This month the MAS in Singapore announced a re-centring of their FX basket and a bias towards a strong currency to counter inflationary pressure. Brazil has a CPI running over 5%, while India’s WPI is near 10%, as is Russia’s. Meat prices are rocketing due to diminished herds. The CEO of Australia’s largest utility expects electricity prices to triple over the next decade. Steel prices will rise sharply due to the 100% increase in coal and iron ore costs, with obvious implications for the prices of manufactured goods. Thermal coal, copper and nickel are soaring, as are Platinum Group Metals. Some independent analysts calculate US CPI at 4% already if the farcical Owner Equivalent Rent is excised from the calculation. So why are forecasters extrapolating low short rates for the foreseeable future? No one apart from Goldman Sachs can borrow at them anyway (ask the average small businessman or the Greek Government) and yield curves are rapidly starting to resemble the north face of the Eiger. Welcome to the new ‘normal’, where Central Banks remain the only believers in output gap analysis and where the Bond Market vigilantes are back to the accompaniment of Roger Daltrey screaming ‘Won’t get fooled again’. You can see inflation everywhere apart from in the official data. Stay long inflation hedges such as Gold, utilities with index-linked asset bases and businesses with monopoly-like pricing power. Avoid bonds like the plague.

The SEC’s suit against Goldman Sachs looks a rather marginal prospect from a legal perspective, but in the current climate this is likely to be cold comfort to the masters of the universe. It should come as no surprise to anyone in the financial markets that investment banks exist to make their employees – and very occasionally their shareholders – richer. If their clients do well, that is a bonus as they may come back again to pay more fees, but it is not and never has been the prime directive. In a genuinely open and competitive market there is nothing wrong with this and aggressive behaviour on the part of banks can be found nearly everywhere. (For an entertaining account of Morgan Stanley’s attitude to client relations, we suggest FIASCO by Frank Portnoy as a good read). What sets Goldman apart is that it is better at making money than their peers, and this has set them up as the easiest target for a populist backlash. If the lawsuit had come from an aggrieved counterparty (aka a victim) it would be deemed a case of sour grapes and desperation following a failed bet. A lawsuit from a regulator is very different, and it seems that the case will be enthusiastically joined by several Governments as owners of losing counterparties to the infamous Abacus vehicle. It will become increasingly easy for Governments and large institutions with any kind of public service connection to sever relationships with the banks and the likelihood of punitive legislation increases every day that headlines consist of allegations that Goldman misled clients. Producing bumper Q1 profits merely inflames the argument. It is also safe to assume that some of the most profitable parts of the investment banks’ businesses will come under pressure, whether it is the 7% fee for an IPO, the privileged status of the primary treasury bond dealers or the ‘easy money’ of parcelling out underwriting risk for rights issues. We suggest a continued aversion to the sector as the playing field is tilted (back) to a fairer disposition of financial spoils.

The portfolios have recently benefited from takeover and other corporate activity to an unusual extent, with four or five major transactions in the last month or so alone. While we would never underestimate the importance of occasionally getting lucky, we view this as something slightly more fundamentally rooted and goes to the heart of how we select stocks. We have always looked at equities as businesses first and entities on a Bloomberg screen second. Voodoo technical ‘analysis’, behavioural considerations or momentum attributes are notably absent from stock selection criteria, though they may play some part in timing a trade inasmuch as some of the more obvious chart shapes can tell you something about investor sentiment and/or become self-fulfilling prophesies if they are obvious enough. We focus on underlying value, business franchise and (if applicable) novel technology. These also appear to be the criteria which acquiring companies look for as well and in an environment of low interest rates (for the moment, at least) and undergeared large companies with limited top-line growth opportunities, M&A will prosper. We look forward to a few more deals as the year progresses.

It is no surprise that a lot of this activity is concentrated in the resource arena. We have bored for Britain over the last few years over the continuing land-grab that China and India are making for scarce resources, but we now see a more generalised feeding frenzy over assets in the ground, especially if new extraction and synthesis techniques make previously uneconomic assets potentially profitable. Coal bed methane is one resource that has come of age due to improved horizontal drilling techniques and shale gas may prove to be another if the wells can be shown to have longevity of production and the environmental challenges of ‘fracking’ can be overcome. We are very optimistic over underground coal gasification as part of the next wave of ‘clean coal’ technologies, but will not repeat our polemics on
the subject here – please call if you are interested – but we would like to mention a new technology which could make a lot of coal mines both more profitable and lower their emissions. A company called White Energy has perfected the art of drying and compacting wet coal to produce a more compact, dust free and high calorific value briquetted product. The end product is lighter to transport and burns better. It does not sound like rocket science and the principle is straightforward. The problem that their many competitors have found is that coal has a nasty habit of igniting and/or exploding when one applies temperature and pressure, so the process technology is both key and non-trivial. Peabody amongst others is very interested as one can take $12/tonne wet coal and at a cost of circa $25/tonne transform it into a $90/tonne product. Some of the most experienced and successful coal investors in the world have just taken a major stake. We have been shareholders for a while and continue to see a lot of upside in these types of businesses which can add economic value and tick environmental boxes at the same time without any ephemeral government subsidy.

Large (i.e. listed) companies globally are (financially speaking) in rude good health, in stark contrast to the public and consumer sectors. Yet every business survey continues to highlight the stark difference between the parlous state of the SME sector and its larger peers. Yet the unlisted SME space is the one which should have the highest beta to the recovery. This time it isn’t happening. Small companies cannot get credit – or if they can it is at usurious rates (how else could the bankers get their well deserved bonuses?) and are being routinely beaten up by their clients, which tend to be the final consumer or a larger business. Having to cut prices and wait longer for payment is par for the course, and does not lend itself to going on a hiring spree. Do not assume that the optimism in the stock market is a genuine harbinger of strong and broad based economic recovery and be very wary of bullish and rising analyst forecasts, especially as the financial sector is in the vanguard of these raised expectations. The experience of the last few years should instil some caution as to the ability of the financial sector to predict its own future!

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