Monday digest

Posted 26 February 2024

Overview: M&A activity sets growth against value
Equities moved higher again last week, with gains made across global markets. Even China put in another week of positive returns following the largest ever cut to the five-year housing loan prime rate (admittedly only 0.25%). Government bonds fared less well, with yields rising slightly after a small rebound in general economic growth optimism. Corporate bonds did better, with yields broadly unchanged, on the back of that optimism of credit risks likely to recede even further.

Last week, some of the data releases reinforced the previous week’s pessimism about the potential for near-term UK economic growth, with GfK’s Consumer Confidence Index falling from -19 to -26 in February. And yet… UK business confidence has been picking up. February’s interim ‘flash’ Purchasing Manager Indices (PMIs) estimates showed services doing particularly well, with manufacturing less well but still better than January. The PMI data is definitely welcome news, with companies getting more positive on their outlooks and therefore on their hiring and business investment intentions. Overall, for the rise in optimism to be maintained, we think rate cuts in relatively short order are still needed on this side of the Atlantic. The good news is that China may well be starting to show more optimism as well. We will get its PMI data at the start of March.

Elsewhere, the talk in markets was all about merger and acquisition (M&A) activity, which tells us about a gradual shift in investment sentiment. In the UK, electricals retailer Currys received a cash bid (ultimately rejected) from activist investor Elliott Partners. Chinese retail internet platform said it would bid as well, although there are yet to be any details. Meanwhile, in the US, credit card company Capital One announced an all-share agreed offer for Discover Financial Services, another credit card and payment system company. At $35 billion, this deal would easily be the largest of the year so far.

M&A activity has interesting implications for investors. Here at Tatton, we leave the business of picking particular shares to our selected fund managers. Since the start of 2023, ‘quality growth’ companies have been the clear winners, both in revenue and profit performance and in share price valuation terms. Now though, rising M&A activity could mean that investors will start to look for value.

Into the Questverse: Is AI analysis changing market patterns?
According to JP Morgan Research’s February ‘Questverse’ report, the most central investment themes right now are artificial intelligence (AI) and inflation. This will surprise no one, but a notable thing about this observation is that it came from an AI program itself. JPM’s Questverse uses a natural language processing model along with machine learning. It does so in a rather complex way, but the basic premise is that the program tries to recognise patterns in large datasets. The program’s architecture means it is very good at recognising patterns. Therefore, it is no surprise that the Questverse system can detect investment themes and their prominence more consistently than a human.

JPM is far from being the only company applying AI to investment information or decisions. In fact, many of the AI investment programs currently in use are not that different to programs that have been around for many years – high-frequency trading (HFT) for example. But when it comes to using those themes in investment decisions, on their own they give no information about underlying value. Discerning themes and trends might give you some hint about whether an asset’s price is going to go up or down, but they give you no sense of the asset’s fundamental value. We wrote last week about asset bubbles – and ironically the current bubble talk is all about AI stocks – which are defined as instances where an asset’s price systematically deviates from its fundamental value. If everyone is looking for price patterns and not value, bubbles are more likely – and hence, so are sharp unpredictable corrections.

Of course, humans are just as susceptible to feedback loops as machines. But machines are able to process massively more amounts of information several times quicker than any human – meaning the feedback effects can be much larger and sharper. This is exactly the criticism regulators and campaigners have made against HFT programs for years – demanding that regulation be brought in to address growing problems. That brings us to the question of what should be done. Clearly, the AI genie cannot go back in the bottle, and it would be foolish to try and stop the use of AI investment tools. What we can do – as with any investment strategy – is to better educate ourselves on the risks involved. Ideally, this would be mirrored at the regulatory level too. Without it, ever-bigger feedback loops and sharper price movements will likely be a feature of markets under the influence of AI.

Uranium prices go nuclear
Uranium is in a bull market. Triuranium octoxide – also known as ‘yellowcake’ uranium – cost $87 per pound at the start of this year, but has risen to $103 at the time of writing. If trading carries on like this, we will edge closer to the astonishing peak seen before the Global Financial Crisis of 2008.

As the only source of fuel for nuclear fission reactors, uranium is and has long been a vital commodity. Moreover, nuclear power’s inevitable role in the global energy transition away from fossil fuels is clearly acknowledged by politicians and, in many instances, is being backed up by strategy and investment. At last year’s COP28 summit, 22 countries, including the US and UK, pledged to triple nuclear energy capacities by 2050. This global structural push inevitably means more uranium demand, at least in the future. But perhaps there are other factors driving prices in the near term. One reason might be the strategy of ‘fast investors’ capitalising on a flaw in how utility companies structure their contracts. Utility companies often secure supplies with longer-term contracts with producers. These contracts often peg the price to the spot market at the time of delivery, plus a premium. This makes sense when utility companies expect falling – rather than rising – prices going forward. Fast investors have tightened spot market conditions and now a demand surge has put a ‘short squeeze’ on the utility companies.

Fortunately, the potential physical supply of uranium – the amount it is actually possible to mine and enrich – is not a problem in the long term. There are plenty of mines and potential deposits throughout the world. However, near-term supply and demand is tighter, and geopolitics is clearly involved. Crucially, the uranium price squeeze is likely to be short term and will not stop the transition to nuclear energy – or the broader decarbonisation strategy of which it is a part.

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