Are your confused as to why we have so recently had a series of individual banking failures?
With the emergence from the Covid 19 lockdowns one might think that banks would participate in an economic recovery. With interest rates having risen from ridiculously low levels, that should be music to the ears of any banker who is slow to pass on any rate rise to depositors.
In general, our domestic banks should be enjoying that backdrop and they clearly are. So why has there been a banking crisis with the failure of specialist and regional banks in the US and the end of a major Swiss bank; Credit Suisse, in that bastion of high grade international banking, Switzerland.
The answer is simple, we have left the sunny landscape of low interest rates that have been such a distorting factor for so many years. Cheap money and the printing of money by central banks everywhere has led to an artificial world that engenders the miss allocation of capital.
Take Silicon Valley Bank in the US. Cheap money and overvalued tech businesses led to inappropriate investments by the bank. Indeed. The 16th largest US bank went out of their way to invest in diversity and sustainability that left it unable to withstand a limited run from depositors who felt nervous.
Poor capital allocation, facilitated by cheap money was the cause – and the same ills perpetuate the existence of zombie companies who eventually cannot cope when interest rates rise from unimaginably low levels. If one was picking a lame duck bank that might be in that category, then Credit Suisse was at the top of most people’s list. Of course, banking is not the only sector affected this way and it is no surprise that general insolvencies are rising as the capital miss allocation and the sustaining of zombie businesses in general is exposed.
Now let’s turn to inflation, which has reluctantly pushed central banks into raising interest rates.
It seems that the current orthodoxy as set out by the International Monetary Fund (IMF), is that we will soon return to low interest rates and all will be well. The Bank of England now forecasts that inflation in the UK will be down to 2.9% by the time the year concludes. If they are right, that is great, but why should we believe an institution that has always been behind the curve and thought that early inflation was just ‘transitory’?
Sure, in the USA, inflation is down to 5%, but that is no guide for the UK. Energy induced inflation has always been much more limited in the US, as it is virtually self-sufficient in oil and gas production. The Government has seized on the Bank’s projections in its negotiations with the Health Unions and their claims for wage growth to match inflation of 10%+. It has been offering a much lower settlement for this year, sometimes with a cash sweetener and a figure around 5% for next year. This is well above the level expected by the bank which is suggesting inflation will fall back to the Bank’s 2% target range in 2024.
History tells us that inflation can become more embedded in the economy, and we will have to see if these projections are at all realistic. If not, there will be lots of unhappy health workers in the NHS. I have to say I think so many of the public sector Unions are playing a political game, with sometimes
excessive claims that are not backed by the facts. They seem unwilling to entertain any changes to working practices that would produce productivity gains to offset increased wages.
Inflation leads inevitably onto pricing power; the ability of companies to recoup inflationary cost pressures quickly. This is a key factor that investors need to focus on. I see a whole range of companies with quite different abilities to do this.
Take the simple distributor, it can be building supplies, electricals, feedstuffs for farmers and general wholesaling. If the price they pay for goods goes up, then straight away, so does the price they charge their customer. Other businesses are often less fortunate. They may have to wait a year to recover the inflation they have already seen in input costs over the past year. Competition may be too intense. They just do not have pricing power.
Exclusive products that the customer really wants is the characteristics that you want to see in companies that you invest in. Moreover, the ability to hold onto those higher prices if commodities, such as energy, or steel actually fall, so margins can improve.
History also teaches us that pricing power is even more paramount when economies slip into ‘stagflation’. No growth is often the product of debt-ridden economies, where inflation cannot be tamed. Investors need to watch for this risk, which in some ways can be worse than a short sharp recession which purges the system of its weaknesses.
Despite all these troubling features, one should not forget that the UK stock market remains very cheap relative to others. Hence, we are likely to see continuing bids for UK listed companies from overseas sources.
Pressure on Government finances is unlikely to be easy to manage going forward. There are plenty of cases where a combination of neglect and misallocation leaves much to do. The simple pothole problems in British roads is a fine example.
Higher interest rates mean higher Government borrowing costs and we now have to face the realisation that defence spending throughout the Western world has been too low. Putin’s attitude and actions have led to an abrupt change in defence needs. We have a much smaller navy than should be the case for the new world. The army has been culled and it takes a long time to turn those weaknesses around, At least a decade in my view, in which case this sector remains one of my prime sectors for selecting shares.
Returning to banks, everyone has seen the reluctance to raise deposit rates and with the constant fall in the savings free slice for interest receipts, there are good reasons to look at short dated low coupon gilt stocks. These are now offering quite attractive capital gains, which are tax-free and low running income that may be increasingly taxed. These may be a better home for cash balances and capital can be accessed very quickly from any sales in what remains the highest calibre investment in Britain.
If you would like to discuss your current investments or future plans we would be happy to schedule a call – Contact details for the CFM team are here and my contact details are:
T: 07977 784167
Barrie Newton, May 2023