Monday digest

Posted 15 April 2024

What the return of volatility tells us

Equities were fairly stable in the US and UK last week, despite bond yields moving higher. Europe was the opposite: stocks fell despite falling yields. We might have thought bond volatility would hurt risk assets more than it did.

American investors still seem to be in “buy-the-dip” mode. Stronger growth and inflation signals have been hitting equity prices (since inflation holds back interest rate cuts) and core US CPI rose to 3.8% year-on-year last week. US Treasury yields broke above 4.5% for the first time since November, and the probability of a June rate cut fell to just 30%. But markets are happy enough about growth that they don’t seem to mind rates staying high – hence equities keeping pace.

US growth is still lopsided, though. The outlook for small business profits is reportedly the worst it has been in 10 years, and firms are worried about returning inflation. Manufacturers are thankfully feeling better, and overall profits are on the rise thanks to strong pricing power.

Analysts have been raising their forward profit estimates for the S&P 500 at a 10% annualised rate for most of this year, compared to a 6% historical average. Much of that is concentrated on the Mag-7 – US tech behemoths – whose profits are expected to jump 38% year, compared to a 2% fall for the rest of the index. That being said, the also-rans’ profit estimates have risen 6% since last May. Uneven distributions aside, growth is broad enough to worry the Fed. No one thinks they will raise rates, but if CPI keeps rising idea might be tested.

Europe has the opposite problem, which is why the ECB has finally promised rate cuts in June. Labour markets are tight either side of the Atlantic, but European companies are hurting, as shown in stock markets. Manufacturers are still battling energy costs and – according to a European Commission report – are suffering from Chinese ‘dumping’.

Europe might have to impose tariffs, like the US, but will struggle considering how much it exports to China. Then again, China is struggling with domestic demand too – not a surprise considering President Xi’s philosophy frowns upon individual consumption.

Thames Water investable, but badly priced

Thames Water is in a standoff. It says it needs investment, but the pension funds that own the company say they cannot give it unless regulations that limit prices and payouts are changed. The stakes were raised two weeks ago when its parent company, Kemble Water Finance, defaulted on £1.4bn worth of debt. Shareholders say the utility company is “uninvestable” in the current environment. We disagree. It is investable; they just paid the wrong price when they bought it from Macquarie in 2017.

Kemble cannot pay its debts because the regulator, Ofwat, has blocked dividend payouts from Thames Water. But the default might push Thames Water into Special Administration, meaning a write-down of the operating company’s £15.6bn net debt. Shareholders recently rejected a planned £500mn equity injection, demanding Ofwat approve a 56% real price increase by 2030 and allow dividend payouts again.

A Financial Times article last week argued that Thames Water’s nosediving equity value – from a £5bn purchase in 2017 to practically zero now – shows that the Capital Assets Pricing Model (CAPM) pension plans used to value the utilities company is faulty. But focus on CAPM’s failings is misleading. The problem is that key information about the asset was misrepresented or ignored. Models give conclusions based on the information you input. No model can give you the right conclusions if you input the wrong information.

Macquarie deserves some blame, taking £2.7bn worth of dividends when it owned Thames Water from 2006 to 2017, loading it with debt and underfunding infrastructure updates in the process. But the pension funds should have done their due diligence too.

They assumed prices would scale with inflation – when in reality people don’t like paying more for water when other prices are spiralling. Low-returning assets like utilities can only compete with other investments if they are highly leveraged. But for public services, leverage and shareholder payouts are always political.

If pension funds had appreciated this and known what they were buying, they wouldn’t have paid anything near what they did. Nationalisation or tight regulation are always likely for crucial public utilities with little private investment value. Asset values should reflect that.

Gold as a currency alternative?

Gold has been one of the best performing assets of 2024. This is strange for a so-called safe haven asset. Returns on cash – interest rates – are high, and the stock market rally proves investors aren’t running scared.

That is in the West at least, but gold’s reputation as a cash alternative is arguably stronger in emerging markets. Zimbabwe just announced a gold backed currency, and the central banks of India and China are buying bullion reserves to protect against Russian-style sanctions. Chinese and Indian middle classes are a big source of demand.

Wealthy Chinese in particular are increasingly buying bullion as a means of shielding assets from an overzealous government. Economic malaise, stock market volatility and the dire state of China’s property market are driving more citizens toward physical gold.

The People’s Bank of China is indirectly (and directly) supporting demand. It has been maintaining a stable exchange rate against the US dollar despite selling pressures on the renminbi. The PBoC holds a loose dollar peg by setting a target exchange rate every day and allowing a 2% trading band around it.

Keeping a stable rate against the dollar helps Chinese citizens buy gold because the precious metal is priced in dollars. But that could be about to change. The PBoC has consistently been letting the renminbi get closer to the upper bound of its 2% range. The last time that happened was before the sharp renminbi devaluation of 2015. A devaluation against the dollar now would make sense too: it would boost Chinese exports and maybe spur some life into a deflationary economy.

For now, Chinese savers worried about a devaluation will be even more likely to buy physical gold. So, the longer the PBoC maintains its current exchange rate, the longer gold’s rally has left to run. If it does devalue, gold prices would struggle to climb higher.

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