In the face of increasingly grim news, financial markets rallied during October. Jeremy Hunt's appointment as chancellor and Rishi Sunak's as prime minister went down well.
Expectations of tighter fiscal policy presaged a drop in UK government borrowing costs. The 10-year gilt yield dropped to 3.5 per cent, a percentage point below October's peak of 4.5 per cent. The one piece of good news was the fall in European gas prices, helped by unseasonably warm and windy weather. That meant that storage levels would stay higher for longer. Electricity prices fell back to levels seen in the summer. While welcome, prices are still well above those in pre-pandemic times. The US markets bounced back as investors again looked towards a 'pivot' to looser monetary policy from the Federal Reserve. There were no interest rate announcements from the Bank of England or the Federal Reserve during October. We had to wait until November, but more on that later.
Continental European markets were robust, with the DAX up 9.4 per cent, the CAC up 8.8 per cent and the MIB up 7.3 per cent. Markets shrugged off higher inflation numbers out of Germany (10.4 per cent) and Italy (11.9 per cent). In the US, the S&P 500 gained 8.0 per cent, but the Nasdaq Composite was up just 3.9 per cent as some of its most significant components came a cropper. Amazon was down 9.4 per cent on reduced guidance for the fourth quarter.
In the UK, the FTSE All-Share was up 3.1 per cent, helped by a 4.2 per cent rise in the FTSE 250. With the economic squeeze under way, smaller companies were under pressure. The Aim All-Share was flat, and FTSE Small Cap was down 0.4 per cent. After the collapse during September, sterling rallied. It was up 2.7 per cent vs the US dollar to 1.147 and against the euro to 1.16.
Within commodities, oil rallied as Saudi Arabia made clear that it was Saudi "first" from now on, and the US Strategic Reserve had fallen to its lowest level since 1984. US President Joe Biden intends to refill the reserve below $72 per barrel. Good luck to him. Industrial metals were a mixed bag. There is a battle between those focusing on slower economic growth, which they believe will hit demand, and those, such as me, who say that the secular uplift in demand from the move to renewable energy will more than compensate.
Gold was down another 2.0 per cent in US dollar terms. It is down 10.0 per cent this year, which is better than bitcoin, down 56 per cent, but hardly a ringing endorsement of its protection against inflation. I may be too short term.
Performance
The JIC Portfolio was down 0.7 per cent in October. A disappointing result against the 3.1 per cent return of the FTSE All-Share (TR) Index. Since its inception in January 2012, the JIC Portfolio is up 303.7 per cent (13.7 per cent annualised). That compares favourably with 100.2 per cent for the FTSE All-Share (6.6 per cent annualised) and 245.6 per cent (12.1 per cent annualised) for the FTSE All-World (GBP TR) Index. Year-to-date, the JIC Portfolio was down 10.6 per cent, compared with a 5.0 per cent loss for the All-Share. It was, though, nicely ahead of the FTSE 250, down 23.8 per cent, and the Aim All-Share, down -33.8 per cent.
The best performance came from K3 Capital (K3C), up 16.9 per cent. The share price responded nicely to its results for the year ended 31 May, published at the back end of September. K3 Capital also acquired a Yorkshire-based restructuring and insolvency practitioner, which could be in high demand in the coming year. CentralNic (CNIC) was up 14.0 per cent, helped by another robust trading update. It said its results would be materially ahead of forecasts after recording 66 per cent organic growth in the 12 months to 30 September. Forecasts were upgraded by over 10 per cent, leaving the shares valued at only 7.4 times December 2022 forecasts. Renew Holdings (RNWH) issued an update for its year ended 30 September. There were no changes to earnings forecasts, but cash should be ahead of consensus forecasts. Results are due in early December. BlackRock World Mining (BRWM) was up 7 per cent, and Sylvania Platinum (SLP) was up 5.8 per cent, despite going ex-dividend at 8p a share, equating to a 9 per cent dividend yield.
All the damage to the Portfolio came from its oil and gas holdings. The drop in the gas price and speculation about an increase in the energy profits levy were to blame. Last week's budget saw the chancellor increase the Energy Profits Levy from 25 per cent to 35 per cent and extend it from 2025 until 2028. That means oil & gas companies will pay 75 per cent tax on UK earnings. While unwelcome to shareholders, current valuations are more than discounting the impact of these changes. Investec believes the increase in the tax could have a material effect on the UK North Sea. Lower investment levels could lead to a faster production decline and accelerated decommissioning. It could also mean that the UK, which currently imports 50 per cent of its gas from Norway, Qatar, and US LNG, will increase its reliance on imports. Imported LNG is estimated to have around seven to eight times the carbon dioxide emissions of gas produced in the North Sea. Two of my positions, Harbour Energy (HBR) and Serica (SQZ), have already stated that future investment could be outside the UK in friendlier climes.
In October, the Portfolio's most significant position, Serica Energy, was off 19.9 per cent. Kistos (KIST) was off 18.7 per cent, and IOG (IOG) -43.9 per cent. All have fallen further in November. Luckily, IOG was one of my most minor positions. It issued a trading update on 19 October that did not go down well. It downgraded its guidance for 2022 with production constrained by aqueous fluids on the Blythe field and the shutting-in of the Saturn Banks complex for four weeks. The mitigating factor for its finances is the high price of gas sales achieved. The next day, CFO Rupert Newall stepped up to CEO, and he and other directors bought a substantial number of shares in the market. Despite the share price collapse to a low of 7.3p, Arden Partners kept the faith. It increased its target price from 41p to 50p. In a beautiful understatement, Arden said, "Overall, this is not a particularly helpful update from IOG". It went on to say that the news is frustrating, but there is potential for higher production as and when the fluid handling issues at Bacton are solved. Arden's raised price target comes from it updating its forecasts. It reduced 2022 and 2023 production, but raised its forecast for achieved gas prices. Their analysis led to a downgrade to 2022 but upgrades to 2023. It sees its risked net asset value (NAV) move from 41p up to 60p. Arden forecasts post-tax profits of £30.7m this year and £127.2m next year. That gives EPS of 4.2p followed by 17.8p (2.8 times falling to 0.7 times). Net debt is expected at £72.4m at the end of 2022, shifting to a net cash position of £1.8m in 2023. If Arden's figures are nearly correct, the shares are extremely cheap. I haven't added to my current holding yet.
The Funds' Portfolio was up 1.8 per cent compared with the 3.1 per cent increase in the All-Share and 2.7 per cent in the FTSE All-World (GBP, TR) Index. The Portfolio is down 8.8 per cent this year compared with a loss of 6.7 per cent for the All-World. Nine of the 11 positions were up, and six were better than the All-World Index. The best-performing positions were BlackRock Energy & Resources Income (BERI), up 8.1 per cent, Smithson (SSON), up 7.0 per cent, and BlackRock World Mining Trust also up 7.0 per cent. The worst was Ecofin Global Utilities and Infrastructure Trust (EGL), impacted by talk of the imposition of an energy levy on electricity generators. NextEnergy Solar Fund (NESF) was down 3.4 per cent.
Activity
All was quiet up until a flurry of activity in the last week. There were five buys, including two new positions and one complete sale. In October of last year, I posted a diary entry explaining why I had extensive exposure to commodity stocks. I followed this up a year later, renewing my commitment to the sector. In brief, stock market investors have yet to fully appreciate the demand for metals required to power the move to renewable energy generation. Share prices need to reflect the lack of supply caused by years of under-investment in new projects. Lack of investment has been due to higher environmental hurdles and a newfound discipline from mining companies concerning capital allocation.
Well-respected energy research and consultancy firm Wood Mackenzie published a paper highlighting the severity of the situation. Its research shows that producing enough copper to achieve a base case of limiting global warming to between 2.2 and 2.4 per cent will be challenging.
The main points:
· 9.7mn tonnes (mt) of mine supply is required over the next decade from projects yet to be sanctioned.
· More than $23bn per annum investment will be needed, which is 64 per cent higher than the average annual spend over the last 30 years
· A growing market deficit will underpin a copper price rally to $11,000 per tonne within five years (current price $6,690 per tonne).
It ends the summary by saying that, in theory, higher prices should encourage project sanctioning and more supply, but political, social, and environmental hurdles are higher than ever.
I decided to increase my exposure to mining to 25.0 per cent of the Portfolio. On 26 October, I added to BlackRock World Mining Trust at 608p, taking it to 7.5 per cent, and on 27 October I bought Glencore (GLEN) at 515p per share. My target weight in Glencore is 5.0 per cent, and on 2 November, I added more, taking it to 4.0 per cent. Glencore has considerable exposure to copper and other metals required for net zero transition. Cash flow is robust, and the forecast dividend yield for 2022 stands at 9.4 per cent.
There is a strong case for oil & gas companies alongside miners within commodities. There will need to be a massive increase in electricity generation capacity as electric vehicles (EVs) replace internal combustion engines and heat pumps replace central heating powered by gas. While wind power and solar are great contributors when the sun is shining and the wind is blowing, a solution needs to be found for when they aren't – the intermittency problem. Battery storage is one solution, but you need more than a few hours of storage, as Europe saw in the late summer of 2021 when there was very little wind for weeks. Storage of 'green energy' as hydrogen makes sense, but the electricity required to manufacture hydrogen adds further to the demand for electricity. In short, gas and oil will be part of the energy mix for many years despite massive investments in renewables. Investment in the sector has fallen due to environmental concerns weighing upon oil companies. Now the sector is being used as a cash cow by cash-strapped governments. Things are not helped by a shift in geopolitics, with the likes of Saudi Arabia no longer bending to the wishes of the US. Saudi Arabia is producing near to maximum anyway.
The upshot was that I decided to increase my oil & gas exposure to 20.0 per cent. I added to Gulf Keystone (GKP) on 26 October at 208p, taking it to a target of 5.0 per cent and increased Kistos on 20 October at 403p, reaching my target of 2.5 per cent. I added a new position in Harbour Energy on 27 October at 389p and increased it further to 3.0 per cent on 2 November at 384p. My eventual target is 5.0 per cent. FTSE 100-member Harbour Energy is a low-cost oil and gas producer, predominantly from the North Sea. Cash generation is such that it should be debt-free next year. It is returning around 10 per cent of its share capital through buybacks this year, and its forecast dividend yield is approximately 5.5 per cent.
The sale of Lloyds Banking (LLOY) funded all these purchases. While it is benefiting from expanding its net interest margin as interest rates increase, there is a risk that the share price will struggle as investors worry about the state of the UK economy. A recession in the housing market, comparable to the early 1990s, would not be helpful.
No trades in the Funds' Portfolio, although I reviewed my exposure to commodities early in November and made some adjustments. Transaction details and the current Portfolio can be found at www.jicuk.com.
Other news
Apart from IOG, the corporate news from my holdings was generally positive. Bioventix (BVXP) published its results for the year ended 30 June. It increased its final dividend by 20 per cent and is paying a special dividend of 26p. The total dividends for the year ended June 2022 were 152p, giving a yield of 4.6 per cent. Growth in the underlying business accelerated to 8-10 per cent due to the roll-out of its high-sensitivity Troponin assay, testing for heart attacks. SDI Group (SDI) made its largest acquisition to date, adding around 11 per cent to revenue, and like acquisitions before, it should enhance earnings.
Dividend income
So far this year, dividend income totalling £24,897 has been received compared with £14,336 in 2021. With a few more big dividends due to be paid from the likes of Sylvania Platinum, Serica Energy and Polar Capital (POLR) this year will set a challenge for 2023.
Outlook
The first week of November saw a rude awaking for those expecting the Federal Reserve to pivot. On 2 November, it increased interest rates by a further 0.75 per cent, but the chairman gave no hint of easing pressure in his press conference. Rates are likely to stay higher for longer. The Bank of England followed suit with a 0.75 per cent increase. The governor was clear in his warnings about the economy's future direction. He warned of a prolonged recession and opined that interest rates might not need to go much higher, especially given the coming fiscal squeeze. The problem for policymakers on both sides of the Atlantic is that employment markets remain tight, although there are tentative signs of things changing.
We had unambiguously good news from the US on the inflation front, with October's 7.7 per cent 0.2 per cent below expectations. Importantly, core inflation of 6.3 per cent was 0.3 per cent below forecasts. Even if not a 'pivot', it could open the way for less hawkish Federal Reserve rhetoric at its December meeting. Sadly, the UK could not match this good news. October inflation of 11.1 per cent, up from 10.1 per cent in September, was 0.4 per cent above expectations and setting a complex background for the chancellor.
Last month I pointed to evidence of high cash holdings by institutional investors and that in the last week of September, only 3.0 per cent of stocks in the S&P were above their 50-day moving average. This has historically marked a market bottom. We got the rally in October but where from here? I don't know. We could easily see a US-led year-end rally in markets as investors look forward to better times in 2023 but, equally, sentiment could change on a sixpence. It will be a challenging year ahead for the UK economy. Higher inflation, higher energy prices and higher taxes will squeeze household spending. Still, valuations might now reflect much of the bad news. Consumer-facing companies will find it challenging, and sadly, Made and Joules will not be the last to go into administration. I will continue to focus on companies with solid balance sheets and reasonably predictable turnover and cash flow. I like dividend income which stays in the Portfolio and adds to the steady compounding in value over the years. The exposure to commodities is a medium- to a long-term theme, which should pay dividends.
