Monday digest

Posted 29 April 2024

Inflation, a common side effect of growth

Volatility is back, but it’s not all bad. UK stocks fared well, thanks to BHP’s takeover bid for Anglo American, and China is recovering from January blues. On the other end is Japan, whose equities are now 7% down from their March peak in Sterling terms – partly down to currency weakness. Geopolitics were thankfully calmer, but bond yields edged higher.

US growth for Q1 came in below expectations, but this hides the strength of US demand – with domestic final demand still above 3% annualised. Inventories came down and, for the first time in two years, the US imported more than it exported. While it is unusual that net exports have taken this long to move into a negative contribution, the fact that this has happened shows the strength of US demand.

This is a problem for the Fed. Core personal consumption is running well above where it should be to meet the 2% inflation target. The US is so strong it’s making problems for the world’s other central bankers – with March’s core global inflation picking up to 3.7% annualised. The ECB will probably cut rates in June, but its recent messaging suggests it may leave a big gap before the next cut.

That is unusual in rate cut cycles, which normally move down swiftly. Markets are pricing just 1 percentage point’s worth of cuts in Europe for the next year, and less in the US. At least inflation pressures aren’t enough to make central bankers talk about raising rates. And at the moment, interest rate disappointment is being offset by strong corporate results and pricing power – as shown in the Anglo American deal and the impressive profits at Microsoft and Google.

Next week’s Fed meeting will be key to watch, but we should brace for more volatility before then. It seems markets have finally realised that returning inflation could be bad news after all, having gotten overexcited during the Q1 equity rally. The correction makes sense, but the medium-term growth outlook remains strong, as shown by earnings reports. Keep calm and carry on.

Buying Back: growth strategy or accounting trick?

UK companies have a deserved reputation as dividend payers, but many are increasingly opting to buy back shares instead – most notably Tesco’s recently announced £1 billion buyback plan. People debate whether dividends or share buybacks are better value for the company or its investors: US companies historically favour big share buybacks, while European firms prefer to give shareholders the money directly.

In theory, there should be no difference for long-term investors. If the capital that would have been paid out instead manifests as added stock demand, the share price should go up in direct proportion, all else being equal. If you are a total return investor, the value of your holdings (cash plus stock) should be the same. But the reality is more complicated in terms of tax implications, for example, with share buybacks historically having more tax benefits.

The bigger debate is about how buybacks affect value. Self-bought shares are cancelled after buybacks, which reduces the number of shares outstanding and therefore increases earnings per share. This shouldn’t affect valuation in terms of price-to-earnings, since the price should go up in equal measure. But growing EPS looks good, particularly in the current era where ‘growth’ stocks dominate the market.

Moreover, the more companies spend on buying back shares, the less they have for earnings. So if firms are always opting for buybacks instead of dividends, their share price will go up but projected earnings would go down, meaning the price-to-earnings ration increases. This growth focus is probably why European firms are increasingly buying back shares instead of paying dividends. They are emulating the American model, which ironically seems to be delivering less value for US corporates now than it used to. European corporates might stand to benefit though, as buybacks are starting from a low base. If it is an accounting trick, it could be a very handy one to use.

China long on copper

Copper is in the news after BHP lodged a takeover bid for Anglo American. The world’s biggest mining company wants Anglo’s copper exposure, and is willing to pay above market valuation for it. This comes amid rallying prices: S&P’s copper index is up 6% in April, despite negative returns for wider commodities.

Citi Research reported that copper funds have a record $36 billion in ‘long’ investment positions – an all-time high. Copper prices rallied above $10,000 per tonne on Friday, but Citi think they could go even high thanks to structural and cyclical factors. Copper funds with ‘short’ positions are also at a record $21bn, but these bets could drop out as prices rise. Underneath this prediction is both long-term copper demand from the global green energy transition, and short-term demand from returning global growth.

The fact so many are buying doesn’t mean the buying is justified, though. Other eco-related assets haven’t done as well recently, and the global reflation story has been challenged in recent weeks. Interestingly, a lot of the physical copper demand is coming from China – despite continued weakness in the world’s second-largest economy. Chinese companies’ copper buying has been well above seasonal trends this year.

We suspect this is a precaution against potential currency devaluation. The People’s Bank of China (PBoC) is letting the renminbi-dollar exchange rate push the boundary of its target range, something it historically does before devaluing. Chinese citizens are buying gold to protect against this (a big reason for gold’s huge rally) and it looks like firms are buying copper.

This will likely continue as long as the PBoC maintains its holding pattern with the currency. If devaluation happens, copper demand could drop suddenly. Until then, Chinese manufacturers and financial speculators will probably keep buying, even if the metal looks expensive in dollar terms.

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