May 2024
‘Prophesy is a good line of business, but it is full of risks.’ – Mark Twain
Welcome to our second letter of 2024.
In a meeting recently someone uttered the words, ‘this is the fastest year ever’ and in a moment of reflection, I concluded that not only was it spot on with regards to it being the end of May already, but that it also has a read through to the rapid changes in investor sentiment and asset prices. Prices are responding to the deluge of economic information, corporate results, and the ongoing narrative from the central banks – most notably the US Federal Reserve (FED). In addition, the ongoing war in Ukraine and the Middle East conflict, alongside political tensions between the West and China, continues to add to geopolitical uncertainty.
As always, this letter is not a comprehensive look from where we have come but should there be any doubt that investment markets are volatile, a few statistics will provide some clarity. Since the start of the year, US equities had risen 12% before falling rapidly by 6% while other markets have gyrated within a range as follows: New Zealand 4%, Australia 8%, Europe 14%, and China 18%. Year to date, the US has moved +11%, -9%, +21%, -11% and +17%. Fixed income is supposed to be a less exciting asset class however miscalculation of the trajectory of interest rates has provided a rollercoaster ride. The US 10 Year Treasury saw its yield start 2024 at 3.83% as investors anticipated there would be up to six interest rate cuts this year despite the ongoing ‘higher for longer’ rhetoric of the FED. However, despite falling, persistently higher and sticky inflation saw the yield rise 0.9% to 4.73% while in New Zealand the 10 Year rose 0.68% to 5% and Australia 0.6% to 4.55%. And of course there were plenty of false dawns along the way.
But enough looking back. As we stand today, equities are higher, and bonds have recovered from the recent spike in yields and present a compelling opportunity over the short to medium term. Of course, it is too simplistic to lay investment volatility on inflation alone, but it is certainly playing its part.
Inflation remains the common thread
This letter is only scratching at the surface of some investment themes that we consider important, and the ones raised in the first letter of 2024 (here) remain as valid today as they were then. The common thread was, and is, inflation. Our view remains that inflation will be stubborn and slow to respond to monetary policy. We do believe it will fall and it may even reach the golden 2% that central banks wish for, but at this time it is difficult to see it staying there and a move higher seems likely. This may not be what anyone wants to read but the balance of probability suggests that inflation will be persistent and may be structural. Interest rates will fall but perhaps toward long-term averages and most unlikely – excluding an existential shock – to the lows that have been enjoyed in recent years.
The items raised in our last letter remain unresolved and will continue to influence long-term returns. In some instances, they may be discounted quickly, but for others, their contribution may be imperceptible.
One of the big conversations for investors surrounds the significant levels of debt that need servicing through repayments and refinancing. This spans all areas of the economy whether it be government, commercial or personal debt. Getting a precise read on the overall level of US Federal debt is difficult but it is currently reported to be over USD 34.5 trillion and rising rapidly. In conjunction with increasing borrowing, the cost to service it is also rising rapidly as older, cheaper debt matures and is replaced by more costly issuance. The current interest rate across US Federal debt stands at significant 3.22% which is up from approximately 1.5% post the pandemic low. This has driven the interest burden to be more than USD 1 trillion per annum (here). I highlight the US given their exuberance, but these data points are similarly replicated elsewhere. The simple fact is that the level of overall debt will need to be a focus of successive governments, central banks, and investors in the years ahead and the question we are asking ourselves is ‘will politicians have the appetite and ability to address it, or is it destined to balloon still higher?’ Debt, while part of the economic expansion DNA, may ultimately end up slowing growth as governments are forced to balance the books.
Revisiting an earlier discussion, the aging population will bring a broad range of challenges in the years and decades ahead. We are living longer, and the total fertility rate (TFR) has plummeted with the number of countries with a TFR higher than the ‘steady rate’ of 2.1 – the rate at which a population size will remain broadly the same – firmly in the minority. Attempts to kickstart these, either through baby bonuses or the end of China’s one-child policy, has not led to a notable increase in the global TFR. China’s is a paltry 1.1. India, whose population surpassed that of China in 2023, has a substantially higher TFR but it still falls short of the steady state at approximately 2. Worse, recently released data highlights the issue further, with South Korea reporting a catastrophically low 0.72 and Italy at 1.2 has seen its population decline steadily for almost 10 years despite migration.
This is a problem given a productive workforce is the lifeblood of tax revenue that funds government spending, the outlook for which seems inexorably up. Increases in defence spending, rising healthcare costs, infrastructure spend, social security support and higher interest expense are taking their toll on debt and increasing issuance. Balancing the budget is going to be difficult and unpopular. Outside of a boom in births, governments do have other levers they can pull to increase the pool of available workers – such as immigration policy – but that also pressures the economic system elsewhere. Besides, how are migrants to be enticed. Better pay? That is inflationary. It is like squeezing a balloon, one part captured causes another part to pop out.
Debt remains a hot topic
Talking of debt, commercial real estate debt and the property valuations supporting it continues to be a hot topic with a confluence of events causing some concern. The pandemic forced people to ‘temporarily’ work from home, however this sparked behaviour changes that have rapidly become normal and led to an explosion of unused office space which is estimated to be nearing 1bn sq. ft. in the US. This has obviously led to some pressure on building valuations and in extremes, especially where there is a refinancing need, has seen some asset owners walk away. Falling lease and rental income is exacerbating the situation although whether this endures remains a significant and unanswered question. Anecdotally, and in company conversations, there does appear to be some return to work, whether a company directive, personal preference, or peer pressure optics, and this has seen the extremes begin to unwind. Of course, the situation is not the same everywhere or in every class of building with the best office space remaining desirable and industrial premises faring far better in the downturn.
Certainly, the phrase ‘commercial real-estate’ covers multiple property types such as office, retail, hotel, industrial and healthcare, with the first three hardest hit given specific industry dynamics. One area we are keeping an eye on is unlisted real-estate trusts. These are huge investment vehicles that typically raise significant sums of money to acquire properties for investors and recent action has seen some funds suspend redemptions or sell assets. Illiquidity is not your friend!
Whether or not the debt on commercial real-estate becomes a canary in the coalmine remains to be seen but delinquency rates in mortgage-backed securities are rising. While they remain significantly below the levels seen during the global financial crisis, many commercial-real estate loans are in distress and refinancing these without further equity injection may prove impossible. Some owners will take the decision to sell which in the absence of buyers may pressure valuations still further.
Here in New Zealand and across the Tasman in Australia, the outlook is not nearly so problematic and while occupancy rates have declined, they are still tracking well compared to prior cycles and compared to other countries. Values have fallen, but not precipitously given refinancing has been possible and sales of existing buildings and new developments are mothballed. High interest rates are putting a strain on owners but there have been little if any sales because of distress.
Sticking with the debt theme just a little longer, there are some interesting developments that suggest the bond market continues to function well despite concerns of dysfunction caused by FED rhetoric of ‘higher for longer’, the ballooning of federal debt, commercial real estate loan overhang and signs that the slowing economy may be overdone. Recent data from the London Stock Exchange Group reveals that more than USD 14bn of high-yield and junk bonds have been successfully issued while those borrowers that qualify as investment-grade issuers have raised more than USD 55bn.
At first glance this issuance may seem curious, however, it does appear to be well timed. Mildly weaker economic data has emboldened bond investors to price in additional interest rate cuts (having recently taken them out) and with it and spreads over government bonds tightened. Expectations of a July cut in interest rates have increased as has the total expected by December. Despite higher interest rates, there remains substantial liquidity looking for an investment return and I would expect further opportunistic and substantial debt issuance when yield spreads over government debt look tight. In the remainder of 2024, investors currently expect there to be two interest rate cuts from the FED while in New Zealand and Australia the outlook is rather more confused given recent economic data, and cuts this year are uncertain.
My final comment on debt surrounds that of the consumer and personal consumption. During and post the pandemic, central banks flooded the economy with money and governments introduced polices to support business and consumers. Even when the worst had passed the stimulatory policies continued and the consumer savings rate moved meaningfully higher. Subsequently, these savings had shielded the consumer from the increases in interest rates until late last year. Revolving credit (e.g. credit card) debt was reduced and until relatively recently, growth in the overall amount had been subdued. However, this phenomenon appears to have ended and data now shows it to be steadily rising. What does this mean?
Rising debt is not just sitting with governments but also companies and consumers. Mortgage interest rates are at multi-year highs with fixed rate mortgages rolling off and requiring refinancing, resulting in significantly higher repayments. Personal loans and rising credit card debt is more expensive as of course is everything else. Ultimately, unless wages continue to rise then consumption expenditure will slow as will economic growth. While a generalisation and depending on the economy, personal consumption represents approximately 60% of a developed country’s GDP and any meaningful slowdown in consumption will impact economic prosperity. Of course, this is well understood and is usually addressed by central banks by the lowering of interest rates (monetary policy) simultaneous to governments increasing fiscal stimulus or spending. However, it should be remembered that inflation remains stubborn and underlying pressure from wages is unhelpful but unavoidable. In addition, geopolitical uncertainty, supply chain issues and of course government spending also pressures prices higher. This is the cycle and destructive nature of inflation laid bare.
Artificial Intelligence poised to revolutionise industry
Changing topic, all things Artificial Intelligence (AI) continues to dominate investments with the yo-yo in prices continuing. Recently, spectacular revenue growth from Super Micro Computer still disappointed investors and the share price dropped markedly, albeit only briefly. All companies that have a flavour of AI about them have provided momentum to investment markets and in some instances, company share prices are up over 100% this year. When there is this much excitement and elevated valuations there is little room for execution error. The burgeoning industry is poised to reshape traditional business processes and workforces and to revolutionise business as we know it.
While there are thousands of different flavours of AI related tools, simplistically they are probability engines with statistical foundations. Large language models (LLMs) are trained with data that provides a statistical understanding of the relationship between (for example, words and phrases), and its accuracy lends gravitas to the word ‘intelligence’. LLM’s are vast in size, require enormous compute and physical space to work and their proliferation has spawned new, as well as accelerating existing adjacent industries. These are growing rapidly too but without doubt various industries run at different speeds and this has the potential to cause indigestion and bottlenecks. This may lead to disappointment down the road but for now at least, the news headlines press the excitement of the next industrial revolution.
What the end game of these LLM’s is remains to be seen. Will OpenAI’s Chat-GPT triumph over Google’s Gemini or Meta’s Llama? Perhaps, but maybe this is not the correct question, and rather it should be, ‘how is AI deployed and through what tools?’ Meta’s Llama is considered ‘open source’ while Chat-GPT and Gemini are closed. Open sourced comes with advantages such as its availability to developers and therefore the speed of development.
As LLM’s converge in quality and capability, the eventual winners may be the deployers of the technology as opposed to the LLM providers themselves. The data, if not propriety, is ubiquitous whereas the application and capability of the tools of today and those yet to be imagined may not be. Indeed, LLM’s are the start of the journey toward artificial general intelligence, and it is going to be a fascinating journey with leaders in their field providing enormous growth rates. Given this is being dubbed as the new industrial revolution, outsized investment returns in this field may well be years in the making, but it is important to remember when there are excess profits, competitors will follow. One must only look back to the dot-com era and its ultimate demise in the crash of 2000 to see the effect of technological change and over exuberance on share prices. For example, having seen a meteoric rise, Sun Microsystems fell to earth over three crushing years after they failed to embrace new technology that sparked a glut in, and the eventual (rapid) downfall of, their high-end servers.
A hint of how important the deployment of AI will become at a company level is visible through the behemoths, Alphabet (Google), Amazon, Meta, and Microsoft. It is anticipated they will spend over $150bn over the next 12 months in AI related activity. This colossal sum is aimed at achieving the ultimate prize, leadership, and relevance, both of which are necessary for the protection of their substantial moats. In Meta’s applications (Facebook, Instagram, and WhatsApp), it is already incorporated, and Microsoft continues to deploy ChatGPT through Copilot. Microsoft’s offering is aimed squarely at boosting productivity, but it further shores up their Office moat and in my limited use is impressive. These companies are rich in unique training data too. Every interaction that we make when using these companies’ products sends a bit of us with it. That will provide learning that purchased data will be unable to match.
How can AI disrupt? What if search is precise, that as a user you get the exact answer you wanted for a given request? What does that do to paid search and the industry of search optimisation? What about coding? What if you can type a phrase and ask AI to provide the code to a task? The list is endless and the implications widespread.
As I noted in the most recent letter, at its best, AI may provide the developed world the tools with which to reignite productivity where is has stalled. It may accelerate economic growth to a rate that we thought was no longer possible.
It is exciting, and if AI does become the next industrial revolution, we are likely at the beginning and we should expect to see a pace of technological change that will make the last 30 years look pedestrian. Of course, it is tempting to just invest in AI related companies but as a cohesive strategy that will not hold water. The pace of change will see companies come and go, with increasing rapidity and investment missteps through the investment cycle are likely. Nevertheless, it should form part of a robust strategy.
Investing for the long-term
As always, we do not focus on the short-term noise of the market; rather we take a long-term view of the investment landscape as it applies to our asset allocation and investment decisions. For example, we believe interest rates have peaked and we are selectively increasing the sensitivity of fixed income securities to interest rate movements. Elsewhere we have increased equity weightings at the expense of cash.
The geopolitical situation remains a significant and unpredictable risk and in time the level of debt around the world will need to be addressed and brought down for fear of some contagion correction. But while there are clouds on the horizon the seas are relatively calm. They always are before the storm.
Tim Chesterfield
Chief Investment Officer
Perpetual Guardian Investments
May 2024.
