Another emotional week for Mr Market

Doubtless many readers will be familiar with Mr Market, who was an allegorical figure invented by renowned investor Benjamin Graham. Mr Market swings from pessimism to optimism with alarming and unpredictable frequency.

On Monday morning, Mr Market’s pessimistic personality trait was to the fore. The US Government had failed to approve a badly needed stimulus package and central bank stimulus was seen as insufficient to lift the mood. Mr Market was having a justified case of the Monday blues.

At the beginning of the week, finger in the air estimates on dollar corporate bond supply was around $20bn. As I write this on Thursday evening we have seen $70bn of new supply, which was dwarved by investor demand. Over the last week, we are close to record levels in $ supply.

We don’t have to look far for the reasons behind Mr Market’s apparent schizophrenia, Fed’s QE bazooka and significant fiscal stimulus package agreement in the intervening period goes some way towards an explanation.

The $70bn of supply has been, predominantly, from blue chip entities. At times of stress, these are the only companies able and willing to issue at elevated costs of borrowing. While COVID remains a matter of life and death for us all as individuals, we have a reasonable expectation of these companies living through the current turbulence. Strong balance sheets and a continued need for their products assures us of that.

When blue chip companies such as Procter and Gamble, Kimberly Clark, State Street and Mastercard (among others) are paying generous credit spreads to issue debt, it puts the onus on us to try to look through the challenges of the weeks and months ahead. We therefore added selectively through the supply we have seen this week. 

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Portfolio immunisation from coronavirus

To be clear, there are no winners if coronavirus continues to spread.

However, as bond investors it behoves us to make a realistic assessment of how assets will perform under a pandemic scenario. This then allows us to take prudent steps to immunise portfolios as far as possible. 

Stating the obvious to an extent, government bonds will continue to perform well – or very well – under such a scenario. The US 10-year yield is pushing towards record low levels, despite the prevailing economic data coming out of the US continuing to be reasonably firm. However, while current levels are not underpinned (thus far) by observed economic data, we should expect these bonds to continue to outperform in a pandemic scenario. 

Domestically-focused entities may also be more insulated. With companies continuing to report fourth-quarter results, many of those exposed to China specifically – and more generally global demand – have sounded the alarm. In many cases, CEOs continue to expect a recovery to come through and benefit numbers in the second half of the year. However, for those that are globally exposed, the uncertain trajectory of infection is likely to lead to investors seeking safety elsewhere.

For example, early indications are that the utilities sector will be a relative outperformer. This may be attributed not only to their domestic focus, but also to their bond-proxy characteristics. These are likely to offer stability, and are beneficiaries of lower government bond yields. On a case-by-case basis, of course, these characteristics are also shared by some names in the telecommunications sector.

On the flip side…

Cruise lines, airlines, conference providers and international hotel groups will suffer. In many cases the business model involves attracting customers from all over the world and placing them into close confinement (though often luxurious in nature). Historical references to cruise liners as floating petri dishes have garnered much publicity of late.

The auto sector remains heavily reliant on China as a growth engine. As the virus has escalated, we have seen supply chain issues (with Jaguar Land Rover reportedly flying parts out of China in suitcases to factories in the UK). We have also seen some early warning signs on the demand side of the equation, with reports of China’s car sales falling 83% year-on-year for the seven days through to 23 February. While car purchases are more likely to be delayed than cancelled, one tends to go to a showroom in order to buy, and the early signs are that in China, consumers are unwilling or unable to do so.

And lastly, there are catastrophe bonds with high yields (and in many cases, high yield ratings), with payment at maturity linked to the absence of a so-called catastrophe event. In 2017 the World Bank issued two tranches of pandemic (catastrophe) bonds, which default under a defined pandemic scenario (as funds are used to deal with the fallout of said pandemic). These bonds are set to mature in July, unless the scale of the outbreak is such that they are triggered (read default). Needless to say, we are not holders.

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Monstrous bond supply

Henry Frankenstein: “Look! It’s moving. It’s alive. It’s alive… It’s alive, it’s moving, it’s alive, it’s alive, it’s alive, it’s alive, IT’S ALIVE!”*

The bond market enjoyed a record breaking year in 2019 in terms of the quantum of bonds issued globally. And following a brief hiatus over the festive period, issuance in the first week of 2020 saw bond markets resurrected with a monstrous amount of supply.

Investment grade supply in euros was at its highest level since March 2016, with €31.3bn of deals pricing. The overwhelming bulk of this was squeezed into four days, with Monday considered a holiday in some parts of Europe. Including all issuers (i.e. including covered bonds, sovereigns, supranationals and Agency bonds, etc.) euro supply for the week was a whopping, and record breaking, €79bn. 

In US dollars, while not a record breaking week, it was not far off! Last week was the fourth busiest week ever by volume and by number of deals, as 41 companies pumped out $61.9bn of new bond supply.

Closer to home, the absolute numbers in the sterling market were smaller, but we saw several senior bond deals from UK and international banking names. This was enough to expand the senior financial market size by nearly 5%! 

Elevated periods of issuance are sometimes treated with a degree of trepidation by bond investors, who are prone to fret about the difficulty in digesting said supply. In this case, however, we saw healthy demand, well covered deals and broadly strong initial performance, suggesting cash remains for attractive issues.

As one would expect, there were opportunities among the weight of issuance, and we selectively participated in these across our fund range.

* Quote from the movie: ‘Frankenstein’ (1931)

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Save the whale

When President Trump recently met with Prince Charles, the “Prince of Whales”, one quote taken from the subsequent interview of Trump struck me:

“He wants to make sure future generations have climate that is good climate, as opposed to a disaster, and I agree.”

This is not only a noble aim, but I think one which would garner near-universal agreement. However, BP’s recently-presented annual statistical review was a stark message that we may be diverging from our aim of a “good climate” for future generations. BP’s chief economist, Spencer Dale, stated that “the world is on an unsustainable path”, revealing that “the increase in carbon emissions [in 2018] is roughly equivalent to the emissions associated with increasing the number of passenger cars globally by a third”.

Let’s take a moment to think of an equivalent scenario. Imagine, in 2018, it was well known and well understood that the number of passenger cars on our roads had increased by one third, would we really feel that the world was on anything other than the brink of disaster regarding climate change?

Averting disaster will be difficult from here, though we are moving in the right direction. For example, this week the UK set a stretching and legally-binding target to have net zero emissions by 2050, with Theresa May saying there is a “moral duty to leave this world in a better condition than we inherited”.

In the financial markets, there are an increasing number of opportunities to invest in green bond issues. Over the past two weeks the utilities sector has seen three green bond issuers, two of which are new to the financing structure. We continue to evaluate these on their own investment merits of course (and are wary of “greenwashing”), but it is pleasing to see borrowings being dedicated to environmentally-friendly projects, particularly in the utilities sector where the arguments for this issuance type are so strong.

Some reasons to be optimistic, then, but as with our investing decisions we prefer cautious optimism as we endeavor to achieve President Trump’s (and indeed most people’s) objective of a “good climate”.

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Fuel-hardy plans for utility nationalisation

The spectre of nationalisation of the water and energy sectors under a Corbyn government has reared its head again. Labour recently firmed up their plans to nationalise the energy sector with the release of a document entitled “Bringing Energy Home”. Perhaps the resurgence of the debate has been precipitated by newspapers having more pages to fill, with a temporary hiatus of Brexit from the news agenda.

As ever, details on how this would be achieved are sketchy, but (in the case of water) would appear to involve shareholders being compensated at less than 50% of “market value”. The energy network plans are again suggestive of an attempt to compensate shareholders at below market value. This is in spite of the fact that many UK pension funds hold substantial stakes in these companies. It is difficult to imagine trustees welcoming the latest announcements.

Bondholders and shareholders would be compensated by receiving gilts, under the latest proposals. Among the many flaws in this approach are concerns around the theoretical value of UK government debt (typically, credit holders would be keen to receive gilts as proxies for their corporate holdings, but that may be challenged) under an administration that seeks to expropriate private assets.

The proposed methodology used to assess the compensation due to stakeholders (seemingly based on a calculation of how much stakeholders have historically spent investing in assets) would be an archaic method, and this would be unlikely to stand up to legal challenge (it is worth noting that under the previous wave of UK nationalisation, the legal view was that the Government should pay compensation based on the six month period prior to announcement of the nationalisation policy). As an indication of the legal difficulties in the proposed method, a partner at Clifford Chance, Dan Neidle stated that in every UK privatisation so far, the state paid market value, so it was not up to Labour to decide what was a fair price. He stated “That’s not what the UK precedent is and that’s not what international law says”.

The ongoing investment required to maintain the infrastructure of the energy networks and the UK water sector is huge: the last Ofwat regulatory review saw the 17 companies responsible for maintaining the UK’s water sector invest a total of £44 billion. Ofwat’s regulatory regime was described as stable and predictable by rating agency Moody’s (before nationalisation pressures started to bite). It is this stable, predictable and market-leading regulatory framework that allowed investment of this magnitude to take place.

Whilst we recognised and highlighted the benefits of expedited closure of the opaque Cayman entities (used by some water companies) in terms of restoring public trust and lobbied the sector to this effect bringing both sectors back into public hands would represent a retrograde step and one that could do untold damage to the UK’s reputation as a place to do business.

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Anyone want to rebel against the extinction of coal?

After the angst and widespread despair that characterised much of the coverage of the recent climate-change protests in London, there was some good news to report in recent days with regard to the UK’s energy usage.

Selected highlights from the National Grid publication (covered in The Telegraph on the 6th May) included the startling fact that of the 31.45 GW powering the UK on May 5th, none was generated by coal-fired power stations. At Kames, our portfolios have financed many of the companies that have facilitated the transformation in the UK’s energy provision. One of the pre-eminent issuers in this regard is Orsted (formerly known as Dongas), a company that develops, constructs and operates a significant proportion of the UK’s offshore wind farms (the UK is the world leader in offshore wind power, and Orsted is the market leader in the UK, with a pipeline of projects to power over 4.4m homes by 2020).

Having financed Orsted’s remarkable transformation into a supplier of predominantly renewable energy (we participated in the company’s 2012 debt issue), we look forward to engaging with the company over the coming days as it seeks to issue multiple green bonds to consolidate its position as one of the world’s leading providers of wind energy.

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Price caps: Burnt fingers?

Here in Scotland it was recently the season for Burns’ supper celebrations. In case you haven’t had the pleasure, the haggis, neeps, and tatties are usually accompanied by whisky (preferably lashings thereof) and readings of the native bard’s poems.

I cannot hear the poem “To A Mouse”, and in particular the lines “the best laid schemes o’ mice an’ men, gang aft agley”, without being reminded of a notable highlight in PG Wodehouse’s “Jeeves in the Offing”.

The inevitable failure of a typically hare-brained scheme leaves its unfortunate protagonist, Bertram Wooster (or “Bertie” to his friends, among them “Kipper”!), commiserating with Kipper, as he rues,

“I don’t know if you know the meaning of the word agley, Kipper, but that, to put it in a nutshell, is the way things have ganged.”

Among the Conservative party’s “best laid schemes”, we saw the party abandon their free market mantra by voting in favour of a price cap on home energy bills.

Notwithstanding the price cap, the Conservatives remain staunch proponents of free markets when compared to Labour’s stance on utility nationalisation. Presumably, in the Tory party view, the real issue of concern to consumers was one of affordability, not of ownership.

Under the cap, the maximum monetary value that UK consumers are charged on the default Standard Variable Tariff is set (and periodically reviewed) by market regulator Ofgem. The price cap has now been in place for just over a month, and it is widely expected that this Thursday Ofgem will move to increase the cap by around £100.

A wave of smaller operators going bust, combined with job losses at Innogy’s UK subsidiary Npower, suggest all is not rosy in the capped-price world of UK energy supply. A rise in the cap is likely to be a difficult sell to the electorate, but it may be viewed by Ofgem as the most prudent approach. Against rising wholesale costs for suppliers, it is hard to argue that smaller operators going bust reflects an effectively functioning marketplace.

The rise in the cap level will doubtless counteract much of the positive spin from the introduction of the cap at the start of the year. Here as elsewhere, reality bites.

When it comes to the energy price cap, agley appears to be the way things have ganged.

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Supercalifrag-heuristic-expialidocious

Heuristics are simple efficient rules that we all use on a daily basis. We have all learned these through experience, and often they aid our decision making. They are especially helpful in making decisions with the limited resources we all have, particularly in terms of time.

As an example: many people do not have time, or perhaps the inclination, to consider the various parties’ policies and form an opinion on their impact when voting in an election. Often the quick heuristic (a rule of thumb in this case) used is “Do I like / trust this politician?” (a single factor decision). This is far easier to evaluate than the party’s position (set against other parties’ positions) on the economy, healthcare, crime, education, etc. (a multi factor decision). Even those who do not have a strong view on political matters are highly likely to have a view on whether they like a particular candidate (or not). Often a referendum result can be dictated by the popularity of the PM responsible for asking the question, perhaps reflecting this tendency. It is easier to decide whether we like David Cameron (or Boris Johnson?) than to examine the full implications of a Brexit vote.

As is ever the case with rules of thumb, nuances are lost, which can sometimes lead to suboptimal outcomes. Similarly, when we look to apply rules of thumb to Environmental, Social and Governance (ESG) investing, we should be wary of unintended consequences. For example, where portfolios are not already excluding, let’s consider one of the ESG rules of thumb that has been suggested for investors to manage their coal exposure; specifically not investing in any company with more than 10 gigawatts (GW) of electricity production from coal-fired power stations.

Let’s quickly evaluate a company that would fall foul of this limit. If we take the Italian utility Enel, its installed coal capacity of 15GW in 1H2018 would dwarf the total installed capacity of many other utilities. However, Enel has embraced renewables generation more than many others in the industry (some of which, crucially, would pass this test), focussing their investments on green energy and grids (43 GW in installed renewable capacity). Even so, because of their sheer scale, they would fall foul of the coal capacity rule of thumb. Despite not investing in new coal plants, and despite reducing coal generation by 14% year-on-year in their first half results.

Taking a company which would pass this limit rule: CEZ are a Czech utility which uses lignite (also known as “brown” coal) in their coal and lignite power plants. Lignite is widely considered to be worse than coal from an environmental perspective and comprises 76% of CEZ’s thermal and 38% of total generating capacity. They also expect new and upgraded lignite plants to continue to operate for 25 years. Contrast this with Enel which talks about ‘renewables being the driving force of growth’.

In a carbon constrained future, which is the better choice? Enel or CEZ? We would argue it is Enel, but it is CEZ that passes this test! And even though most of our portfolios do not have coal powered electricity production restrictions, we have actively made the considered choice to invest in ENEL (we passed on the recent deal for CEZ).

This is taking only one rule of thumb, so is a single factor evaluation. However, it shows that nuances can be overlooked.

This is why our long history of running ethical funds has led to a multifactor approach in our ESG evaluation, and why our preference remains to evaluate the drivers behind the exclusions, rather than applying a heuristic rule of thumb.

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If The Cap Fits

The Conservative party has long been in favour of a free and open market economy. So it was no surprise to see, at the party conference, Theresa May extolling the virtues of this at some length. Then, after a brief pause to collect ‘her’ P45 from a prankster in the audience, the PM moved against the same free market economy to hit energy suppliers with a price cap.

Summary – free market economy works, except when it doesn’t.

Subtext – free market economy works, except when your main political rival (exogenous to your own party, that is, not Boris) is espousing a ‘grass is always greener’ alternative of nationalisation and shared profits for all.

May’s speech noted the broken energy market as customers are punished for being loyal with higher prices. Though this is very difficult to justify, energy market practices of increasing bills for those who are reluctant to switch are overlooked in other industries (when was the last time your car insurance renewal quote came down in price?).

Yesterday’s price cap announcement has grabbed less headlines than intended, being overshadowed by the P45 (on which reasons for termination included “neither strong nor stable” and “we are a bit worried about Jezza”, in case you were wondering…). And in true Conservative party style of late, the announcement was light on detail (“Brexit means Brexit!”). But as some details emerge, we can make an initial assessment of the impact:

  • Ofgem is likely to be involved in implementing the cap, and it is better for utilities in the hands of the independent regulator, versus being overly punitive in the hands of MPs.
  • There will still be incentives for switching customers and the regulator will be mindful of striking a balance between incentivising competition and penalising unfairness.
  • The cap will be temporary in nature, with a date set for its removal. Who said politics was short-termist in its outlook?

So what does the announcement mean for our bond holdings? Should we sell out of bonds issued by UK energy suppliers? In summary: no.

The big six UK energy suppliers are international companies with diverse business lines. A UK price cap, in whatever form it takes, will not affect Centrica’s robust US business, nor will it affect German utility E.ON’s substantial grids business. In addition, the substance behind the headlines noted above all suggests the implemented policy will be a watered-down version from the past reports of all customers saving £100 a year.

Economic history and the unintended consequences of restricting free market forces tell us that the consumer rarely benefits in the long run. As Reagan noted, the most terrifying words in the English language are: “I’m from the Government, and I’m here to help.”

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The Future will be green, or not at all

Before President Trump began a period of mutual sabre rattling with North Korea, he made arguably his biggest decision so far as President in withdrawing the US from the Paris climate agreement.

The withdrawal of the most powerful country in the world failed to derail the other members of the G20 from their commitments, they were unwavering. Even in the States they are likely to meet their targets on emissions in spite of the President.  The move towards environmentally friendly policies feels inexorable.

It is perhaps no surprise then that issuance of green bonds is increasing (up 56% in the first half of the year) matching a growing desire among companies and investors alike to fund projects which will aid the fulfilment of the aforementioned Paris agreement.

Recently, we saw a green bond issuance from Anglian Water, the company already having several climate aligned bonds as estimated by HSBC. These are issues which are used to finance low carbon and climate resilient infrastructure. This was their first issue which could be officially labelled as green, being assessed for its eligibility by the company DNV GL.

Anglian have a practical interest in supporting action against climate change. The company operate in the British region most prone to weather related water shortages, which is likely to be exacerbated as population under their coverage is forecast to increase by one million over the next 25 years. As the company noted, environmentally friendly projects are efficient and cost effective, and in a sector that rewards efficiency (through terms set by the regulator Ofwat), this is a consideration of vital importance.

The Anglian Water green bond issue fulfilled Kames screening criteria for our ethical funds, and was added selectively throughout our fund range.

Trump may disagree, but the signs are that “the future will be green, or not at all” (Jonathon Porritt).

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