Investors and Economists: Two Tribes

We are all largely prisoners of our own experiences and so it is in the debate about whither the economic future. Those with a macro economic background are pretty upbeat about the world from an economic point of view. Those, however, with a financial investment background are a good deal less than upbeat: a lot of half empty glasses at this party. The economists tell us that the global economy is doing pretty well. The investors tell us that pretty much every asset looks expensive. The economists think it’s Summer and the investors that it’s Autumn.

The investing folk are full of statistics about stuff never having ever, since records began, ever, ever been so expensive, which is mostly about bonds. And it is hard to disagree. But there are lots of other peak prices being spotted. Swishy residential is one. The corollary is that if you invest now, you won’t make much money in the long run. And the question is how this plays out. Do we have low returns for a long time? Or do we enjoy a “resetting of market expectations” aka a massive sell off followed by recovery from a lower base.

The economists, meanwhile, tell us that the global economy is actually doing rather well and that growth is widely dispersed with positive outcomes in most regions. Unemployment is low, which is good for general welfare. There seem to be some signs of positive real growth in incomes. Yet, inflation also remains low and inflationary pressures stubbornly hidden – or, simply, non-existent. Emerging Markets are humming along. Thousands continue, in that favourite phrase, to be lifted out of poverty. Of course, there is this dreadful social ennui in the advanced economies but that’s the fault of the wretched politicians having created such unreasonable expectations; life was meant to be hard. Snowflakes. Hmmph.

Indeed, where there is no dissonance between our two groups is their view of politicians to whom they similarly condescend. So ignorant. So backward. So simplistic. The investing folk simply cannot understand why politicians keep failing to make to the electorate the compelling case for financial markets as efficient tools for sharing and pooling risk, for the general welfare indeed. As for the unwillingness of politicians to accept the idea that financial market participants should earn many multiples of average earnings and then to popularise this view among their electorates: such failure of leadership. The economists take an even dimmer view of politicians.

It may come to pass that the politicians do, indeed, mess it up for everyone. For everyone, read economists, investors and like folk. If they do not, however, which view prevails – the happy economists or the gloomy investors? In the long run, the answer is probably a bit of both. Short term, it looks as if the economists may have it. Longer term, our guess is the investors have it and, moreover, we probably believe more in a sell-off followed by recovery, rather than years and years of consistent low returns.

How does the endgame play out? It pays to watch the credit cycle and to keep a weather eye on commodities. Why not FX or equities? While sharp moves in a country’s FX rate can have a material impact on its performance, both good or bad, FX only measures relative value; not all countries can have their FX rates going up, or down, at the same time. And while equities may be the market through which many of us measure how which we feel, it is not always the leading indicator. If equity markets dry up a bit and issuance falls away, there is a long-term impact but less of a short-term one. Companies typically raise equity in a measured fashion and there are other sources.

Credit, though, for businesses large and small, is here and now. If credit markets dry up, tighten, take profits or whatever, businesses feel it pretty quickly. There are few businesses that can finance raw material purchases, inventory and sales invoicing with cash on their balance sheet. Right now, credit looks available but with some signs of tightening, particularly in softer areas like lending standards.

All the while, we keep an eye on the commodities. Big rises in oil prices, or big falls, affect businesses and economies pretty rapidly. But prices can change direction quickly as we have seen; the sell-off of H2 2014 preceded the recovery of H2 2017. Economies can ride price cycles. But, commodity price moves can be accelerants to a fire already underway. If you mix rising energy prices with a tightening credit cycle, a lot of stuff gets burned.

Invest with caution is how we feel right now. Not for snowflakes. Watch credit and commodities.

The traditional tribalism of investors in private equity versus investors in public equity has given rise to some interesting knockabout between the two over the years. However, we are observing increasing signs of collaboration between the two camps and this is something of which private investors should be aware.

In a fully-valued market and with a huge weight of client capital to put to work, private equity firms are increasingly employing new ways to find potential target firms. More innovative private equity investors are scouting the public markets and looking for ways to work with public equity fund managers to winkle out opportunities without overpaying for assets at auction. One of our fund managers tells us that they have had more approaches from private equity firms over the past eight months than in the last six years.

Such approaches include taking publicly listed firms private in order to effect management change and then seeking a relist or a private sale. There has also been an increasing propensity for public equity activists to set up their own private equity arms. While activists can’t ensure campaign success, direct access to a private equity capability clearly increases the certainty of victory.

Enterprise software has been a particular target for this approach and there’s a reason for this. Successful enterprise software businesses have recurrent and stable revenues which make them appealing to the public market, and good holds for public equity managers but the high barriers to entry and lack of equity analyst coverage at the smaller end of the market (made worse by recent MiFID efforts to unbundle research) mean that efficiency can be lacking. This makes them an ideal target for concentrated public equity fund managers teaming up with private equity firms with an eye to taking such firms private before effecting a restructure and a profitable exit.

As ETFs further increase their market share and tip the balance away from stock picking in the public market generally, we expect to see an increase in what is effectively stock picking in the private market and the underserved end of the public market. This potentially provides an opportunity for investors who have both the ability to be flexible around asset allocation (unlike many institutional investors) and the ability to provide liquidity to a relatively illiquid market (unlike many smaller or shorter term investors). As this describes many of our clients, we watch these developments with interest.

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