Money Makers

IMPORTANT NOTE

This is an edited transcript of our recent podcast recording with Peter Spiller, published on Saturday 02 November 2024. We cannot vouch for the complete accuracy of every word, but are confident that it caters the essence of the conversation.

Opener
Hello and welcome to the latest Money Makers Investment Trust podcast with me, Jonathan Davis. A reminder that for regulatory reasons, nothing you hear today, however stimulating and insightful, should be regarded as constituting individual investment advice.

Jonathan
I was delighted this week to have a chance to catch up with Peter Spiller, the manager of Capital Gearing Trust and indeed a longstanding participant in the city, been involved longer than I have. There aren’t many people left like that. So Peter, I wanted to kick off by asking you about the budget. In your long experience, how would you rate this one?

Peter
Well, I think the City’s reaction has been one of disappointment. I think I have to share that. So she started off by saying she was inspired by the Attlee government. So the Attlee government was one which had one great achievement, which is the foundation of the NHS, which of course was adopting plans that have been drawn up during the war. But it was a great success for a long time.

In every other respect, it was not a successful government. It was characterised by nationalisation, high taxation and high regulation. And that’s laid the foundation for 30 years of underperformance by the UK economy against our European neighbours, France and Germany, which essentially lasted until Thatcher. So I did not find that an encouraging start.

And the OBR [Office for Budget Responsibility forecast] does make quite depressing reading. There’s not a huge movement, but everything’s cycling in the wrong direction. So interest rates are expected to be 35 basis points higher than they otherwise would have been across the board from now on. The deficit is obviously bigger than we were expecting. The increase in borrowing is £28 billion. And the growth forecasts of the OBR are lower going forward than they were before, not by a huge amount.

But everything’s going in the wrong direction. So I think the City has not received it particularly well. You’ve seen what’s happened in the gilts market, which is, again, unfavourable. And I think the other point to make is it’s a gamble on growth. So if you don’t get growth, then next year, we’ll be back again with another marked tax increase, because there is limited flexibility to increase borrowing from here. So the certainty is in the eye of the Chancellor, but I think probably not in the eye of the consumer.

Jonathan
Yes, the thing that struck me about this budget was that it was, if you like, a high-risk operation, both politically and economically, because they left very little margin for error if anything goes wrong. I mean, in particular, if there’s any economic slowdown of any kind, it’s going to cause havoc to those numbers. It’s normal practice for Chancellors in their first budgets of a new government to be big and bold and normally to take the unpopular decisions. Do you think that she may yet be vindicated by being able to do some better things down the line if the world pans out better than perhaps you or I are expecting?

Peter
I think the big determinants of that are not in the Budget. So we’ve had one piece of bad news and one piece of good news. The bad news is that the employment laws have been amended to make the labour force less flexible. Unquestionably, that’s raising costs for employers. Quantifying that is extremely difficult, but it’s not helpful.

But the good news is that there seems to be some recognition that the level of regulation in the UK is crushing growth. So Rachel has talked about infrastructure growth, investing in infrastructure, but something has to be done about the fact that it costs between two and four times as much as anywhere else in the world to build that infrastructure, whether that’s nuclear plants or roads or rail or whatever. There’s actually a wonderful example in the documentation of the Lower Thames Crossing, which might or might not happen, but so far the documentation runs to 320,000 pages, which is quite impressive.

So there have been mentions by the Prime Minister and the Chancellor of recognition that regulation is a problem. So I think we can all agree on that. The problem arises when you come to address it. So in the case of housing, there has to be clear rules to free up planning. So the Town and Country Planning Act, which has been the source of Nimbyism, ironically was introduced by Attlee, but it’s all the bureaucracy associated with it. So what we call in the office the bat and newt sector has to become much more streamlined. You can’t delay planning for a long period, 10 years or so in some cases.

And the financial regulation as well, I think, has to be addressed. Again, we’ve had statements that it just has to the addressed from the Prime Minister, but as far as I’m aware, very little colour to what might change because it’s notable that actually the Chancellor mentioned in her speech that R&D is important and it is. But for the UK, the central problem is not the level of research. We’ve got some of the best universities in the world, producing a lot of great research. The problem is translating the small businesses, which gets one out of them, into the big businesses that the UK needs.

And the regulatory barriers, essentially, to small quoted companies have been so overwhelming that the small-quoted market in the UK, not just investment trusts, but all the small companies have more or less evaporated. That has been the route of growth, small companies becoming big companies, the engine of growth. So it’s really important that that is addressed. And it’s possible that it will be. So that will be very exciting, although it takes quite a long time to change behaviour from changes in regulations.

So quite notable, for instance, in the investment trust market, that you no longer need to produce a KID [Key Information Document].

Jonathan
Yes, hallelujah to that, yes.

Peter
But only 21 investment trusts have ceased to produce a KID. And the reason for that, I think, is that they say that some of our clients would like the information. So as I say, once you’ve set in place a huge bureaucratic machine, with huge penalties for any compliance problems, you just create a self-sustaining system that even though the engine of it is removed, it has the momentum all of its own. So it’s going to be very difficult. But I am hopeful that at least the problem has been recognised. So that’s the beginning of the solution.

Jonathan
That’s the first step, indeed, is to recognise the problem. Do you think that looking across the piece, the moves that have been made on inheritance tax and non-dom status, do you think they actually will have an impact in deterring entrepreneurship and the willingness of wealthy people to stay in this country and spend more money in this country and run their businesses from this country?

Peter
Well, I think the first thing to say, Jonathan, is that there’s always been the case that people say everyone’s against a tax, we’re going to get adverse taxation and leave. And it usually turns out that what they think is that other people will be, but they personally

Jonathan
are going to stay.

Peter
So I should say that up front. However, I do know from personal anecdotes that quite a lot of people are leaving.

Jonathan
Yes.

Peter
I mean, the interesting thing is that that was happening before the Budget. So the commentary about the Budget, obviously, was very gloomy. And it’s very clear that a fair number of non-doms are going to leave, or actually are leaving. What’s less clear is whether the non-doms that really matter, the non-doms that are working, in the City particularly, but outside the City as well, whether they leave. But I’m also aware of successful individuals who are residents also leaving, and they’re going to Dubai, which I wouldn’t particularly recommend as the place they live. But I think that is what’s happening.

Jonathan
Yeah. I’ve heard the same stories of people who actually have left or are leaving. But I wondered also if I could ask you about whether you have a view on this issue around farming, because I think we all know that there are a lot of quite rich people who bought a lot of farmland for various reasons. And the government may feel that there’s an element of tax avoidance going on there. But on the other hand, you can’t really afford to seriously upset the people who are actually doing farming because they’re farmers. So is this a case of ideology, perhaps trumping pragmatism?

Peter
Well, I think as ever, it’s the move that’s costly. So the price of farmland, I mean, because our question is large tracts of land, do the large people who are doing it for tax efficiency, the more polite word than tax avoidance, and there’s no question about it. And the result of that has been that the value of land has been driven up. And therein lies the problem, because if land is £10,000 pounds an acre, as roughly it is, then the allowance is 100 acres. So 100 acres is a lot less than a working farm. So the people who are going to inherit that as working farmers clearly do have a big problem.

And the other problem is the change in that value, because of that £10,000, a substantial portion, I have no idea what it might be, but it would not be insignificant at all, with the yield on agricultural land being very, very little. So I’m going to guess at least half the value of that £10,000 is the capitalised value of the tax break. So if you take away the tax break, then you lose that premium. And that’s very tough on people who have borrowed money to buy more land. So I think there are risks.

However, it’s a transition that’s not necessarily unfair. I don’t actually think it is that unfair. All assets should pay something at the same rate. But the transition can be very problematic, because it’s very tough on people if that turns out to be correct. So what we’ve in fact got is a halfway house, if we can take credit for something. So that’s not as extreme, as I talked about, maybe rather less. So as a wild guess, and knowing nothing at all about the land market or the forestry market, as a wild guess, there will be very few transactions in the next year while people establish what the new level is, rather as happens in the property market when property prices are falling, the bid and the ask are too far away from each other for a transaction to take place.

Jonathan
Also, maybe you would agree with me that there always has been scope for tax simplification and tax reform. And no chancellor ever gets around to doing really sensible things, because politics, in the end, trumps long term optimisation. Do you think that overall, looking at the Budget, that the tax changes we made as far as their impact on savings and investment, as opposed to what might happen to growth and inflation, do you think that they are likely to be positive, negative or neutral?

Peter
They are clearly a short term negative. If you increase the taxation on capital returns or income returns, come to that, obviously you’d raise the cost of capital for investment. But with tax reforms, I think there are some clear things we should not do, which I would be really enthusiastic to see instead of loading the taxes on business, and primary among them would be a land tax. Economists have loved the land tax for about 150 years, and it has huge positive implications, not the least of which is that you can’t move it, so you have certainty of the revenue. But it would take time to introduce, probably beyond the end of this Parliament, you need to introduce it now, because there’s a lot of assessment to do. And the result is it never happens. But if you ask me: are there tax reforms which could be made, and be very constructive? I think the answer is yes.

Jonathan
Certainly, if you wanted to bring the price of housing down, that would be one way to do that.

A Short Break
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Jonathan
So let’s just talk about the overall picture for the UK economy and the UK market, shall we say. A lot of people have been saying for a while that the UK equity market always looks cheap against other markets, but it was looking particularly cheap. And this would be a good time to buy smaller companies in particular, which also look particularly cheap relative to history and so on. Has that argument taken a bit of a knock with the Budget?

Peter
Well, I think the argument remains intact. Obviously, the move in the Budget was negative because of the additional pressure on small businesses in particular, but also because, as mentioned earlier, the OBR forecast that inflation will be somewhat higher than it would have been. Interest rates would be somewhat higher and growth somewhat lower. All of those are unhelpful on the margin to UK businesses.

But we’re still seeing acquisitions of companies, suggesting that small companies are really quite severely undervalued. And I think we all know the reason, which is what we’ve heard earlier, the environment makes liquidity in small companies negative. So I do think that they are attractive, small companies. I think the UK market as a whole is attractive, notwithstanding an adverse background. And the background is adverse going forward too, because essentially we don’t have a Blairite government, we have an old Labour government. And that obviously suggests that future moves will not be helpful to growth, as well as this Budget not being.

Jonathan
Right. And we noticed that one or two of the smaller company investment trusts, for example, they did pack up a little bit after the Budget because it wasn’t perhaps quite as bad as they’d feared or already been priced in, shall we say, more likely being priced in. But are you concerned about the AIM market? Should one be concerned about the AIM market? They have made some changes to business property relief, for example, and that may withdraw some demand for AIM stocks.

Peter
So actually Jonathan see above for that. So the AIM market came up very sharply before the Budget and has been very weak for some time now. But it has had a bounce, a bounce on the Budget, because the allowance was not abolished, it was just halved. So that has reduced the pressure for a bit.

And I think the other thing about the Budget that’s positive is that it’s over. So we saw a tremendous amount of selling of UK assets, certainly including investment trusts, beforehand, in order to lock in the lower rate of capital gains tax, which I should have mentioned, the actual rate of 24 is lower than many people feared, in fact, lower than levels that were trailed before. So that’s a relief, but the main point is that from now on, you’re paying 24. So there’s no motivation to realise things in the near future. So there was a lot of what one investment bank called “bed but not breakfasting.”

But there are other adverse features. So the taxation of pension funds, for instance, is much more adverse. Maybe that will tempt people to take money out of their pension funds, in the form of income, as opposed to just accumulating. So that’s not, in the medium term, particularly helpful. There have been substantial outflows in investment trusts. But the truth is that we’ve been through a very difficult period for trusts, leading up to the Budget, and now it’s happened, so with any luck, we have a more stable period going forward.

Jonathan
Yes, I suppose the risk is that they may come back and do more in future. That is, the government may come back and complete the job on AIM, for example.

Peter
I don’t think it’s going to happen within a year or anything.

Jonathan
No. Indeed. OK, so can I ask you, Peter, about gilts? I mean, a year ago, you were talking about gilts looking quite attractive. Well, certain kinds of gilts and certain types of U.S. government bonds looking attractive. We have seen, though, yields back up, certainly in the last month or so. We see on both sides of the Atlantic, we’ve seen yields going up, maybe for similar type reasons. But do you think there’s still value in bonds? If so, where is the value in the bond market? Let’s put it that way.

Peter
Well, I do think that [there is], if the bonds you’re referring to are index linked bonds. I think they’re a very different proposition here from nominal.

Jonathan
They’ve sold off, too. I mean, let’s be fair.

Peter
No, no, they have. They have. And we run a fund, which has a duration of five years, that expresses the view of what we think the yield curve can do and indeed has now done, i.e. steepened a lot. And in both countries, the supply of bonds relative to the central demand for it is a problem. And it could become a huge problem. But that remains to be seen, more in the U.S., I would say, than in the U.K. at the moment.

So real yields are in the U.K. roughly 1.3%, that sort of thing. And the growth rate going forward is roughly 1.3%, suggesting that they’re fair value. But they’re fair value in quite a constructive way. They remain the safest asset there is and the after-tax return on low coupon index links in the U.K. remains very appealing. So they probably get 1.1% or something after tax, real. That doesn’t sound like an exciting return. But it might be better than anything else if things go wrong. And in the U.S., the return on TIPS is significantly higher, 100 basis points higher. And that, again, more or less matches the long-term growth rate in the U.S. So fair value, but it is still pretty attractive, in a very volatile outlook, to lock in those sorts of return.

Jonathan
And of course, we’re just a few days ahead of the U.S. presidential election. It seems to be going on for quite a long time. Well, it has been going on for quite a long time. Do you share the kind of consensus City view that it seems to be edging towards Trump, but perhaps more relevant is that if Trump does win, that will be more positive for the markets than if he doesn’t in the short term? Would you share that perspective?

Peter
It’s an interesting question. First of all, I have no value to add on predicting the result. I have no insight that other people don’t have. The betting markets do look heavily manipulated. They suggest pretty powerfully a Trump victory. But it all comes down to, you know, very few states. What we’re hearing from those states is that on the margin, Trump is ahead. But I wouldn’t like to say.

But just think what we’re talking about here. So if Harris wins, then the deficit in the U.S. rises from roughly six and a half [% of GDP] to roughly seven and a half. And if Trump wins, roughly six and a half to roughly eight and a half percent. These are extraordinary numbers – really bizarre – and they suggest inflation. And so the consequences of a Trump victory, I think, have been expressed in the market, higher interest rates, but good corporate profits.

So he wants to lower the corporate tax rate from 25 to 19, is his number. And he wants to put on tariffs, which are helpful to domestic corporate profits in the short term at any rate. They’re probably also inflationary. So the consequences for the bond market are usually poor. On the other hand, we don’t know what he’s going to do. So he’s not a man who has enthusiasm for independence of the central bank. He’s been on at the central bank to get cut rates by more than they proposed to. So there’s an awful lot we don’t know, Jonathan.

And the other thing is the dollar. So he has expressed the view in the past that he thinks the dollar is too high for the economy, at least for the Americans. But with his tariffs, he’s less worried about that, because the other forces at work are pretty bullish for the dollar. Again, it just remains to be seen

Jonathan
Yeah. I mean, of course, a lot depends if he does win or whether or not he actually does. But he says he’s been talking about and, you know, tariff is my favourite word in the whole language and all that sort of stuff is quite extraordinary. Finally then, Peter, perhaps I can ask you to give a bit of context around what we see around the world, because it’s puzzling to some of us, certainly those of us who’ve been around a while.

When you look around what’s going on, we’ve got the equity market, which is dominated by the Americans, dominated by a very few number of companies, high level of concentration in the equity market, high valuations relative to history. We’ve also got very narrow spreads in the corporate bond market and things like that, nearly record lows. And this all seems too good to be true, does it not? I mean, are we at risk of having what we think we might call a Minsky moment at some point, because all these things are being supported together at the same time, and they may at some point, or will at some point, prove to be fragile?

Peter
Well, we are in danger of having an echo chamber here, because actually, in the very first paragraph of the talk I’m going to give to our guests on Tuesday, I mentioned the word Minsky, so you can tell that we’re very much on the same page. So I think the thing about the American market is that profit growth, just to reiterate what I said about Trump, still has quite good prospects. So the market’s got quite big numbers for profit growth next year, which follows lower numbers this year, of course. That’s a standard feature that the EPS has always been terrific.

But nevertheless, with tariffs and corporate taxes being favourably moved, I’m reminded of the study of the Federal Reserve that’s come out with demonstrating that the share of GDP going to corporate profits in the United States, which has gone up a lot, and a very large part of that comes from interest rate changes and corporate tax changes, not from operating. I thought that was an extremely interesting insight. And given that the deficits are ludicrously high, there must be a danger that these features are less helpful going forward. And we do start off with, as you rightly say, very high interest rates, and much lower elsewhere, so that always remains the big question, which is that if the United States, sneezes, does the rest of the world catch cold. And I’m sorry to say that history suggests that that is true.

Jonathan
I’m sorry to hear you say that, too, but I fear that it is the case. So that was Peter Spiller, the manager of Capital Gearing Trust and the longest serving manager in the investment trust universe.

Close
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