Market Commentary - Q3 2021
Written by Ivan Sedgwick
Whilst the moves in markets overall in Q3 were fairly muted, relative to what we have seen over the last couple of years, this has been a very interesting period, and perhaps a pivotal one.
The recovery of demand in at least some major economies – particularly the USA – has been striking and demonstrates once again how poor forecasters are at understanding moves that are not trend lines. The dislocation of supply chains and of the labour market looks like being with us for some while. Unfortunately in a repeat case of British exceptionalism, the focus on the UK is a pointless argument about whether Brexit or the pandemic has had the greater effect. It seems to me that Brexit has exacerbated labour supply problems, but otherwise problems in the UK are repeated elsewhere. The lack of gas storage in the UK may have affected prices at the margin but the underlying problem is the Russian squeeze on supply which is affecting all of Europe. There is a shortage of HGV drivers in the UK, exacerbated by strikes at the DVLA affecting testing, but there is also a shortage across Europe exacerbated by new safety rules – and in the USA too. Felixstowe is overcrowded and ships are being turned away, but Long Beach has the longest queues of container ships ever. We have in the words of Stephen Roach, the former Morgan Stanley investment guru, “a full-blown global supply shock: energy and food prices are soaring, shipping lanes are clogged and labour shortages prevalent”.
Are we therefore heading into a period of sustained inflation – or possibly the bane of the 1970s, stagflation? Bears such as Jonathan Ruffer argue that we have come to the end of a long (circa 35 year) period of ever lower inflation, ever lower interest rates – and therefore ever higher bond prices – and ever higher equity valuations, and that the correct response is a heavy weighting in index-linked bonds, real assets such as gold bullion, and even – despite the ethical issues – Bitcoin. Less apocalyptically-minded commentators like Roach, or the former MPC member Andy Sentance, still argue that at the very least central banks should accept that inflationary effects are not transitory and that rates should rise sooner rather than later. Where have we heard the precautionary principle being argued for elsewhere? There are definitely echoes of the groupthink that MPs found in the UK’s response to the pandemic in central bank thinking. The contrary view that what we are seeing is transitory, and that, for instance, the rise in energy prices is a one-off not a trend, is still more general. And some commentators, Cathie Wood for example, take an even stronger view which is that the big risk is deflation, driven by technological change, in particular AI.
Where does this leave us? LGB claims no expertise in index-linked bonds or bullion, and there are plenty of ETFs and other funds available for those interested in that kind of hedge. The MTNs that we arrange are relatively short term. A percentage point increase in interest rates makes less difference to a three year bond paying 8% than to one paying 1.1% over ten years (the UK 10 year gilt!). The general watchword if you fear rising rates is to keep duration short and make sure that your fixed interest securities have adequate security arrangements. The Bank of England has already given a clear signal that it will start to raise rates, but it is fair to wonder if any central bank can afford to go too far with this. And inflation combined with negative real interest rates is a great help to governments wanting to reduce the overhang of debt.
In the equity market at index level little changed. The FTSE100 dropped just under 1% in Q3. The AIM 100 exactly the same. UK midcap stocks did a little better.
Within that however there were some interesting moves. The run-up to COP 26 did not see gains in the fuel cell companies, indeed they fell (in tandem with their US peers). On the other hand the big oil companies were up, Royal Dutch by about 14%, and sustained their recovery buoyed by strong oil and gas prices. Against that background the ESG-driven calls for institutions to disinvest from fossil fuel stocks may be matched by the companies’ increased ability to buy back their own shares. So perversely we could see interest in both sides of the divide, both the fossil fuel and also the hydrogen economy companies. What we may also see is increased corporate activity by large energy majors in buying into alternative energy technologies. They have the infrastructure and if we are to shift to a hydrogen economy they can be and will want to be part of the solution, whether in supplying hydrogen, or offering refuelling. Most of the corporate interest in fuel cell companies to date has been from engineering groups. That may change. Other technologies are emerging. We are aware of a number of pre-market sodium battery companies, and there is a lot of investment in this area in China. Improvements in electric motors to reduce weight, increase durability and increase efficiency, will create other opportunities worth considering. So, the wider decarbonisation agenda is not going away – funds such as the recent HydrogenOne in which LGB investors participated, and which plans to be 85% invested in private companies and projects, give a window on earlier stage opportunities, and AIM seems receptive to more developed businesses.
The broader decarbonisation / green agenda continues to be a focus for us. Getting products to market, whether due to protracted approval processes or just the slowness of OEMs to adopt new technologies, can be frustrating, but there are some interesting AIM companies involved in for example non-toxic crop treatments and compostable packaging. New food production methods and agtech seems mostly the province of venture funds, some of which we have introduced to investors.
Life science had a mixed quarter, and with Nasdaq being the end of the Yellow Brick Road for many ambitious UK companies, the 14% fall in the Nasdaq biotech index seems to have had a knock-on effect. Some of the AIM companies that listed on Nasdaq have fallen sharply in the quarter. Equally some recent AIM listings also performed poorly despite having in some cases well-articulated products already partly approved or endorsed (GenInCode with its existing CE marks for cardio tests, SpectralMD with already c. $100m of US government funding, for example). Nonetheless, successes in trials and licensing deals have had positive effects on prices where they have come through, for example in the case of Arecor which was up 78% in the quarter. We will however need to return to thinking hard about runways and equity funding risk in this sector.
Returning to the problems of dislocation in the supply chain, where there are problems, there will be opportunities. The digital transformation of the economy moved apace through the pandemic, with the rapid adoption of cloud communication – and a concomitant increase in cyber risks. We remain alert for companies who can potentially benefit from the opportunities as well as the risks, whilst aware that there are too many sub-scale players in this area. The economy and the market that emerges from the pandemic is not going to look the same as before, already some old certainties (e.g. reliance on dividend-paying stocks in the UK, for example) have been dented, and in the wider world the end of the unipolar US dominance must create increased political risks and uncertainties. Meanwhile we shall continue to look for innovative growth companies who can navigate an uncertain world.