Jamie Clark

How to benefit from a rise in fiscal spending

Jamie Clark

In the first of two long-read articles, Jamie Clark explored the switch in focus from monetary to fiscal policy and how this will be implemented. In this follow-up article, Jamie explains the two key ways the team has positioned the Liontrust Macro Equity Income Fund to benefit from this development: one is stylistic and the other concentrates on sectors that should benefit from greater fiscal spending.  


1. 
Buy value

 

Like most income managers we have a natural bias to value stocks: those companies trading at a discount to market, peers, history, or intrinsic value. This follows the broadly inverse relationship between valuation and dividend yield.

Value companies trade at an unusually large discount to their growth peers. The long-run price/earnings ratio spread between the US market’s most and least expensive quintiles offers a representative illustration.

US price earnings spread

While this discount narrowed in the second half of 2019, it remains wide. We see confirmation of this effect across other valuations metrics (price-to-sales, price-to-book, price-to-cashflow) and this applies equally to UK equities.

We have previously remarked on how curious this seems, particularly in light of value’s superior long-term returns. Again, this holds across different valuation metrics and markets.

Like others, our assumption has been that value’s historic cheapness and strong track record would be enough to ensure a bout of mean reversion wherein any discount narrowed.

That this is yet to occur sustainably is best explained in terms of duration, a term typically associated with bonds but with relevance to equities. For our purposes, we may define duration as the senstivity of a security to changes in interest rates. Growth companies are long duration, because a bigger chunk of their worth resides in future earnings and the discounted present value of these earnings can vary wildly according to the rate assumptions baked in to discounted cash flow (DCF) models. Value stocks are short duration, reflecting a greater emphasis on current earnings relative to future earnings; this offers comparative immunity to rate changes under DCF analysis as the discount rate is less of a factor for near-term earnings.

The colossal scale of the monetary response to the financial crisis, through rate cuts and quantitative easing, has fed valuation models and effected a mechanical uplift in the estimated worth of long-duration growth businesses. The persistence of this response and its increasingly exotic forms (negative rates, forward guidance, yield curve control, etc.) underpin value’s broadening discount to growth.

The return of the money tree threatens disruption. Although Keynes prescribed that fiscal policy should work counter-cyclically, stimulating in a contraction and restraining in an expansion, history indicates that it is typically used for expansionary purposes. This is why the age of Keynes, both Golden Age and the 1970s, is defined by growth and then inflation. Such conditions are a remove from the low growth and disinflation experienced post-crisis.

This promises a sea change in investor preferences. While growth thrived as rates fell, value’s immediate returns become more attractive if fiscal policy stimulates economic growth and inflation stirs. Getting your money back now is infinitely preferable if it’s worth less tomorrow.

Proof can be seen in value’s outperformance of growth in the expansive Golden Age and inflationary 1970s. Using US data, the below employs three investment factors to demonstrate value’s superior returns.

Value versus Growth

This bodes well for our portfolio of value-rated, UK Income stocks.

2. (i) Buy UK housebuilders

The current crop of UK politicians have been eager adopters of the money tree. 

Early signs were seen in the government’s November revision of its fiscal rule – the limit on investment spending rising from 2% to 3% of GDP, or a sizeable £22bn.

 

But this was peanuts compared to December’s election. Notably, Labour’s £55bn public investment pledge entailed a “vision of the state with a far greater role than anything we have seen for more than 40 years”[1]. But before we deride this as a Hail Mary pass from a doomed manifesto, its worth noting that the Conservative’s new fiscal rules permitted debt-funded public investment on the scale promised by Labour in 2017[2] - confirmation that the consensus had shifted and that fiscal policy was rehabilitated.

 

This change is writ large in Boris Johnson’s talk of “levelling up” the country, or narrowing the wealth and productivity gap between regions; state intervention and regional development proposals mark a break with precedent[3].

 

The keystone policy of this agenda is a £100bn infrastructure spending commitment. According to the Conservative manifesto, this covers regional rail projects (not HS2), transport upgrades for regional cities and improvements to strategic roads.

 

While headline numbers are impressive, this isn’t where investors will profit. Civil engineering businesses run on operating margins of 2-3%, leaving little room for error on large, complex projects. This explains Carillion’s failure and Balfour Beatty’s seven profit warnings between 2013 and 2015.

 

The opportunity is in housebuilding. It’s understood that the UK builds too few houses to ensure price stability in the midst of population growth. Consensus argues for roughly 250,000 new homes per year to satisfy this goal[4]. UK housebuilding completions have declined since 1967 and have failed to exceed the post-war average since 1979. The average since 1980, the post-Keynesian era, falls to 190,000 and its clear that the drop in local authority activity is a contributory factor.

 

UK housing completions


While there won’t be a significant upturn in local authority housing, there will be housebuilder incentives. These include public funds for required infrastructure and fast track planning approval[5], which says nothing of extensions to demand-side inducements like Help to Buy.

 

The combination of government stimulus and deficient supply offers a powerful tailwind to UK housebuilders. This is a major reason why our portfolio exposure is around 3x market weight, our 6.8% allocation rising to over 10% if we include building materials businesses. What’s more, these companies are characterised by high margins, strong balance sheets and generous dividend policies. Taylor Wimpey, our biggest housebuilder position, exemplifies these qualities with its near 20% operating margin, net cash position and 8% dividend yield (ordinary and special).

 

3. (ii) Buy Miners

Our second sector opportunity offers a way to exploit the money tree’s likely future form.

 

The Financial Times’ Gillian Tett is correct when she explains that 2019 was the year that ethical, social and governance considerations moved out of “a specialised niche and into the mainstream”[6]. As investors, we read this in questions over executive pay, pressure on pollutive businesses and the appetite for green bonds.

 

These attitudes are also shaping political platforms.

 

The chief example is the Green New Deal (GND) of US Democrats Bernie Sanders and Alexandria Ocasio-Cortez. In invoking Roosevelt’s New Deal, the aim is to align themselves with Keynes and ideas of large public works[7]. Such grand comparisons hint at the scale of the GND’s ambition, a point confirmed by the startling promise of US$16.3trn for public investment in renewable energy, green infrastructure and research[8].

 

The Green Deal of European Commission president Ursula von der Leyen offers a similar vision. Again, the emphasis is on decarbonistation, with a pledge to provide €1trn of state funding for green energy and technologies[9].

 

In the UK, Labour’s 2019 manifesto co-opted the GND in arguing for the state to orchestrate a “green industrial revolution”[10]. GND rhetoric has even permeated Sadiq Khan’s London mayoral re-election campaign.

 

The point is not that these proposals embody realistic legislative agendas. Rather, they are straws in the wind, signalling the growing likelihood that future fiscal policy is used to arrest climate change.

 

Which brings us to mining. One of the paradoxes of decarbonisation, or the energy transfer, is its dependence on mineral extraction. As shown below, the required roll out of green technologies and infrastructure implies increased demand for a range of metals[11].

 

matrix of metals and energy technologies


Copper offers an excellent example. Valued for its conductivity, durability and versatility, copper is without substitute. This makes it critical to electric vehicles (EVs), EV charging stations and wind turbines. Such technologies also require an increase in the copper intensity of GDP, or more copper per unit of output than traditional alternatives[12]. Recycling and innovation may satisfy some of this[13], but the dearth of recent copper discoveries implies a significant demand pull and higher copper prices.

Decarbonisation and its effect on metals demand  is a critical reason for the Fund’s mining overweight, our 15% allocation equating to around 2.5x benchmark weight. At over 5%, Rio Tinto is the Fund’s largest holding. This business dovetails neatly with the resource requirement of green fiscal agendas. As at the 2019 interim stage, Rio generated 12% of earnings from copper and a further 11% from aluminium; another important metal in the energy transition. The contribution of copper should also increase, as Rio’s extension of the Oyu Tolgoi mine takes effect from 2027. Staggeringly, Rio trades on an historically modest single digit earnings multiple and offers a very attractive 6% dividend yield. This is an opportunity.

 


 

[1] IFS, Manifesto Analysishttps://www.ifs.org.uk/election/2019/manifestos, November 2019;

[2] IFS, Labour’s Manifesto Spending Plans are Impossible to Costhttps://www.ifs.org.uk/publications/9218, May 2017;

[3] Parker and Bounds, Brexit: will Boris Johnson reverse ThatcherismFT, 30/1/20

[4] Barker, Review of Housing Supply (2004); KPMG and Shelter, Building the Homes We Need (2015); House of Lords Select Committee (2016);

[5] See Conservative Party Manifesto (2019); and Department for Communities and Local Government, Fixing our broken housing market (2017);

[6] Gillian Tett, Ethical investing has reached a tipping point,FT, 18/6/19;

[7] The connection between Keynes and the New Deal is tenuous; see Wapshott, Keynes vs Hayek (2012);

[8] https://berniesanders.com/en/issues/green-new-deal/

[9] Ursula von der Leyen, A Union that strives for more: My agenda for Europe, EC (2020);

[10] Labour, It’s Time for Real Change, (2019);

[11] Ali et al, The Growing Role of Minerals and Metals for a Low Carbon Future, World Bank (2017);

[12] Paul Gait, Metals and Mining: Copper and the Green economy, Bernstein, 30/9/19;

[13] Manberger and Stenqvist, Global metal flows in the renewable energy transition: Exploring the effects of substitutes, technological mix and developmentScience Direct, 2018;

For a comprehensive list of common financial words and terms, see our glossary here.


Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Macro Thematic team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. The performance of the Liontrust GF Macro Equity Income Fund may differ from the performance of the Liontrust Macro Equity Income Fund and is likely to be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Friday, February 28, 2020, 12:53 PM