Commentary, Panorama —

Don’t Fight the Fed

Scott Morrison

Scott Morrison

Founder & CIO


Will interest rates ever rise again? In July’s Panorama commentary, CIO Scott Morrison talks rate cuts, our new minister of finance, and the new winners of the summer.

Source: Bloomberg

I often talk about interest rate levels in our monthly comments, and as you can see in the chart above, this has been a year of interest rate cuts around the world. I do not want to seem complacent, but it is truly difficult to imagine a scenario whereby central banks would allow interest rates to move materially higher since debt levels are so high around the world. Even if central banks did allow rates to regain some measure of equilibrium, I am not sure that they would reach high levels as so many technological advancements and demographic factors in society are deflationary. Since the crisis took shape back in March, actions taken by the U.S. Fed in early April to articulate a strategy to buy junk debt has worked by collapsing the cost of debt for many companies and investors who were in trouble. This is evidenced by the compression of spreads for investment-grade and junk debt versus sovereign debt, as you can see below. Once again, the Fed has reinforced the axiom, “DON’T FIGHT THE FED.

U.S. BBB SPREAD VS. U.S. 10-YEAR
Source: Bloomberg
U.S. HY SPREAD VS. U.S. 10-YEAR
Source: Bloomberg

We read with particular interest recent comments made by U.S. Fed Chairman Powell that highlight the Fed’s willingness to keep rates lower for longer and have inflation run “hotter” than we have seen for some time. This is important and highlights why we believe we need to be balanced in our portfolios:

“The persistent undershoot of inflation from our 2% longer-run objective is a cause for concern. Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy. And we are certainly mindful that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes. However, inflation that is persistently too low can pose serious risks to the economy. Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.This dynamic is a problem because expected inflation feeds directly into the general level of interest rates. Well-anchored inflation expectations are critical for giving the Fed the latitude to support employment when necessary without destabilizing inflation. But if inflation expectations fall below our 2% objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates. We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome. We want to do what we can to prevent such a dynamic from happening here.”

I have always told our research team that the most important thing that drives capital markets is interest rates. 2020 is a year where I must admit that the most important thing from here on out will likely be that government spending rates must rise since interest rates are nearly as low as they can go. Here in Canada, we recently appointed a new minister of finance. This former accomplished journalist and author has rocketed to this very important political post. Since I believe that the most important thing going forward is government spending, I thought I should read her most well-known book which was published in 2012 called, Plutocrats – The Rise of the New Global Super-Rich and the Fall of Everyone Else.

The simple conclusion I have formed at this point is that we should expect to see a lot of spending directed to those who are not wealthy. You should expect to continue to hear the 1% referred to with a negative connotation from the left-of-centre political parties. In the conclusion of this book was a statement that said: “Low-taxes, light touch regulation, weak unions, and unlimited campaign donations are certainly in the best interests of the plutocrats but that does not mean they are the best way to maintain the economic system that created today’s super-elite.” This quote is important because changes in tax rates, regulations and unionization in particular tend to have an impact on earnings and free cash flows which drive asset prices.

I am not a politician and I am not attempting to spread political views, but I am a capitalist. Thus, I understand that capitalism still needs to evolve and change to achieve better results for all of society. I also know as an investor that with change, comes risks and opportunities.  I anticipate a risk moving forward that there will be fewer politicians who support the capitalistic structures that I have grown up investing in. I have always watched finance ministers have a tug of war within their own parties around how much spending can be put in place for their constituents.

Typically, politicians promise all kinds of spending on the election trail and if they win office, the finance minister delivers a reality dose of how much those promises will cost and that without more tax revenue they will have to run higher deficits. Given a choice, politicians have begun to run deficits more and more, since increasing taxes usually will not lead to re-election. For example, when I entered this business in the early 1990s, I watched Liberal Finance Minister Paul Martin behave in a manner more fiscally conservative than his predecessors from the Conservative party, who ruled during most of the 1980s and had run up Canada’s debt load. Finance Minister Paul Martin had to reign in all the promises made from Jean Chretien’s popular “Red Book” policy piece. At that time, the Liberals had promised to replace the Goods and Services Tax (GST) and create a national childcare program. Neither promise was fulfilled, as Paul Martin doubtless would have recognized that money was needed to reduce the deficit from the GST, and the Liberals did not have the budget capacity to deliver an expensive childcare policy.

Today, Canada has a finance minister who is not a plutocrat like former Finance Minister Martin. Paul Martin went onto become the Prime Minister and I am sure that oddsmakers are already readying for Ms. Freeland to take the same path. I found it interesting that Ms. Freeland quoted Paul Martin on the back cover of her book:

The issue of rising inequality poses a threat to all economic systems, but none more so than those anchored in the free market and democracy. Those who agree with this statement will not be able to put Chrystia Freeland’s book down once they have picked it up. For those who disagree, Plutocrats should be required reading.

One recent investment that is benefitting from the new reality of governmental re-allocation of monies to those parts of the population most affected by COVID, is called Provident Financial from the United Kingdom. Essentially, they lend money to consumers that traditional banks deem too risky. They have a 20% market share of this segment and a bank license that allows them to fund their loan book from low-cost deposits. Many of their competitors without a deposit arm will be forced out of business, and this will allow Provident to gain further market share and maintain pricing power, as they are very well-capitalized — so much so that they recently paid off some of their debt early.

Provident’s stock was off over 60% year-to-date and 90% from when I first met them on a trip to the UK in 2017 while I was researching Brexit-recovery ideas. Our thesis assumes that as governments increase spending and push to get people out of unemployment, consumer lending growth will re-accelerate as a new cycle begins. Meanwhile, governments putting money directly into the hands of consumers who have been laid off has actually resulted in those people paying down their personal debts. This is therefore not a typical recession, in which there would be far more personal bankruptcies by now. Thus, we actually anticipate that the company will experience much lower bad-debt levels than previously expected, and due to their surplus capital we anticipate that their dividend payment will be reinstated next year.

Provident is an example of a company that indicates how I am encouraging our team to spend their time at present. I am trying to balance time between those businesses that are growing strong and performing very well and those companies that will recover as the world makes progress on virus treatments and maybe find a vaccine. As you can see below, we have reached very extreme levels between companies that represent good value versus those that are growing strong.  In Panorama, we have stocks that would be labeled growth and others that would be labeled value. We do not know when this powerful spread will revert back to the mean. Stay tuned.

S&P 500 PURE VALUE INDEX/PURE GROWTH INDEX
Source: Bloomberg

On the growth end of the spectrum, we saw fantastic results reported by one of our video game software holdings in Electronic Arts at the end of July. These were truly amazing considering that software sales typically slow down before new consoles are released, as we anticipate from Microsoft and Sony later this year.  I find it hard to imagine a scenario whereby new video game console and software sales not being strong this year, as parents are likely struggling with children at home and have limited activities for them to pursue. This $40 billion market cap company with over $5 billion in net cash on the balance sheet is on pace to generate over $2 billion in free cash flow this fiscal year. Quarterly earnings came in at a whopping $1.42 versus expectations for $0.80. We still believe investors are underestimating the growth potential of this business, which makes more money when they sell their games digitally versus in brick and mortar stores. Although I played varsity soccer in university and am a big fan of soccer talents like Lionel Messi, I do not play FIFA online. However, I am always amazed to see that player demographics are older and older. Another driver of video game companies moving forward is a rapidly-growing female player base.

On Electronic Arts’ conference call, they highlighted that they “welcomed tens of millions of new players into the EA network.” Only time will tell how many of these players will stay and play after the COVID crisis is over. If we are wrong and the video game industry succumbs to less consumer spending due to unemployment, delayed games, election delays, etc., then we will be comforted by the fact that they can take cash from their balance sheet to buy back stock. In a recent conversation with management after results were announced, it was revealed that they have paused their buyback program because business is so good and the economy is so bad that they do not want to be perceived as insensitive to widespread struggles.

Summer is usually a time when air conditioners run, and we have benefitted from our investment in a world-leading air conditioner producer from Japan called Daikin. I first met Daikin on a trip to Osaka, Japan nearly 15 years ago. Since then they have expanded into China, the U.S. and many parts of Europe. Daikin stock has been going straight up since the virus hit because they are a massive beneficiary of the desire of both consumers and businesses to improve indoor air quality and ventilation. As well, Daikin will benefit from regulatory rule changes in many jurisdictions that would see the reduction of energy usage by more energy-efficient equipment that they supply. As such, the summer heat will not be the only driver of sales as we approach autumn.

Another holding of ours that has benefitted from the hot summer is Generac. The stock was up over 15% alone in July as it became increasingly clear that this was going to be a dangerous hurricane season. As a maker of back-up power generators, they are seeing increased demand from consumers and businesses that need to have a Plan B for the increased prevalence of natural disasters in the world. They have also benefitted as many legacy generators are converted from diesel-fired to natural gas-powered, which are more environmentally friendly.

Lastly, the company is also expanding and leveraging its distribution and customer relationships to sell solar storage technology. We will trim our holding as peak hurricane season approaches.

During July we saw outsized gains from a more complicated investment thesis that we were quite happy to see materialize. As recently as March, I spoke about our investment in AMD after I attended their analyst day in San Jose earlier in the year. The simple thesis was that this smaller semiconductor supplier of chips for personal computers, video game consoles and data-centre hardware was likely to gain market share against its much larger rival, Intel. At the same time, we were also an owner of AMD’s supplier, Taiwan Semiconductor, to whom they outsource all their chip manufacturing. In July, the Fund benefitted from its bet against vertically integrated Intel, which led to double-digit returns in our investments in AMD and Taiwan Semi, as Intel’s stock dropped by double digits. This was truly a hat trick scored by the Fund and illustrates a great example of how to profit from technological changes occurring in the world both today and in the future. We continue to be holders of AMD and Taiwan Semi as major long-term winners of so many secular tailwinds occurring for the semi-conductor industry.

We opened these comments by talking to the very important macro variables of interest rates and government fiscal stimulus — two very important factors in market recovery despite a continued global virus threat. We also hope our sample stock illustrations towards the end of these comments help explain how we are making money with certain individual stock picks that have improving fundamentals. This past quarter has been one filled with many more positive than negative surprises from our companies, in relation to earnings and free cash flows. This is what is driving the appreciation of the capital you have invested with us. Yes, there are macro risks ahead, not the least of which are the U.S. election, tensions between the U.S. and China, and fears of a COVID second wave. We will do our best to navigate risk versus opportunity, by remaining focused on owning businesses with improving fundamentals.

We truly wish everyone a safe end of summer.

Panorama

Panorama

Panorama Fund strives to maximize capital appreciation by investing only in securities that we believe offer above-average returns on a risk-adjusted basis. The fund employs a variety of strategies including investments in equity, bonds, currencies, commodities, and publicly traded real estate. The fund also makes prudent use of derivatives to generate yield and enhance or protect our positions.

As Wealhouse Capital’s flagship fund, Panorama takes advantage of market inefficiencies across different geographies, industries, market capitalizations and asset classes to build a balanced portfolio. We actively analyse different risk factors in the markets to better diversify and safeguard our clients’ capital.

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