As we step into 2018, there is little question as to the direction of the global economy – barring an unexpected external shock. For the first time since the Great Financial Crisis, the OECD in aggregate is operating above potential, thanks to years of easy monetary conditions and the ending of fiscal austerity. Momentum appears to be particularly strong in corporate investment spending, with the compromise on tax cuts signed last month by the US Senate and House of Representatives only to add fuel.
As 2017 wraps up, investors’ quest for return is becoming ever more desperate. The money flooding to private equity and venture capital funds is mind-boggling, as are the valuations at which some managers in these spaces are making transactions. Paying up to a hundred times sales for a recently-founded unprofitable company cannot in our view be called investing – rather it is a gamble. «But hey», even sophisticated investors are saying, forgetting prior discipline about double-digit portfolio internal return rates, «perhaps this one company will be the next Google?»
Complacency rules in this “Goldilocks” environment of improving global activity with no flare-up (so far) of inflationary pressures. The investor mantra is that markets are expensive but no severe correction is to be expected in the near future, thanks to never-failing central bank support.
We begin this letter on what might seem an incongruous note for a financial publication: the end of the ban on women driving in Saudi Arabia. We are even tempted to paraphrase Neil Armstrong, considering it “one small step for Saudi women, one giant leap for Saudi Arabia”. Yes, we view this development as momentous, in so far as it underlines the speed at which the Kingdom of Saudi Arabia (KSA) is evolving under the influence of the young Crown Prince. A more acceptable form of society to “developed world” eyes will allow the KSA greater support from Western countries. Ties with US have already grown noticeably stronger during the past year.
The month of August was certainly noisy, with Hurricane Harvey and escalating North Korean military provocations dominating the headlines. Such commotion should, however, not detract investors from what we consider to be the crucial longer-term development: the normalisation of monetary policy – assuming of course that a dire scenario will be avoided in North Korea.
Numerous are the concerns that we have written about in recent letters – all the while striving to make the most of the ongoing sweet spot for the global economy and financial markets. Rich equity valuations, eventual wage-driven inflationary pressures, high correlations due to ETF and quantitative hedge fund proliferation, (geo)political uncertainties, build-up of Chinese non-performing debt: these matters (and more) have long featured on our worry list.
However enjoyable the ongoing upward ride in risky asset markets, we confess to becoming increasingly worried about the longer-term outlook. By this we do not mean that we fear a market crash. That, to put it bluntly, would be the better scenario – rapidly aligning valuations with intrinsic company worth and opening a new investment window. No, what we dread is a slow grinding process, whereby risky assets produce poor returns for many years. Alongside slowly rising bond yields, aka negative bond returns, this would be nightmarish for investors.
The money currently flowing into the private equity space is quite astounding – and a testimony to how desperate investors have become for returns in a world of zero rates. Not only are they willing to entrust massive amounts to newly established private equity funds, but they are also requesting that their money be put to work fast. The ensuing competition between private equity firms to find investments means not only that target company prices are bid up well above the level suggested by standard valuation tools, but also that proper due diligence is not always performed.
Economic indicators are virtually unanimous in pointing to (very) strong global growth in the second quarter. Confidence is high at both the consumer and business levels, with Purchasing Managers Indices particularly buoyant – typically reliable leading indicators.
Politics rule our investment letter again this month, albeit shifting focus from the US to Europe. With the first episode of a heavy 2017 electoral agenda just around the corner, investors are understandably concerned that a populist backlash could undermine the European construction. Our position, taking a hard look at each of the countries involved, is that the European Union (EU) will likely not only survive the political challenges of 2017, but perhaps even emerge more united – thus in a better position to rethink its future.