The advantage of Quantitative Easing when it was first initiated, was that it distorted market prices. After the Global Financial Crisis, QE encouraged investors to allocate capital away from government bonds into more volatile asset classes such as property and equities. Our collective problem is that the political cost of using QE was perceived to be so low, that the policy has been over-used. Hence after a decade of market price distortions, we find that the wrong market signals have led to a long-term change in behaviour. Generally, it has been more advantageous for corporates to maximise current cash payments to shareholders, rather than investing in long-term productive assets. As a result, global productivity and wage growth has stagnated.
This link has become more consensual over recent years, so QE has been phased out by most central banks. But it leaves us all with an adverse legacy of the past. Generally, corporates have under-invested in the future, and hence their underlying cashflow is not growing as fast as it has in the past. Alongside, we also have an ageing business cycle, which tends to be reflected in a lower sensitivity to collective risk. When the downside cost of too much debt is a recent memory, there is a natural caution to gearing up corporate balance sheets. However, some ten years after the last recession, the recent memories are dominated by those who have generated substantial returns on growth stocks, including many businesses that are running at sizeable losses.
Stock market investing can be equated to a forest of various trees, with the occasional challenges of a recession culling the weak or overextended. However, the introduction of QE curtailed the usual cull in 2008. So now a decade later, as the current business cycle matures, we have a forest with fewer hardy specimens than usual. So, come the next setback, we will be entering the downturn with a greater degree of vulnerability than might be appreciated.
When large trees fall, they tend to fall into others. So, come the next downturn, it won’t just be the tallest that are vulnerable. The current setback within the retail sector demonstrates the nature of this risk. Whilst some of the most indebted retailers that have failed, the bad debts they have created have been damaging for some of their suppliers. Furthermore, the drop out of anchor tenants in some shopping centres has greatly reduced the footfall for others that have remained open, so quite a few property companies have also suffered.
Generally, the over-riding issue when market liquidity reduces, is that marginal borrowers tend to find it harder to access credit. Over 2018, these challenges have been magnified by the US corporate tax cuts, and tax reductions on cash balances, which have boosted the capital repatriated to the US away from other territories, and thus worsened the effect of the liquidity shortfall. Generally, we believe it is appropriate for fund managers to be unusually attentive to minimising financial risk. We worry that companies that have managed to roll over debt previously, might find it more difficult to refinance these balances in future. And it is becoming harder to raise additional capital in these unsettled markets. Ultimately a number may fail to raise the necessary funds, and end up in receivership. In summary, we worry that excessive debt may be particularly toxic going forward.
This risk is now being factored into share prices, with heavily geared stocks such as Interserve declining to such a degree that any restructuring of their debt will effectively leave the debtholders with almost all of the equity. Valuations of many growth stocks have been marked down more quite a bit recently, especially those that are currently loss-making and hence may run out of cash because their cash balances are finite. Many of the largest growth stocks are listed on the FTSE AIM Index, and over Q4 several suffered a severe share price setback. This explains why the FTSE AIM All Share Index fell 21.5% over the quarter, but the FTSE AIM 100 Index fell 25.0%. Note that the FTSE All Share Index was down just 10.3% over the same period.
Going forward, UK investors face two headwinds. First, there is growing economic evidence that world growth is slowing currently. Second, uncertainty may persist for some months over the terms of the UK’s exit from the EU. There are worries these factors could dilute market returns, especially for those listed in the UK.
In this context, it is worth emphasising that our UK funds have not been set up on the basis that the UK economy was superior to others. Rather, they were set up in anticipation that quoted small cap stocks were entering a longer term period when they would outperform the mainstream indices, especially overlooked small caps, because they have a history of performing better than similarly sized growth stocks longer term.
At times of substantive change, small caps as a group tend to come into their own. Specifically, their corporate agility is a great advantage at times of economic uncertainty – especially for quoted small caps given their scope to access external capital at times when it is scarce.
Importantly in this context, following globalisation, the UK is one of the few remaining markets that still retain a diverse universe of listed small caps. Thus, whilst UK growth may be sub-normal over the coming years, the advantages of quoted small caps are not easy to access elsewhere. Overall, we believe that a small cap strategy investing in overlooked stocks has real advantages in the current investment climate, as it did prior to the period of globalisation.
The value of investments may fluctuate which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.
Past performance is not a guide to future returns.
Forecasts are not reliable indicators of future performance.
Investment in the securities of smaller and/or medium sized companies can involve greater risk than may be associated with investment in larger, more established companies. The market for securities in smaller companies may be less liquid than securities in larger companies. This can mean that the Investment Manager may not always be able to buy and sell securities in smaller and/or medium size companies.