The UK Stockmarket

The UK stock market is commonly spoken about in hushed tones these days, much like one might speak of a dying relative. There is kindness and fondness and respect but mainly nostalgia. To listen to the whispered conversations one might conclude it is not long for this world. UK listed stocks have performed poorly in recent years compared to major developed markets. But it is a relatively recent phenomenon. I would suggest that rumours of the death of the London Stock Exchange (LSE) may be premature.

Tom Stevenson of Fidelity International wrote an interesting article recently (link below) which I received as a client. I hope he does not mind me acquainting a wider audience with his work. Much of the article draws on work by Rathbones. Tom observes that Between 2009 and 2016 the performance of US and UK listed stocks was much the same. This is based on a dividends reinvested time series beginning 03/03/2009 and ending 22/06/2016. The underperformance of UK listed stocks from 2016 onwards is quite dramatic. Now what happened in June 2016…? Today there is a noticeable valuation gap between UK and US listed stocks and some UK listed are migrating their primary listing to the US (though usually retaining a secondary listing on the LSE).

Rathbones has undertaken some research to compare the two markets on a like-for-like basis. It concluded that LSE stocks trade at a significant discount to Wall Street. They also found no statistically significant discount prior to Brexit. The odd thing is that the discount applies equally to multinationals earning revenue globally as to UK based firms, so quite why Brexit should have had such an effect is not clear. Perhaps it reflects concern about UK governance and has generated uncertainty about the direction of UK institutions. Markets hate this type of uncertainty.

The less than competent government that created this situation is trying to blame pension funds and other institutional investors for neglecting to invest in the UK. As Tom Stevenson points out, this process was well underway during the period prior to Brexit. So, no. My experience of markets is that they adjust and don’t leave any arbitrages lying around for too long. Simon Gergel of Merchants Trust (in which I am investor)made the very important observation (link below) that cheap stocks get bought. They get bought by private equity and taken off listing, they get bought by other corporates and delisted, and corporates buy back their own shares and cancel them. In terms of price this has the same effect as investment by pension funds and all these buying channels are evident at the moment. Indeed the activity is indicative of a very cheap market that will get less cheap as this activity proceeds. I would add one more development and that is restructuring and separation of corporate businesses. Some corporations have become an inefficient portfolio of businesses and the stock trades at less that the sum of the parts. Restructuring can release value.

This does not mean UK listed stocks will suddenly start to outperform. A few high growth tech stocks are still driving Wall street and there is no equivalent in the UK. If you want exposure to these stocks you have to invest in US listed. But if you want exposure to the rest of the market then UK listed may offer better value. As the various processes identified above continue, the like-for-like valuation differences will disappear favouring UK exposure. The much lamented trend to move primary listing to the US from the UK has other explanations. These include executive pay freedom, less US shareholder protections which favour start up owners, and the fact that some simply have the bulk of their operations in the US. One important difference between US listed and UK listed is in the nature of the firms. US listed tend to be US corporations that operate globally whilst UK listed tend to be global firms which often originate elsewhere. If you invest in a global index today your actual exposure could be up to 70% in US listed stocks and a large part of this in 7 or 8 giant tech stocks. Doesn’t sound like much of a diversification strategy albeit great while it works.

https://www.fidelity.co.uk/markets-insights/markets/uk/5-ways-to-invest-in-the-uks-return-to-favour/?utm_term=pi_citywire&utm_campaign=pi_newsletter_16.03.24&utm_medium=email&utm_source=marketo&utm_content=lead_story_W_SippY_ISAN_E.%2065%20+&mkt_tok=MTQzLUpSTS0wMzIAAAGR5cpl0QgWQvqrAX0IaOdRfcdonhu0AQpiQ5UEEKrUbqd9MfkGHq2Y28x-QoxpeRJe5d38wNkhpCoMQJAIiJzcpP9yc-S4rWPhDfvpkIC28dV4qA

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The UK Inflation Outlook and Gilts

There is a tendency to look at the inflation and interest rate history of the UK as if it is comparable to today. It is not. The significant event was the granting of independence to the Bank of England in 1998. This fundamentally changed the monetary policy framework of the UK. A target of 2% was set and parameters of variation decided. The BoE had one (monetary policy) job and it was to meet the 2% target over the (poorly defined) medium term. How did it do?

Until recently the BoE has not done too bad. The average inflation rate between 1998 and now is about 3.1% (https://www.officialdata.org/uk/inflation/1998?amount=100 ).It is not far outside of the parameters for variation which is quite an achievement given the recent inflation shock. Inflation is slowly receding and the main issue now is second round affects via the labour market. The BoE seems determined to meet the target and so interest rates will stay high for as long as it takes. No one, including the BoE, can know how long it will take but the bias seems to be to err on the side of caution as long as real wages are rising (and productivity not so much).

Given this context what should long maturity Gilts yield? There is no correct answer to this so perhaps the question should be at what yield do they offer value? This is a much more specific question which depends upon personal circumstances (marginal tax rate, ISA, SIPP) and the available selection of gilts (long dated low coupon v high coupon). The conclusion of an extensive study by two BoE economists (https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2020/eight-centuries-of-global-real-interest-rates-r-g-and-the-suprasecular-decline-1311-2018.pdf ) is that the long term trend in the real interest rate is to decline and the implication is that a negative real interest rate is not an aberration but rather a very long term norm.

Despite the very imprecise nature of all this I confess to have concluded that long dated gilt yields of over 4.5% offer ‘value’ in the sense that they offer a potential for a significant, positive real yield and that for a credit risk free asset this is valuable. If one can achieve an expected real yield of 2% + this should form part of your portfolio. At 4.5% or more nominal yield one might be able to achieve this via an ISA or SIPP or using very low coupon issues . This does not mean of course that you will not experience mark-to-market losses as inflation and hence yields may be volatile. However, as long as the BoE independence framework prevails long dated gilt yields seem unlikely to sustain levels above 5% and that such levels offer an opportunity. The previous much higher levels occur under a non-independence regime. Any changes to the regime will automatically require revision to this conclusion.

Things Change

The world is probably on the verge of a discontinuity; a state change. Such changes do not happen abruptly and hindsight can usually identify signs of the pending change. A droplet of water at the muzzle of tap gives a clue to a pending drip but you never can be quite sure when it will drop. So it is with human discontinuities. Climate change, a huge part of this discontinuity, has been grumbling on for decades. The Russian annexation of Crimea gave a clue to another element. Trumps tariffs and Brexit a clue to yet another element . Covid triggered the discontinuity by accelerating many secular trends. The Hamas strike on Israel has shaped the new state in a unique way. It is beginning to resemble Orwell’s 1984, as three distinct geopolitical regions emerge; the west, the global south, and the islamic world. The rise of the political right may also presage totalitarianism. We are cursed to live in interesting times.

My career made me an observer of humanity. I was most effective when I was dispassionate. It required that I had no opinion but simply an understanding. Opinions imply judgements which lead to biases. Understanding involves no judgement but merely a grasp of risks and consequences. The more objective the better. Of course, being an opinionated person I often failed in my job and I repeatedly got into hot water. But as I have aged, and after 10 years of retirement, I have finally achieved this optimal state of dispassionate observer. This annoys people that take a ‘if you are not with us you are against us’ stance. So, pretty much everybody! But in truth I am neither with nor against anybody or anything. I cannot influence anything so what is the point of having an opinion? It just leads to frustration which leads to anger and finally hate. It serves no purpose. An understanding, on the other hand, helps one position oneself . This blog post is about understanding.

A three state world is unstable. Shifting alliances of convenience create a continuous state of conflict and tension. There is no peaceful equilibrium. Nobody can win so it goes on forever. Each state must have a degree of internal homogeneity to stop erosion from within. This is not consistent with democratic processes, so totalitarianism emerges. The mechanics of totalitarianism are now well known and well advanced in all three regions. The west still has the illusion of free speech but look closely and the illusion dissipates. Some utterances from Suella Braverman as home secretary on the Israel Palestine conflict should illustrate this point clearly. There are many more in the UK and around the world if you look. The broad shape of the new state of the world has been set.

The west is relatively well defined as a geopolitical entity but the global south is still developing. It is led by China and Russia but includes India, much of central and south America, and South Africa. The islamic world is still emerging and it may take a sequence of revolutions to give it proper form. But the birth pangs are there. The big obstacle is the Sunni Shia divide but everything can be overcome if the circumstances are propitious . It includes Indonesia, a populous and wealthy country. The events in Gaza may be the catalyst that gives birth to this new geopolitical force. The west is defined by a political creed (capitalism). The islamic world by a religion. The global south is not internally homogenous and thus not properly defined yet. It exists simply because of its antipathy towards the west. There is room for the tectonic geopolitical plates to shift. And they will.

All three geopolitical regions have a vested interest in fossil fuels so the failure of climate action is not geopolitical. It is simply human. The oil lobby has money and can buy anything and everybody that has a price. It is doing so in order to extract as much value from its fossil fuel assets before they become stranded. Most people have a price so the lobby is very effective [I originally started the previous sentence with ‘unfortunately’. This constitutes an opinion]. To the extent that the fossil fuel lobby does this through higher prices it actually accelerates transition to green energy. It makes green energy more profitable under existing pricing structures and discourages energy use where substitution is possible. It also encourages green energy for energy security. If you don’t have reliable access to oil or gas reserves then green is the only way to generate reliable energy.

Although the distribution of fossil fuel reserves is not geopolitical , control of the oil price is very much in the hands of the islamic world and the global south. This provides an incentive for western nations to invest in green energy (and nuclear). The geopolitical situation is having a much wider impact on investment. The west in particular is investing heavily in ‘on-shoring’. Essentially shifting the production of much that was globally distributed production into ‘safe’ regions. The west is likely to experience heavy investment from these sources for some years. In contrast countries such as China may suffer a slump in investment as its volume export markets dry up. This gives China an incentive to internally unify and promote the global south for new markets and as a source of raw materials. The process is well under way.

The recent inflation shock is inextricably linked to these geopolitical developments. De-globalisation is clearly implicated in the supply shocks that began the process. Fossil fuel prices are an obvious shock rooted in geopolitics. The shocks may dissipate but the second round effects will persist, at least they will do so in the west. Heavy investment will keep the economies going but with already very low unemployment this means second round inflation may persist. The low unemployment rate is clearly not cyclical but structural. The post war baby boomers are leaving the work force and the low fertility rates and hostility to immigration are creating structural labour shortages. Inflation may well become entrenched unless productivity increases above the historical rate. Perhaps it will.

Today’s markets are convinced that central bank interest rates have peaked and rate decreases will be the next move, and pretty soon. This optimism is rooted in the habit of humans to treat recent experience as the ‘norm’. Indeed economists often model expectations using distributed lags of variables with weights declining over time. The benign monetary environment that emerged after the financial crash of 2008 was anything but normal and current conditions are quite different. This is what this blog post is trying to illustrate. Things change but humans adapt only slowly. Interest rates may begin to fall and reverse quite abruptly. They may take much longer to fall than the market believes today. They may even go up again before going down . Markets work on anticipation but that anticipation is always calibrated by the recent past assuming continuous evolution. Markets do not handle discontinuities well.

Formulating an investment strategy over a state shift is quite tricky even if you are aware of the state shift occurring. There is quite a lot of optimism about bond yields falling. Yields have already fallen. But there is a natural brake on the rate of fall because of selling of deeply discounted positions by those that accumulated bonds at the very low interest rates of the recent past. If official rates do fall the yield curve may steepen. Furthermore, central banks are still unwinding QE. Finally, western governments are running, and will continue to run, large budget deficits. If you add to this sticky core inflation and low unemployment, and investment led GDP growth, it hard to see where this bond optimism is coming from. Unless, of course, you believe the recent past is your best guide to the future.

I recently reviewed my own investment strategy and discovered that, properly benchmarked, I had not done too bad. I had done one thing very wrong and one thing very right. I had underweighted US listed stocks too soon but had had no bonds in my portfolio. My reason for underweighting the US was simply because it had become a huge weight in global equity indices and largely driven by seven or so huge corporations. Diversification required I lighten up. The reason I had no bonds was that at basically negligible yields they offered little value over cash and a lot of risk (bad convexity). The two cancelled each other and left me in a position to add bonds at much better risk/reward levels. I have no intention of increasing my USA allocation as long as the market is circa 60% of global equities. In a state shift such concentration is not advisable. In fact it is never really advisable.

The next few years are likely to be characterised by private sector deleveraging and public sector borrowing. Over leveraged corporates will sell off assets to pay back debt taken out when rates were abnormally low and those in a stronger financial position will pick up some cheap assets. Equity indices may not do very much but there may be a lot of movement within the indices. It is a time of structural change so buy assets that look cheap and sell those that look expensive and don’t chase trends as they may not be trends. Entry prices will become very important. [The characteristic of the last decade has been buy expensive and watch them get more expensive and don’t buy cheap because it is a value trap. This should now reverse]. Good luck. We will all need it.

Rent Control

The idea of rent control was very prominent when I was an undergraduate in Economics (1971-74). At the time I took the standard economist position. I drew in my supply /demand curves and drew the rent cap line in (obviously below the market clearing rent) and declared it would just reduce the supply of properties for rent. This would raise the question of how to allocate those properties that were available and some kind of administrative rationing system would be required. Job done. In retrospect this was nonsense.

The stock of properties does not disappear just because the rent that can be charged is fixed below the market clearing rate. The first reaction from landlord and tenant will probably be to find some way to charge and pay the higher rent off the books as it were. If this is not possible some landlords might hang on and hope the negative carry from owning the property might eventually pay off through capital gain. However, this raises cash flow problems and there is an opportunity cost to factor in. So, many landlords will presumably sell up. This may make it easier for tenants to become leaseholders or freeholders. The idea that rent controls may reduce the proportion of the stock of properties for rent might be correct but this does not mean less properties to live in. It is more complicated than my undergraduate chart suggested .

Rent controls may also affect the Build-to-Rent activity. However, this activity is presumably inadequate even without rent controls since rents have been rising because of a shortage of properties. Build-to-Rent has done nothing to ease the shortage in a free rental market. The implication is that there has been some other constraint on the supply of properties such as planning permission and the availability of suitable sites. It may be that those with access to permission and sites have been able to earn an economic rent . This is a rent over and above what they would have been willing to receive in order to supply the Build-to-Rent units. So, the rent controls may simply reduce the economic rent received by Build-to-Rent developers rather than impact the supply of Build-to-Rent units. If rent controls are accompanied by an easier planning environment and availability of sites it might even increase the supply of units.

The self evident need is for a dramatic increase in home units that people can afford to rent (or buy). The free market solution has not delivered this necessary supply but it has delivered excess profits (economic rent) to those able to produce and/or supply some units. Rent controls attack this economic rent rather than reduce supply. Nevertheless, rent controls alone will not provide more homes for people . There is still a need to act to increase supply. Political gestures like rent controls are fine but they do not house people.

Inflation Shocks and their Consequences

The 2008 financial crisis appears to have had far more profound consequences than simply disrupting the financial system. It has affected the capacity for thought especially among economists. The supply driven inflation shock of the last few years was greeted initially with little response. It was deemed temporary. It was deemed unworthy of concern or a severe policy response. This reaction was common among investors, central bankers, and politicians. This was dumb. The problem with inflation shocks is not, nor ever has been, with the initial event. The problem comes from the second round effects that emerge as economic agents fight to avoid the erosion of their real income and wealth. They put up prices. They demand wage increases. It is in this behaviour that the inflation threat lies. This is why the Governor of the Bank of England has resorted to exhorting economic agents not to try and protect their real incomes and wealth. Technically he is correct. Realistically he is naive and this alone renders him unsuited to his role in my opinion. The purposes of higher interest rates is not to magically solve the supply constraints that generated the initial inflation shock. It is to contain these second round effects. It is to create unemployment and thus cap wage demands. It is to reduce goods demand and discourage price increases. It is a blunt tool and it is meant to hurt, economically. It has evidently yet to hurt enough.

The very public tighter monetary policy that belatedly emerged has been accompanied by some aggressive fiscal policy changes that have similar effects on second round inflation but have gone largely unnoticed. There has been aggressive fiscal drag. Tax revenues are boosted by inflation in a progressive tax system as more people are dragged into higher tax brackets. This is often offset by indexing tax thresholds. However, Rishi Sunak, as Chancellor, quietly froze the tax thresholds. So, as nominal incomes rise in response to inflation, an increasing part of this rise accrues to HMRC and thus the Treasury. This removes spending power from the system, ceteris paribus, and thus helps dampen wage demands and price increases. Such below the parapet tax increases are an important part of the policy actions to offset second round inflation.

Many people with cash savings are cheered by the rising rates. I raised this issue in earlier blogs with the warning that you should be careful for what you wish. If you have no other income except for savings then you can earn an additional £5000 of interest tax free above your tax free allowance . This is called the starting rate for savings. You can earn £12570 from other income (your personal allowance 2023/2024) and still earn interest up to £5000 tax free. Each £1 you earn from other income above your personal allowance reduces your starting rate for savings. If your other income exceeds £17570 your starting rate for savings is exhausted but you still have your Personal Savings Allowance, which is £1000 if your marginal tax rate is 20%. You can earn £1000 of interest tax free if you are a 20% marginal tax payer. This reduces to £500 for a 40% marginal tax payer and zero above that rate. So, higher interest rates impact your tax bill.

If you have , say, £85k in cash saving and not in a tax free wrapper, then earning 6% p.a. when you are a 20% tax payer leaves you with £4280 . This is £1000 tax free plus £4100×0.8. If you are a 40% marginal tax payer the 6% leaves you £500 plus £4600×0.6 which equals £3260. Your respective after tax interest rates are 5.04% and 3.84%. If inflation is over 8% your real wealth is taking a big hit. Note than when you were bemoaning interest rates at 1%, and inflation at much the same level, your real wealth was not declining. Interestingly there is a way of avoiding this tax trap; the Gilt market.

Gilts are UK government bonds. They are credit risk free in the sense that the UK government is unlikely not to redeem the bonds at maturity and give you back the par value (normally £100 per bond). Gilts pay coupons, which are bits of interest expressed in pounds, every 6 months. A yield to maturity can be calculated by assuming you reinvest these coupons at the implicit yield until maturity. The YTM is a derived number to give a kind of interest rate but the meaningful data are the price, accrued interest, and the coupon that accrues. In order not to complicate the discussion just think of the YTM as the interest rate.

An interesting gilt for the purposes of illustration is the UKT 0.125 31/01/2025. This pays a coupon of £0.0625×100 every 6 months. This is not very much. However, the clean price (excluding accrued) is £92.225 per bond. This equates to a yield of 5.499%. If you buy this bond and hold it to maturity most of that interest rate will be receivable tax free because this bond has no capital gains tax liability and the pull to par is deemed a capital gain (this is not the case for strips). So, on 31/01/2025 you will get £100 per bond that cost you £92.225. You will also have received a small amount of taxable coupon. If you bought 921 bonds they would have cost around £85k ( depending on spreads, commissions, and accrued) and you will receive £92100 tax free (plus taxable coupons every 6 months) at maturity. This amounts to at least 8.35% free of tax over approximately a year and a half or at least £7100. If you compare to the after tax interest from a 6% deposit you can see this is much better (and I have not added the coupon). There is a way to offset fiscal drag though it does depend upon the existence of low coupon bonds maturing when you need them.

Another feature of the gilt market which is interesting is convexity. Low coupon gilts with a long time until maturity are very convex. This simply means that they provide a bigger mark to market gain from a fall in yield than loss from a rise in yield. Consider the UKT 0.5 22/10/2061. It closed around 29.67 which gives a yield of around 4.219%. Consider a 5 point change in price. If price increases by 5 points the yield is 3.708%. It has fallen O.511%. Now consider and 5 point fall in price. The yield rises to 4.884% or by 0.665%. If we had equated the yield changes the price would have fallen by less than 5 points. This is convexity. In a sense you are less afraid of interest rate rises than excited by falls in interest rates for this bond. This may be relevant in some contexts.

If your objective is simply to protect against inflation then Index Linked Gilts are the best line of defence. The principle and coupon are uplifted by inflation using RPI until 2030 ( I believe) and then the CPI. The same tax considerations apply. The RPI seems to register higher than the CPI so this may be a bonus. Real Yields are also positive at the moment so if you are holding to maturity it may be a good option. However, mark to mark prices are sensitive to real yield changes and this may be a consideration if you do not hold to maturity. The other slight complication is buying them. Barclays SmartInvestor allows purchase of nominal gilts online at reasonable commissions. It does not list Index Linked (as far as I can see). Indeed the difficulty of buying Gilts is one of the reasons I suspect retail clients don’t. It would be nice if NS&I offered a gilt purchasing service. NS&I is a branch of the Treasury and funds the State much like gilts. I have found the berating of banks for not raising deposits rates to match Base Rates annoying because NS&I Direct Saver, an instant access savings account, only pays 2.85%. Why does the government not heed its own advice? In fact, as I have emphasised in an earlier blog, the government could force banks to raise instant access savings rates simply by raising the Direct Saver rate appropriately. It pays over 5% on Treasury bills and the NS&I deposits are small by comparison so what does it lose?

Going from bonds to investment trusts is a leap but I am going to make it nevertheless. Investment Trusts are a diverse group of companies and the assets contained in the trusts can be very different. From wind farms, social housing, and mines, to listed big cap stocks. The reason I am making the jump is because the trusts illustrate important themes in investment. Trusts can be viewed as blocs of assets available for sale. One can look at the liquidation value of the trust and this is what the NAV calculation is meant to indicate. Most trusts have continuation provisions which allow shareholders to vote to wind up if the share price falls sufficiently below the NAV for long enough. Of course, NAV calculations do not guarantee sale values. The NAV is often calculated by discounting the expected cash flows by some discount rate. Which discount rate is used, why it is used, and how cashflows are estimated is all a bit variable and often vague. It is no wonder that in times of uncertainty trusts can fall to large discounts.

Rising bond yields result in lower bond prices and in exactly the same way rising interest rates mean all asset prices fall, other things being equal. But all other things are not equal. In the case of fixed coupon government bonds the cash flows are known and fixed so rising yields means lower bond prices. If we derive a discount rate from these bond yields and discount expected net cashflows from an investment trust we can get an NAV. But those cashflows are not fixed. The circumstances causing the rise in yields and discount rates may also affect the cashflows. The numerator and denominator are not independent. Index linking of rents, commodity prices, energy prices etc may all enhance cashflows in an inflationary environment. So, it is important to look at each investment trust on its own merits rather than as part of an asset class and to consider whether the environment causing the rising interest rates might enhance cashflows. Of course, few have the time to look at each trust in depth (even if the information were available) so taking a diversified ‘asset class’ approach probably makes sense. Many investment trusts are presently offering big discounts and very high trailing dividend yields. For anyone with the capacity to diversify across trusts there is probably value in doing so. If you have time be more selective do so, but, with the best will in the world, you cannot predict incompetence and corruption or tornadoes that take down wind farms or windfall taxes, so diversification is always the way forward if it is an option, even if it raises costs a bit.

The investment environment has become much more difficult than it has been for many years . In part this is a consequence of unforeseen events (Covid) but also foreseeable events ( climate change, Ukraine) and the unwise reactions to such events (economic sanctions). It is also the consequence of wilful acts of self harm (Brexit). The global economy is now bi-polar with a new pole emerging as a direct consequence of the weaponisation of economics. It is a world in which stocks listed in the US form 50-60% of global stock indices. This seems unsustainable . It is very difficult to understand what could happen let alone predict what might happen. In such a world of uncertainty diversification is the only way to position. Investors need to keep some options open and ensure they have degrees of freedom. Understanding assets and asset classes , tax implications , and how values are formed is essential. As someone that has spent their whole career doing just these things, I am overwhelmed by what I see ahead of me. Which begs the question of the vast majority that has not spent a lifetime doing this; what on earth do you see ahead of you?

A State Competition Market Model

Regular and attentive readers will have noticed that I favour a state competition market model. This framework for running a market economy reduces the need for regulation but still enables the state to pursue policy objectives and address externalities. It cannot be applied in all circumstances and simply nationalising some sectors is the only way to go forward in some cases. The state competition model merely requires the state to set up a competitor to private sector provision where public goods or policy enter consideration. The time for a political party to give this model some thought is upon us. Every idea has its time.

A good place to begin is in banking. The so-called free market Tories have been berating the banks for not raising instant access interest rates in line with base rate. There has even been somewhat uninformed comment to the effect that banks should be regulated. Banks are regulated but the regulation does not extend to what interest rate they offer on instant access accounts. You can move your savings and only the terminally lazy or stupid fail to do so. If the Tory government wishes banks to offer more on average to instant access savers it has the perfect tool to do so. It can raise the rate on the Direct Saver account offered by NS&I. The interest rate on this account acts as a floor on instant access interest rates offered by banks. It is presently 2.85%. The government need only instruct NS&I to raise this interest rate in order to raise the spectrum of interest rates on instant access accounts. Why does it not do so? (Rhetorical question).

NS&I provides a perfect case study for my state competition model. Expand NS&I into a state bank. It can still simply fund the state but it can do so by offering a wider range of banking services. It is risk free because it is government guaranteed but this is only relevant up to a point. The FSCS guarantees all deposits up to £85k per separately licensed institution. You can hold funds in all licensed institutions if you wish. So why are NS&I interest rates so far below market rates? And why do savers use NS&I? The answer is only rich people should use NS&I because you can hold up to £2million in NS&I accounts and it is effectively safe. That is a lot of separate accounts ( 24). If you have £2million in a bank and it fails you have a problem. Most people have no need of NS&I and accept lower interest rates for no reason at all. The state could expand its services and offer higher interest rates and thus influence what banks do in a competitive market. It could offer a bank account and perhaps allow customers to buy and hold gilts through a brokerage service. It can set rates and standards through its own actions. In a competitive market place this would be more influential than holding meetings and berating banks.

The model is thus do it yourself and set the competitive standard. This could equally be applied to the retail energy companies. These are the companies that bill you for energy which they source from elsewhere (possibly their own energy production facilities but not necessarily). Set up a state retail energy company and set the standards and costs. You don’t need to regulate these companies. You just offer the customer a state alternative and set the standard you want these private entities to achieve. Simples! Anyone not meeting the standards set by the state entity will be out of business pretty damn quick. The expectation as with NS&I is that the state provider will become the floor. Private companies will typically do a bit better. And when they fail there is a state company to pick up the slack.

This model can be expanded to Broadband and Mobile Phones without much effort. They can piggy back off the infrastructure providers just like other companies do (e.g. Plusnet, GiffGaff). There is no need to own wires or masts or pipes. Infrastructure is a separate issue. In some cases leaving it to the private sector may be appropriate. In other cases (e.g. water and sewerage) perhaps full public ownership is necessary. It should be emphasised that the state can be very influential if it becomes the middle entity between infrastructure and consumers. It does not necessarily need to own and manage the infrastructure. I would like to see this model tested and banking, retail energy, and telecoms, seems a good place to test it. As the election looms keep it in mind and ask the candidates about it. It is an idea whose time has come.

Risk Control in Individual Portfolios

This is a subject that I have addressed several times in this blog but it bears a little repetition. I am minded to return to the subject following an interview with a Robo-Fund of which I am a customer. They charge 75 bp of AUM and ask you to choose a risk profile from a 1-10 rating to indicate your risk preference. Risk avoiding customers will choose 1 and risk loving customers will choose 10, or so the logic goes. But the fee is 75 bp whichever you choose. If you choose 1 you are paying them 75 bp to keep most of your money in cash or near cash assets. My question to them is why would anyone choose 1? They agreed it was odd but that the regulator requires them to ask for this selection.

The logical thing to do is decide what risk level you wish to take and then construct the cheapest portfolio that delivers this risk exposure. Logically everybody should choose risk preference level 10 and allocate a suitable amount from their cash holdings to achieve this risk level. If you are a risk seeker you might allocate the majority of your cash to the Robo-Fund at level 10 and keep a minority in a cash deposit. If you are a risk avoider you would allocate most of your cash to a cash deposit and only a small amount to the Robo-Fund at level 10. You do not pay 75 bp on your cash deposit. In fact you now can get between 3.6 and 4.5% in interest typically. You will be paying 75 bp only on the small AUM invested at risk level 10. If the point is not clear to you then please take advice before making investments. You need it. And regulators take note. You are part of the problem.

The issue applies quite generally to the cash holdings within collective investment schemes. The logic is market timing. Sometimes the manager tries to time the market by increasing cash holdings temporarily in order to invest at better levels. If you believe in market timing by fund managers you might be happy with this. If you don’t then all you have is disruption to the risk structure you thought you had. If you treat cash deposits as risk free, paying a sure return, then controlling your overall portfolio risk by varying your cash holdings relative to risky assets is a sensible approach. However, you then need to be sure you know what risk your risky assets involve. If they are collective investments they may have a variable cash component which complicates matters. ETFs do not typically have variable cash components so are good collective assets in such a framework of individual risk control. Investment Trusts typically use leverage so are very efficient risk taking collective investments. You don’t need to invest quite so much to get some risk bang for your buck because the trust managers borrow to buy assets. OEICs however often keep a significant amount of cash if only to meet redemptions without selling assets, so they are inherently less cost efficient.

The best way to control risk is to start by thinking about how much risk you are happy to take. In my experience people have much lower risk tolerance than they admit to. An individual stock can be completely wiped out. A collective investment is unlikely to be wiped out but a significant drawdown in value is possible. A major stock index can quite easily fall 50%. How will you sleep if this happens? If you think you can live with , say, a 10% drawdown then cash/ risk ratio of your portfolio might need to be in the region of 80/20. If your risk portion of the portfolio falls by 50% (and ignoring interest on cash) then you will experience a 10% fall in the value of your portfolio. Nobody is advising you to keep 80% in cash!

The attitude to risk should vary with your objective and wealth level. If you are building wealth over 40 years and feeding in cash every month then a risk loving approach makes sense. It is the best way to build capital. If you are in retirement and looking to generate income and stabilise wealth then perhaps a more cautious approach is warranted. However if you want your retirement income to grow in real terms you will have to take some risk or be very good at market timing.

The takeaway from this blog is simple. Don’t pay people a risk management fee to hold cash for you. Think in terms of total portfolio of wealth and manage your risk exposure through your cash/risk asset ratio. Whatever risk tolerance you think you have it is probably less. Markets can fall 50% pdq. Some investments can go to zero and never recover. Finally, one more take away (again a point raised before) volatility is expensive. If market falls from 100 to 70 it has fallen 30%. If it rises 30% it only gets back to 91. This is volatility drag.

A Tale of Three Investment Trusts

Three investment trusts in which I am invested throw up some interesting comparisons and at least one conundrum. Brunner Investment Trust trades at a 12% discount to NAV. It has done so on average for at least three years. Murray International Trust trades on a 2% premium having averaged a discount just below 3% over the last three years. Merchants Trust trades on a small positive premium (less than 1%) and has done so on average for the last three years. The conundrum is that Brunner should consistently trade on such a wide discount.

Brunner is an AIC dividend hero. It has increased its dividend the last 51 consecutive years. Merchants is also a dividend hero having done so for 41 consecutive years. Murray International falls into the ‘next generation’ category having increased its dividend in the last consecutive 18 years. The respective 5 year dividend growth rates are 5.44%, (no data), 2.29%. The respective dividend cover rates (in years) are 1.73, 0.57. 0.99. The respective trailing dividend yields at the time of writing are 2.02%, 4.85%, and 4.2%. Brunner is a global equity fund, Murray is a global income fund, and Merchants a UK income fund. Nothing obvious here to explain the Brunner discount.

All three use leverage or gearing. Brunner has 4%, Merchants has 9% and Murray has 7%. Normally one might expect funds with the higher gearing to have the bigger discounts other things being equal. The 5 year performance of the three funds is 8.48%, 7.37%, and 7.76%. The 5 year standard deviation of return is 16.54%, 21.17%, and 18.62%. In short, Brunner has the lowest gearing, highest 5 year return record and lowest volatility. The plot thickens. Why the discount?

Brunner and Merchants are both managed by Allianz and Simon Gergel has a significant role in both cases. The charges in all three cases are similar with Murray prima facie the cheapest and Merchants the most expensive. All three funds invest in liquid listed securities. One material difference in asset allocation is that Brunner has a very high weight in the UK for a global fund and very low weight in developed Asia. However, as all three are bottom-up stock picking funds there is no reason why this should induce a discount. Moreover, Merchants is basically all UK and Murray has a very high developed Asia exposure. All three trusts have unlimited life.

The only significant difference that I can find is that the Brunner Trust shareholding is to a significant extent in the hands of the Brunner family (about 30%). The Brunner family holding does stand out and this may influence investors. The other possibility is the low current yield is having an effect. This idea is suggested to me by another investment trust in which I am invested; Henderson Far East Income. It trades on a premium of almost 3% and has averaged a premium of 1.64% in the last three years. The 5 year return is -0.44%.

The conclusion I am forced to come to is that there is a market bias towards current income and a strong aversion to large family holdings in investment companies. The latter makes sense as a dominant shareholder is always a potential threat to minority shareholders. I regularly hear and read that the Brunner discount is an anomaly and that it is ‘cheap’. Perhaps, but it is consistently cheap and in a world where markets a pretty efficient this discount should not persist unless there is a very good reason. My guess is the reason is the Brunner family holding and the discount will not disappear until that holding is clarified. Very happy to entertain alternative explanations.

The Philistine

It is ironic that if you know the origin of the term Philistine, and its intended meaning, you are probably not one. Yet I have always regarded myself as a philistine. Not so much in the anti-intellectual use of the term popularised by Matthew Arnold in Culture and Anarchy (1865), but in the sense of disdainful of the concept of high art and the baggage that comes with this concept. This has been a hobby horse of mine since I began to think about anything. The origin of my disdain lies in the realisation, from a very young age, that people regarded themselves as superior if they had some knowledge of high art, however shallow their knowledge. They regarded themselves as superior to me for all sorts of reasons but this particular reason irritated me the most.

My first encounter with high art and its baggage was via a kindly, but patronising, old lady that decided I needed exposure to culture. She promptly lured me to the Victoria and Albert Museum with the promise of tea and cakes afterwards. I enjoyed the tea and cakes. The museum merely reinforced my philistinism. It was full of stuff which meant nothing to me. Later a kindly, but equally patronising, middle age man seemed bothered that I did not own any vinyl recordings. I pointed out that the house had one mono record player and it was not mine. Moreover I had no money. He offered to buy me an album. Never one to turn down a free album I chose ‘The Most of the Animals”. His concern for my cultural well-being increased. I had heard ‘ We gotta get out of this place ‘ on Radio Luxembourg (using an old transistor radio the battery for which I could ill afford), huddled under my blankets in the unheated attic in which I slept. It spoke to me! The Animals gave form to an idea and emotion that I was feeling. If this is not art, then what is?

My understanding of art is precisely this; giving form to an idea or emotion. This is a very wide definition of art and would place Martin Luther King’s ‘I Have a Dream ‘ speech firmly in the category of art. Good art is presumably when the artist conveys the same idea or emotion to everyone and it was the idea or emotion intended. Otherwise what you have created is a space for others to interject their idea or emotion. This is also a valuable skill and function but is it art? It is this thought that has bothered me in my later years. If we all see something different in a painting, read something different from a book, or hear something different from a piece of music, then anything can inspire us to have a thoughtful or emotional response. Anything can be art and therefore everything is potentially art. The art is created by the reader, not the author. The latter merely creates the space for the reader to create the art. We are all artists but some are creators of artistic space. If this makes no sense to you try reading Roland Barthes, The Death of the Author (1977). It was this book that finally gave form to my discomfort with high art and its baggage.

My discomfort first arose in my sixth form years when my sixth form master had noticed that I was a philistine (and quite assertive about it) and decided to correct this. He regarded himself as a cultured man but lived in Milton Keynes, which seemed to me a contradiction. He had invited a group of us to his home for lunch during the summer holiday. He showed us his rose garden of which he was obviously proud. I commented that I preferred the blooms of nature to cultivated blooms and this seemed to horrify him. In the upper sixth, he insisted I do a general studies course (12 weeks!) on fine art and promptly dragged me off to the Courtauld Institute of Art to study impressionists. His argument was that an appreciation of art would help me in my career. I wanted to be an economist so this view baffled me but of course, he was correct. Paying lip service to the high arts is important to careers unless you want to be a bricklayer. I didn’t. And therein lies my disdain.

A committee of people decide what is high art. The popular music of one generation (e.g. Opera) can become the high art of another. Social status becomes inextricably linked to the ability to talk about the high arts. Public money, whether taxpayer or charity, is devoted to promoting whatever the committee decides is high art. Children from backgrounds that would not normally be exposed to the high arts for both cultural ( we all saw Billy Elliot right?) and economic reasons are offered the opportunity (much as I was) to acquire some ability to talk about the arts. It is not generally spoken about in this tone of course. We talk of young people being enabled to appreciate art. Art in this form is really just a social rite of passage. A way of identifying yourself in a specific social class or category. So I remain a disdainful philistine.

This said I love Shakespeare and have done so since GCE O Level ( as it was when I was a lad). I also love Puccini’s operas. The latter I discovered by accident. I heard the aria from Cavalleria Rusticana at the end of Godfather III (an awful film) and bought a recording this short opera. From there I tried a few other operas and found Puccini to my liking. Does this make me cultured? No. Puccini, I like the way I like all music. His operas elicit an emotion. Shakespeare is a brilliant space into which I can interject meaning. Shakespeare says as much about today as his own time. What did he mean? Who the hell knows. What can I read into it? A wealth of knowledge and ideas. I have even written a blog on the Merchant of Venice explaining how Shakespeare used fat tails in the plot. I discovered Shakespeare and Opera in the normal course of my life and pursued it because it was fulfilling. No one taught me apart from at school. I grew up in poverty but it was not ultimately an obstacle.

In my view, the most important music form of the modern era is Rap. I am not a fan but I can see its significance. It developed from within a specific community to give form to specific ideas and emotions. It has transcended this community to become a form of expression in communities often antithetical to the originating community. It is the closest approximation to a modern art form that I can think of. I am not aware of anyone spending public money to teach it or promote it, though I am sure it pops up in cultural studies research degrees. Perhaps in 100 years some committee will deem it high art and devote public money towards it.

The problem with society is not a lack of access to art. It is income inequality. Poverty is no obstacle to the creation of art forms. Where do people think the Blues came from? It is however an obstacle to the experience of the various available art forms. If we want to promote art we need to address income inequality. Committees selecting forms for people to label themselves with is simply another way to perpetuate social inequality. The price of a ticket to Tottenham Stadium for one premier league match is similar to that of a ticket to the ENO. Around fifty to sixty thousand people choose to watch a Spurs football match every two weeks not including competitions. This is just one stadium. Multiply that across the country and it is millions. How many people choose to visit the ENO? Do you really think it is because they incapable of appreciating Opera because they are culturally inferior and need to be taught to appreciate Opera? They make choices and their choice is to prioritise football. They may not enjoy Opera. They may prefer Rap. They may not like Shakespeare. They may prefer Love Island. Ironically, this is because, in their cultural existence, it is more useful to be able to discuss reality TV and soaps than it is to discuss Shakespeare. There is no committee guiding them to this conclusion. They work it out.

Art is a meaningful idea. However, it is a difficult concept to pin down. My definition is quite precise and probably unattainable. What is clear, however, is that art as a concept has become so entwined with social status and access to employment and identity that it has lost its meaning and value. Social status should not be linked to art. Art is a form of expression and each of us has a right to individual expression without fear or favour. If people can afford to sample all forms of expression they will choose those that speak to them. It is not for some self-selecting and self-interested committee to dictate what is art and what is high or low art and what should receive public money. Nothing should receive public money or everything should. Let art just happen and serve its function of expression without arbitrary judgement. So says the Philistine. And if you want to help economically disadvantaged children address income distribution.

Listing and Valuation

There has been quite a lot of ‘discussion’ about corporations that presently have their primary listing in the UK and Europe moving this listing to a US exchange. There may be many reasons why a corporation might want to do this but one that keeps being suggested is not entirely logical, especially if you believe markets are efficient. The valuation of US listed stocks is higher than elsewhere. It was originally thought that this reflected the greater preponderance of growth companies. It is now being suggested, implicitly and explicitly, that a company can increase its valuation simply by switching its primary listing to a US exchange. If true this would mean the cost of equity capital for the re-listed company would be lower.

It is important to be clear what is being asserted here. A company presently having a primary listing in, say, the UK and a price earnings ratio of 10 might double this to 20 simply by a primary listing on a US exchange.The company is the same company . Nothing else changes, just the primary listing. The re-listing means investors (not just US investors) are now willing to pay twice as much per unit of prospective earnings as prior to re-listing. This makes no sense unless the re-listing materially changes the quality of those earnings.

US investors could have bought this prospective earnings stream before re-listing. Presumably they did not. Once it pops up on a US exchange not only do they wish to buy it but are happy to pay twice as much. Non-US investors holding this company receive a valuation windfall. Many non-US based investors that did not own this company will now find themselves owning it at the higher valuation. This is because it will end up in indices that they track and portfolios that invest in US listed stocks. US equities are presently about 58% of global equities. In the limit, if all companies that are able do re-list on US exchanges, the US geographic region will become the global equity space and presumably at a higher valuation. There is something faintly preposterous about this.

Ultimately, this is an empirical question. Does re-listing enhance the quality of earnings other things being equal? Arguments about US investors valuing earnings higher are nonsensical because they can buy these earnings now much more cheaply. Even if the typical US investor is myopic there are huge global fund management operations that should ensure the same asset trades at the same price in all jurisdictions unless there is a material reason why it should not. The whole listing debate suggests global markets are segmented in some way but no one has yet explained that this is the case and how it is the case.

My own suspicion is that the valuation debate is a smoke screen. The re-listing probably benefits executives but they do not want to admit this. It may also benefit founders that want more capital but do not want to relinquish control. If my suspicion is correct then any windfall from re-listing is best realised early. But what do I know…