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Client Update - 11th August 2023

Falling prices in China are adding pressure on policy makers to set up monetary and fiscal support even as signs that the decline is temporary may limit any stimulus. China’s consumer price index registered its first drop in more than two years, falling 0.3% in July from a year earlier. Producer prices fell for a 10th consecutive month, contracting 4.4%. Still, the figures might provide only limited help for global central banks, giving them some help in fighting inflation in their own countries but signalling a gloomy outlook in the world’s second-largest economy.

In the face of increasing pressure on company profit margins and a liquidity squeeze, our portfolios continue to favour a quality bias – focussing on companies that demonstrate financial health, stability and consistent growth potential. I thought it would be useful to comment further on why we feel this is the right strategy for the here and now.

I have written before about how central bank rate rising policies will have a lagged effect on the slowing the economy. This is rather akin to an embarrassing experience in your shower – rather than wait for the warmer water to leave the boiler, you lose patience and turn the water gauge to max temperature setting and are rewarded for your impatience with a scorched back. Although here the risk of impatience is a scolded economy.

Between 2020 to 2022, global central banks expanded their balance sheets from $20 trillion to $32trillion, an unprecedented $12 trillion (+60%) injection of liquidity in just two years. Now that the Bank of Japan has also exited the great monetary experiment, every developed central bank’s stated aim is to shrink their balance sheet by selling assets in the market or letting assets run off as they mature. This would not be so problematic if governments were not running significant budget deficits that require funding, which in the absence of central bank buying, will now fall entirely on private capital markets.

In the face of this market environment of tight liquidity, our focus has turned to companies that are not overburdened by debt, or reliant on borrowed cash. We are looking for signs of financial prudence. We must be aware that real cashflows are king - companies can appear to be growing through financial engineering where as true cashflow is hard to fake. When combined with strong governance, this leads to enhanced efficiency, lower costs and increased cash flow, causing the compound growth of capital value over the long-term. That sounds attractive to me.

We often talk about moats or high barriers to entry: companies with high barriers to entry (such as a leading global brand) can maintain their market-leading positions, indicating sustainable growth prospects and this also brings with it a further important characteristic in an inflationary environment – the ability to pass on price rises. With pricing power comes the ability to raise prices without significant demand reduction and our portfolios currently have an overweight to these companies, such as Microsoft, Visa, Mastercard and Nike.

Companies with pricing power demonstrate a sustainable economic moat – durable competitive advantages so that they can pass on costs to consumers without losing market share. Brands that consumers rely on, and trust, often have the pricing power to maintain their customer base too. As an example, Microsoft Office is depended on by businesses globally for their operations. Microsoft is able to raise prices without triggering a significant switch to competitor products, such as Google’s offering, because they have significant pricing power and brand allegiance.

In the face of market fluctuations and economic challenges, quality investing seems like a sensible overweight for the time being, until central bank policy can be better understood and the spectre of inflation tamed. This should offer the opportunity to provide good returns in rising markets but also have the more defensive characteristics in down markets to weather the storm.

That is what we have been up to, and I hope this common sense approach has allowed you to focus on other things and make plans for your summer. This will be my last update for a few weeks as I take some time off. I do hope that you have a lovely summer, and that the sun finally arrives. I look forward to writing again at the start of September. In the meantime, do look after yourselves.

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