a strange one because if your mortgage has gone up £1,000 a month, you are kind of personally in a recession already. You’ll be cutting back on, you know, £1,000 a month, that’s £12,000 a year, that’s way more than a family holiday, so you’ll already be feeling as if you are in recession.

So, we’re going to end up with a very polarised recession, where some people won’t notice it at all and other people are going to be feeling it. And I think again, it depends a lot on income deciles. If you’re in the very bottom deciles with benefits going up with inflation, probably, yeah, it’s not great, but you’re not the worst off. If you’re in the top two or three deciles, your assets have appreciated, so you’re probably okay. But somewhere in the middle, you’re going to be feeling economic times are quite hard. And you know, as well, I think the job market will weaken a little bit as well. But again, you know, we’re seeing good pay rises, we’re seeing 7%-8% pay rises at the moment in the UK. So it’s, yeah, it won’t be a deep recession but I think some people will feel like there is one.

DM: And just finally then Niall, if we may just, what do you feel about the valuations broadly on equity markets? A question I get asked a lot, again, often at this sort of closing part of the year. What do you think about valuations on FTSE 100 vs S&P vs Asia or Europe? Any observations there?

NO: Well, it’s a bit strange, isn’t it? I mean, the NASDAQ’s on around 30 times P/E, the S&P is on about 20 and the FTSE UK Equity’s on about 11. And that feels very wrong because if, at the beginning of the year, you’d told me we were going to get to where we are at the moment with interest rates very high, you’d say that actually, the interest rate sensitive stocks mainly in the NASDAQ and partly in the S&P, they would suffer as they did last year. And non-interest rate sensitive stocks, the real economy stocks, you know, like banks for instance and oil companies would do very well. So actually, if we’d got to where we are now and you didn’t know where markets are, you’d have thought the FTSE would’ve done quite well and the NASDAQ would’ve sold off.

So, I’m scratching my head a little bit. I mean there’s clearly a bit of an AI bubble going on. We’re talking about the weight loss drug bubble as well. Yeah, markets are a bit strange, but yeah, NASDAQ feels very expensive to me. And you know, the FTSE, we’ve seen another small UK company being taken over today. You know, if the FTSE valuations – UK equity valuations – stay where they are, then they’re going to get bought.

DM: Niall, thank you very much for your time this morning and running us through not only your fund, but some of the macro environment and a nice bit of outlook for 2024, so thank you very much.

NO: It’s been a pleasure, thank you.

SW: SVS Brooks Macdonald Defensive Capital is a multi-asset fund aiming to achieve positive absolute returns over rolling three-year periods. To learn more about the SVS Brooks Macdonald Defensive Capital fund please visit fundcalibre.com and don’t forget to subscribe to the Investing on to go podcast, available wherever you get your podcasts.