Falling inflation creates investment trust bargains

The Chancellor rightly included financial services among his five key growth areas. The City of London generates more than 10 per cent of the UK’s gross domestic product (GDP). Yet it is under threat and there is concern the ‘Edinburgh Reforms’ do not go far enough to address the problem. The stock market is only part of the Square Mile. But it acts as a ‘gateway’ for other financial services such as trading, derivatives, legal services and insurance. Many symbiotic relationships are not always clear to the eye. A healthy stock market is essential for the good of the whole. 

Yet it is ailing. Recent news has included the computer-chip designer Arm and building materials giant CRH (CRH) shunning the City to list in the US. These companies are worth £80bn in total. The exodus across the Atlantic is the latest threat to the stock market. The total market value of London-listed equities has fallen by a third since its peak in 2007, whereas the US market has more than doubled. If there is any doubt, the government should ask itself why so many of our promising green and technology growth companies were banking with SVB.

A key part of the problem has been the reaction of the regulators and government to the financial crisis of 2008, which encouraged a more risk-averse approach to investment by our pension funds, among others. This response was not replicated by every G7 country. These funds are the big beasts among our institutional investors and have traditionally been strong advocates of equity investment and especially UK equities. Yet their equity weightings have reduced significantly since the crisis, some estimates suggesting by as much as 90 per cent.

The government needs to think outside the box. The tax penalties associated with equity financing should be ended, tax incentives to encourage longer-term investment to help foster investment in our growth companies should be considered, and many of the recommendations of the two-year-old Hill Review should be adopted. Policymakers and pension funds should better recognise that a low-risk approach will beget lower returns over time, besides causing problems when not achieving adequate diversification.

Investment and productivity

This issue is of course linked to that of investment and productivity. The stock market is not the economy, but investors require growth, which in turn requires investment. Certainly, inward investment has far exceeded the sceptics’ expectations following Brexit. However, there is no room for complacency. There is a real risk of the UK being squeezed between the US and the EU given the scale of their attempts to encourage investment and onshoring by way of investment tax incentives and subsidies.

To better encourage energy security and the energy transition while safeguarding key technologies, the US is committing over £300bn by way of its Inflation Reduction Act while the EU is not far behind via its Green Deal Industrial Plan. These are large sums. The Budget’s response was to increase the annual investment allowance to £1mn for smaller businesses while allowing all investments in IT equipment, plant and machinery to be deducted (in full) from taxable profits for the next three years. 

The chancellor’s response is encouraging, but a close eye will need to be kept on whether it is enough to compensate for the measures introduced elsewhere. The spending of upwards of £150bn on HS2 to save perhaps 30 minutes when travelling to Manchester reminds us such matters are usually a question of priorities. At the moment, there are many companies looking to relocate elements of their manufacturing process and technology to the US in particular.

For those who don’t believe that such incentives and subsidies can influence outcomes should look at renewable energy. In 2010 less than 10 per cent of our electricity came from renewable sources. Helped by the introduction of government subsidies, this figure today exceeds 55 per cent and continues to rise. We are world leaders in many areas across the green technology spectrum and need to ensure this is retained. The extension of the three-year tax break should be considered in good time so businesses can plan.

Regulation and taxes

Another issue that needs to be better addressed if the potential of the UK economy is to be better realised is that of burdensome regulation. This is especially the case for smaller companies, which are the lifeblood of our economy, where most of the entrepreneurial talent resides, and which certainly employ most people in the private sector. UK financial services is a case in point, given small firms are having to labour under a costly regulatory burden.

For example, 50 regulatory submissions to the regulator in a year is not unusual. The burden is not proportionate to their size or complexity. The government should consider a greater focus on a small firms regime that would oversee a simplified set of regulatory requirements and provide guidance. Instead, we have a regulatory framework that is applied to all companies, irrespective of size. This disadvantages smaller companies despite their greater enterprise.

Meanwhile, the OBR has confirmed that we have the highest tax burden since World War II. The evidence shows that lower taxes foster greater prosperity over time – as the Laffer curve helps to illustrate. Despite economic growth and low unemployment, high taxes act as a constraint on living standards. The government needs to lower both personal and corporate taxes as soon as the public finances allow. The best way of helping the vulnerable in society is by creating more prosperity, not more dependents on state aid.

Away from high-profile taxes, there are irregularities elsewhere that do not encourage the flow of capital to where it is best utilised. Investment trusts are ideal vehicles for long-term investment because their close-ended structure means their price is traded instead of their assets (unlike unit trusts). They have accordingly raised £100bn for sectors that governments wish to support – renewable energy, infrastructure, social housing, etc. Yet the government insists on charging investors stamp duty on purchases (unlike unit trusts). 

Policymakers’ mismanagement 

Regular readers are aware of my caution regarding policymakers’ grasp of matters. Interest rates remained too low for too long. This ‘free money’ environment has distorted asset prices, created too many ‘zombie’ companies and exacerbated the debt problem. Belatedly, quantitative easing (QE) has morphed into quantitative tightening (QT) but the road to ‘sound money’ was never going to be easy and a need for liquidity has quickly emerged. The Federal Reserve discount window saw a record $150bn borrowed in the week to 15 March – well ahead of the c$110bn during the financial crisis in 2008. 

Perhaps the greatest criticism of policymakers is their woeful record on inflation. Despite money supply figures going through the roof and clear evidence of pockets of inflation in the economy, we were initially told inflation was not an issue. When it became evident it was, we were told it would be transitory. As this has become evidently wrong, we have now been told that it will fall away to more normal levels by the year-end. Previous columns have explained why inflation is set to remain higher and more volatile than policymakers forecast.

We now have a scenario whereby despite four bank failures and the rescue of Credit Suisse, Office for Budget Responsibility (OBR) inflation forecasts of 2.9 per cent by the year-end and wage growth falling faster than thought, the Bank of England has raised interest rates again, this time to 4.25 per cent – despite rate rises usually taking up to nine months before impacting. Galbraith’s quip that the only benefit of forecasting is to make astrologers look respectable is either valid or policymakers know something we do not – yet. The latest monthly increase in inflation should certainly focus minds.

Market implication

An injection of liquidity could help markets over the short term, with those markets looking undervalued relative to others perhaps benefiting most. The UK market stands ready. The companies held within the 10 real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk that should particularly benefit if this is the case are Edinburgh Investment Trust (EDIN), Finsbury Growth & Income Trust (FGT) and Schroder UK Mid Cap Fund (SCP) given their discounts and performance relative to peers.

Rising interest rates will continue to increase strain on highly indebted companies, so ensuring borrowing costs can withstand the pressure will be important. This is perhaps particularly true for commercial property Riets. The only such company held within the portfolios is Abrdn Property Income (API) which has recently fixed its costs and so will be protected from any further interest rate increases. Meanwhile, a discount approaching 35 per cent and a yield exceeding 7.0 per cent does not leave much to trust.

But perhaps the biggest implication is for those companies most impacted by inflation, of which the renewable energy and infrastructure companies are preeminent – courtesy of changes in discount rates, power price forecasts and inflation-linked revenues. This is in part because the consensus is expecting inflation to fall dramatically and to stay low, many of these companies now stand on historically wide discounts. The expectation being that lower inflation will ultimately necessitate a downward revision in forecast earnings.

Examples held within the portfolios in the former group include JLEN Environmental Assets Group (JLEN), The Renewables Infrastructure Group (TRIG), Bluefield Solar Income Fund (BSIF), Octopus Renewables Infrastructure Trust (ORIT), Downing Renewables & Infrastructure Trust (DORE) and Gore Street Energy Storage Fund (GORE). Examples within the latter include HICL Infrastructure Company (HICL) and International Public Partnerships (INPP). And therein now appears the opportunity for long-term investors.