Thoughts through the cycle: W2 October ’20

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  • The new letter-du-jour for describing the current economic situation is K-shaped. This seems to mean some people (generally those who were already rich) are doing well, and those in lower socio-economic groups are struggling and will likely to continue to struggle if the global economy stabilises at a lower level. Central banks are generally pretty happy with their performance so far (quantitative easing increased, bond yields controlled, asset prices at highs, no currency crises yet), although one wonders whether there is a little bit in all of this of George Bush Jnr standing on the deck of the USS Abraham Lincoln back in May 2003 famously proclaiming mission accomplished in Iraq just as the insurgency was getting into full swing.
  • One of the reasons the recovery (or recession?) is K-shaped is the radical policy action from central banks and governments, not least the lockdown and subsequent restrictions and rule-making that has ensued. In the UK, the memory of governments in the 1970s trying to ‘pick winners’ in the industrial sector is still strong, with the disaster that was British Leyland looming large. Because the pandemic has greatly increased government activism, there is a bit of a sense of a re-run on the ’70s, although this time the government appears to be avoiding losers rather than picking winners, and those who win are only doing so by accident.
  • So when one week bicycle-retailer Halfords (HFD.LN) saw its stock price rise 28% to 237p as it announced higher-than-expected summer sales in its cycling and car-repair business due to changes in the public’s transport preferences, the next week, Cineworld (CINE.LN) stock falls 30% to 27.5p as it announces the closure of its UK operations with the loss of 5,500 jobs due to falling demand and delays to the release of blockbusters like the new Bond film. The fates of companies are being decided seemingly at random when in fact this is all the product of government policy.
  • The final version of the UK’s main Q2 macroeconomic data was released on 30th Q2 GDP fell a staggering 19.8% (although this was better than the initial estimate of 20.4%), taking the economy back to 2000 levels. Private consumption fell 23.6% quarter-on-quarter, while business investment fell a terrifying 26.5% quarter-on-quarter. There is no benefit to putting lipstick on this particular pig. The only solace is that after a collapse of this magnitude, the numbers in Q3 will bounce sharply. The question is not whether there will be a bounce, but at what level the economy stabilises versus its pre-Covid level.
  • One area where the bounce can already be seen is in housing. The Bank of England has cut rates making mortgages more affordable while the Treasury has temporarily removed stamp tax from the first £500,000 of any housing purchase as a further incentive. If one takes these measures together with pent-up demand from transactions delayed by the lockdown as well newly planned acquisitions resulting from those who have decided to relocate as a result of the experience of lockdown itself, then the graph below showing the Nationwide house-price index rising at a 5% year-on-year clip in September are not all that surprising. Funny old recession eh?

Source: Bloomberg as at 5 October 2020.

  • With house prices so buoyant, one would have thought the UK bank stocks would be having a right old time. Sadly, that is not the case. The graph below shows Lloyds Bank (LLOY.LN) languishing at a price well below half that which it traded on the day Boris Johnson won the election back in December 2019. Equities are forward-looking instruments. If the dividend were resumed at say 1.5p, the stock would yield around 5.5% with 10yr gilts at 0.25%. The stock trades on around half 2019 tangible book, and a fully-loaded core tier 1 ratio of 13.4% (vs management target of 12.5%). Mortgage lending is clearly recovering vs H1 2020, even if management estimates that commercial lending is still not recovering from the 10% fall seen in H1. Not that bad a bet?

Source: Bloomberg as at 5 October 2020.

  • One way of explaining the lack of positive price momentum for a stock like LLOY is Brexit uncertainty. This may be the case, but equally one could say that the pound trading around $1.30 against the dollar is doing an awful lot better than it was at the distressed levels of $1.15 seen back in March, even if part of that differential is really dollar weakness rather the sterling strength.
  • Another reason could be that the UK yield curve is lower than it was in 2019. The graph below shows the current UK gilt curve in green with the same curve as of election day (12/12/2020) in yellow (dotted). Not only have rates been cut, but the UK gilt curve is now negative out to seven years. The Bank of England (BoE) is currently flapping around the issue of negative rates like a mother hen around a particularly prized egg. The Fed is vociferous about the detrimental effect of negative rates on the banking sector. The ECB is far more sanguine, in part because negative rates are already a fact in the Eurozone and to decry them would lead to a banking crisis. The BoE will likely be forced to go negative as the market has already done so, although Brexit will likely provide a convenient bit of cover for the policy change.

Source: Bloomberg as at 5 October 2020.

  • Cancelled dividends, negative rates, Brexit uncertainty and the recession all play their part in the drouthy performance of UK bank equities. Minus Brexit, banks stocks in Europe and the US are struggling too. But there may be another issue, one which has only existed as a result of the pandemic and the government’s response to it, and which will change the dynamic not only of the banking sector, but potentially other areas of the economy.
  • As a response to the lockdown, the UK Treasury initiated the Bounce Back Loan Scheme (BBLS) to help companies survive the shock of quarantine. Around £58b was lent, and it is estimated that as much as a third of loans were potentially bad at the time of being written. These are clearly loans no bank would ever have made – only a government would make a loan like that (i.e. handing out tax payers’ money). The tenor of the loans was extended from six years to ten years in September, so already we are seeing evergreening or ‘extend and pretend’.
  • More recently, the Sunday Times has reported that Boris Johnson is now looking for a policy allowing for long-term fixed-rate mortgages with just a 5% deposit. Such products are now few and far between in the market (most mortgages have a loan-to-value of 85% or lower), and in any case, long-term fixed-rate products are a feature of the US market not the UK one (PM sparks alarm with plan for 95% home loans, Sunday Times, 04/10/2020). When George Osborne was Chancellor and introduced the help-to-buy policy, the government guarantee to lenders was supposed to cover the first 15%. The article hints that a lot more of the risk would have to be shouldered by the taxpayer for these new loans, especially as there would likely be a relaxing of lending standards in terms of checks on the borrower.
  • While the article focuses on how help-to-buy policies actually increase house prices rather than making housing more affordable, and while building firms may be salivating over the prospect of another gravy train of government-induced building (remember the outcry at the boss of building firm Persimmon Jeff Fairburn initially being awarded a £100m bonus in 2018?), there is something far more important going on here.
  • In the name of a general, economic recovery after the pandemic but also of prior commitments to ‘levelling up’ as part of its election mandate, the British government seems increasingly willing to step into the lending market and underwrite or guarantee credit which banks otherwise would not make on their own. This transforms the banking sector into the conduit of government policy. Key to the execution of policy is low rates, and the close coordination of BoE quantitative easing with government deficit spending is another key pillar of this populist policy approach.
  • While monetisation of the deficit by the central bank is still only a de facto practice and one about which BoE governor Andrew Bailey was concerned enough back in April 2020 to go on record in the Financial Times to decry, reality is that BoE QE is already mirroring the government’s deficit spending. If the BoE were to get cold feet, the Treasury already has policy options (the Ways and Means fund) which allow it to bypass the bond market and have the BoE fund the deficit directly.
  • UK CPI inflation was 0.2% year-on-year in September, and will likely stay low or possibly even head negative in the next few months. What investors should however be aware of is the likely consequence of the fusion of fiscal and monetary policy as a result of the pandemic for a government which was already populist in its pretensions, especially when the point of departure is zero rates and therefore apparently no cost to borrowing, and even if there were a cost, the central will bank would step-in to cap it. While there appears to be no consequence to all of this now, this is a genuine change in government practice and can only eventually lead to inflation. At some point people will not be looking at the value of house prices, but the value of the money that the price of houses is denominated in.

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