As fund managers investing in a broad range of global assets, we swim in the pool labelled ‘capital markets’. This is particularly the case in equities and bonds. The primary function of capital markets is to allow companies to tap as wide an audience as possible to raise new investment capital from among those prepared to take risk to find a higher rate of return than might be achieved through holding cash in the bank or keeping it under the mattress.
This access to private sector capital is the bedrock of the capitalist system; it is underpinned by the fundamental belief that through effective competition and the Darwinian principle of survival of the fittest, the markets are more efficient allocators of capital than is the state. How capital is allocated, priced and owned is essentially what divides capitalist and socialist ideology: the former believes in the freedom of ownership and as frictionless movement of private capital as possible to achieve the best returns. The latter, taken to its ultimate degree, believes in wholly centralised investment and full state ownership.
Most modern, mature democracies lie somewhere on the spectrum between the two poles. They comprise a mix of private and state ownership of assets; regulatory frameworks are put in place to protect consumers against being taken advantage of, either by unscrupulous managements or because the goods or services consumers are purchasing are from a monopoly supplier, or from an oligopolistic industry with a handful of dominant suppliers which offer very little competitive choice or price differentiation.
This access to private sector capital is the bedrock of the capitalist system; it is underpinned by the fundamental belief that through effective competition and the Darwinian principle of survival of the fittest, the markets are more efficient allocators of capital than is the state. How capital is allocated, priced and owned is essentially what divides capitalist and socialist ideology: the former believes in the freedom of ownership and as frictionless movement of private capital as possible to achieve the best returns. The latter, taken to its ultimate degree, believes in wholly centralised investment and full state ownership.
Most modern, mature democracies lie somewhere on the spectrum between the two poles. They comprise a mix of private and state ownership of assets; regulatory frameworks are put in place to protect consumers against being taken advantage of, either by unscrupulous managements or because the goods or services consumers are purchasing are from a monopoly supplier, or from an oligopolistic industry with a handful of dominant suppliers which offer very little competitive choice or price differentiation.
The rising tendency towards state intervention in the UK
As if these defining characteristics are not already obvious, we need reminding of them because the pendulum is shifting. Here, the new government is driving reforms which involve significantly greater state intervention in several sectors.
Labour Mayor of London, Sadiq Khan, mirroring the Green-led initiative already put in place by the Scottish coalition government in Edinburgh, is drumming up support for centrally-imposed rent controls across the London rented housing estate; Greater Manchester’s Labour Mayor Andy Burnham has similar ambitions. The empirical data collected by the Institute of Economic Affairs think-tank for the two years since Scottish legislation was enacted so far concludes that rent controls have distorted the market to the extent that they have driven out private landlords and they have restricted the supply of available rental accommodation leading to a sharp rise in rents in the unregulated sector; further, developers seem unwilling to have their hands tied with regulated social housing and the pace of new builds has slowed placing upward price pressure on the existing housing stock. One imagines this was not the intended outcome when the policy was dreamed up.
In the transport sector, rail assets will be re-nationalised when existing franchise terms expire; passengers will become state customers (as they already are on such services as LNER on the East Coast Main Line which have already reverted to public ownership) though whether the customer and the taxpayer will see any great benefit is doubtful (as part of its cynical “ticket simplification” scheme introduced in 2023, LNER scrapped the concept of return journeys, significantly increasing the total cost of travelling from A to B and back to A again). As we have discussed before in these columns, regulated rail fares based on the RPI+1 inflation formula (adding a percentage point on top of the Retail Price Index, or RPI, measure of inflation) which apply to all season tickets are on the painful side of Einstein’s ‘Eighth Wonder of the World’: compound interest. Despite a benign inflation environment for virtually all of the past two decades except the most recent three years since the pandemic and Putin’s invasion of Ukraine, the insidious effect of RPI+1 (RPI in turn is habitually higher than the Consumer Price Index inflation rate) has led to a near-three-fold nominal increase in annual commuters’ travel costs between 2003 and 2024 (if rail fares have risen by a multiple of 2.7 times over the period, they have far outstripped UK average wages which according to the Office for National Statistics have increased by only 1.9 times over the same time frame).
But there are two areas of direct interest to investors which are under the spotlight from government intervention and both are in the utilities sector. First, although introduced under Theresa May’s administration but lifted directly from current Energy Secretary Ed Miliband’s playbook in 2015 when he was the Labour Party leader, is the energy price cap regime for gas and electricity; second is water.
Both energy and water need massive investment: in the case of electricity it is meeting the significant increase in prospective demand on the path to carbon net-zero while simultaneously undertaking the most radical change in how electricity is generated in more than a century; for water, it is not only about meeting the needs of a growing population amid the variabilities in the origination of supply brought about by climate change, but also managing and replacing ageing, leaky and environmentally unsafe infrastructure. In both cases, with regulated pricing regimes, investors putting up private capital are effectively being asked to assume asymmetric risk. These are private sector companies in which the shareholders who provide the capital are the owners but it is the government rather than the market which fixes the pricing constraints (and often too limits the rates of return the businesses are allowed to make). The most egregious example, and highly topical, is Thames Water: whatever the history of its challenges and wrong turns in meeting the competing needs of all its stakeholders and interested parties, and it being in danger of running out of cash by May 2025, the company’s response to the latest price limiting regime announced by the Water Regulator OFWAT (in turn under considerable political pressure) this week was that Thames’ business plan is ‘neither financeable nor investable and therefore not deliverable’. Both shareholders and bond holders are significantly at risk; other than full nationalisation and the taxpayer picking up the tab it is an intractable problem with no palatable solution.
Labour Mayor of London, Sadiq Khan, mirroring the Green-led initiative already put in place by the Scottish coalition government in Edinburgh, is drumming up support for centrally-imposed rent controls across the London rented housing estate; Greater Manchester’s Labour Mayor Andy Burnham has similar ambitions. The empirical data collected by the Institute of Economic Affairs think-tank for the two years since Scottish legislation was enacted so far concludes that rent controls have distorted the market to the extent that they have driven out private landlords and they have restricted the supply of available rental accommodation leading to a sharp rise in rents in the unregulated sector; further, developers seem unwilling to have their hands tied with regulated social housing and the pace of new builds has slowed placing upward price pressure on the existing housing stock. One imagines this was not the intended outcome when the policy was dreamed up.
In the transport sector, rail assets will be re-nationalised when existing franchise terms expire; passengers will become state customers (as they already are on such services as LNER on the East Coast Main Line which have already reverted to public ownership) though whether the customer and the taxpayer will see any great benefit is doubtful (as part of its cynical “ticket simplification” scheme introduced in 2023, LNER scrapped the concept of return journeys, significantly increasing the total cost of travelling from A to B and back to A again). As we have discussed before in these columns, regulated rail fares based on the RPI+1 inflation formula (adding a percentage point on top of the Retail Price Index, or RPI, measure of inflation) which apply to all season tickets are on the painful side of Einstein’s ‘Eighth Wonder of the World’: compound interest. Despite a benign inflation environment for virtually all of the past two decades except the most recent three years since the pandemic and Putin’s invasion of Ukraine, the insidious effect of RPI+1 (RPI in turn is habitually higher than the Consumer Price Index inflation rate) has led to a near-three-fold nominal increase in annual commuters’ travel costs between 2003 and 2024 (if rail fares have risen by a multiple of 2.7 times over the period, they have far outstripped UK average wages which according to the Office for National Statistics have increased by only 1.9 times over the same time frame).
But there are two areas of direct interest to investors which are under the spotlight from government intervention and both are in the utilities sector. First, although introduced under Theresa May’s administration but lifted directly from current Energy Secretary Ed Miliband’s playbook in 2015 when he was the Labour Party leader, is the energy price cap regime for gas and electricity; second is water.
Both energy and water need massive investment: in the case of electricity it is meeting the significant increase in prospective demand on the path to carbon net-zero while simultaneously undertaking the most radical change in how electricity is generated in more than a century; for water, it is not only about meeting the needs of a growing population amid the variabilities in the origination of supply brought about by climate change, but also managing and replacing ageing, leaky and environmentally unsafe infrastructure. In both cases, with regulated pricing regimes, investors putting up private capital are effectively being asked to assume asymmetric risk. These are private sector companies in which the shareholders who provide the capital are the owners but it is the government rather than the market which fixes the pricing constraints (and often too limits the rates of return the businesses are allowed to make). The most egregious example, and highly topical, is Thames Water: whatever the history of its challenges and wrong turns in meeting the competing needs of all its stakeholders and interested parties, and it being in danger of running out of cash by May 2025, the company’s response to the latest price limiting regime announced by the Water Regulator OFWAT (in turn under considerable political pressure) this week was that Thames’ business plan is ‘neither financeable nor investable and therefore not deliverable’. Both shareholders and bond holders are significantly at risk; other than full nationalisation and the taxpayer picking up the tab it is an intractable problem with no palatable solution.
US grocery prices: ripe for Democrat price controls?
Meanwhile in the US, not only with momentum but now with a discernible lead in the polls, while becoming more centrist on policies such as fracking and immigration, Kamala Harris has shifted the Democrat election narrative firmly leftwards when it comes to consumer protection. While the inflation hump has receded, as a champion of the disadvantaged she not surprisingly remains concerned about the distinction between current disinflation and the affordability of goods (particularly food, groceries and consumer staples) while wages have not yet caught up with the significant increase in nominal prices seen since 2021. Her solution to the problem of what is variously called ‘greedflation’ or ‘price gouging’ is the imposition of state-regulated price controls.
Price controls are defensible but they only work effectively in an entirely insular, self-contained command economy where input costs and demand/supply patterns are centrally determined also. However, in an environment in which companies are exposed to the unavoidable variability in input costs (the obvious ones are fuel and commodities which are traded internationally and prices reflect global demand, supply and inventory imbalances) but selling prices of finished goods are artificially fixed, their margins and capital investment returns have the potential to be both volatile and highly unpredictable. Again, for the investor, this represents asymmetric risk: companies lose much of their ability to manage their business effectively.
Price controls are defensible but they only work effectively in an entirely insular, self-contained command economy where input costs and demand/supply patterns are centrally determined also. However, in an environment in which companies are exposed to the unavoidable variability in input costs (the obvious ones are fuel and commodities which are traded internationally and prices reflect global demand, supply and inventory imbalances) but selling prices of finished goods are artificially fixed, their margins and capital investment returns have the potential to be both volatile and highly unpredictable. Again, for the investor, this represents asymmetric risk: companies lose much of their ability to manage their business effectively.
Companies do not sit idly by; if they did, consider the consequences
But in such circumstances, dynamic managements respond actively to what they can control to protect their businesses. Not subject to price controls, (though in a moment of seemingly blind panic, price controls on basic consumer goods were seriously suggested by Rishi Sunak as a solution to the cost of living crisis, a short-lived idea soon shot down in flames), here in the UK’s own inflation bubble, food retailers took pragmatic mitigating action: first, they negotiated terms with their suppliers, a process which was repeated all the way back up the chain. Where the cost of goods still rose, making judgements about business and consumer affordability, market share and competitor response, they absorbed some of the big rise in input costs, they passed most elements on and they took action on other areas of their variable costs more directly within their control.
A cursory look at Tesco PLC’s published headline financial data illustrates the point: in the year to February 29, 2020, immediately pre-dating the pandemic, the company had revenues of £58.1bn and adjusted operating profits of £2.57bn (adjusted margin: 4.4%); in the year-ending 29 February 2024, revenues were £68.2bn, adjusted operating profits rose to £2.83bn but the margin fell to 4.1%. In 2020 there were 243,031 average full-time equivalent (FTE) employees; today that number has fallen to 225,659, a loss of 17,372 FTE positions over four years. To tie this in with our hypothetical illustration above, Tesco’s cost of goods (i.e. those goods it buys in from food and consumer staples manufacturers to re-sell to the end consumer, plus the associated direct labour costs) increased by £4.4bn, or 7.8% in the financial year 2022/3: had it not passed on virtually all of this in its retail prices, instead of reported gross profits falling marginally from £4.77bn to £4.76bn, they would have been virtually wiped out; after allowing for fixed, admin and financing costs the company would have made a significant pre-tax loss and the government would have forfeited £442m of tax receipts; £859m of shareholder dividends would have been jeopardised, a large proportion of which would have been to the detriment of UK pension funds and their scheme members.
A cursory look at Tesco PLC’s published headline financial data illustrates the point: in the year to February 29, 2020, immediately pre-dating the pandemic, the company had revenues of £58.1bn and adjusted operating profits of £2.57bn (adjusted margin: 4.4%); in the year-ending 29 February 2024, revenues were £68.2bn, adjusted operating profits rose to £2.83bn but the margin fell to 4.1%. In 2020 there were 243,031 average full-time equivalent (FTE) employees; today that number has fallen to 225,659, a loss of 17,372 FTE positions over four years. To tie this in with our hypothetical illustration above, Tesco’s cost of goods (i.e. those goods it buys in from food and consumer staples manufacturers to re-sell to the end consumer, plus the associated direct labour costs) increased by £4.4bn, or 7.8% in the financial year 2022/3: had it not passed on virtually all of this in its retail prices, instead of reported gross profits falling marginally from £4.77bn to £4.76bn, they would have been virtually wiped out; after allowing for fixed, admin and financing costs the company would have made a significant pre-tax loss and the government would have forfeited £442m of tax receipts; £859m of shareholder dividends would have been jeopardised, a large proportion of which would have been to the detriment of UK pension funds and their scheme members.
Kamala Harris and the solution in search of a problem
Of course companies have a duty to behave responsibly towards consumers; under anti-trust laws already in place those who behave irresponsibly face significant financial and reputational consequences (including criminal sanctions in the most egregious). Judging by the promotions of brand loyalty cards with their attractive offers, ‘investments’ in price-matching schemes against low-cost competitors (otherwise known as competitive discounting) and knowing that consumers are savvy and cost-conscious and have choice, arguably Ms Harris is tilting at windmills. As one US analyst at Moody’s Analytics said this week, she is at risk of providing a “solution in search of a problem”.
As it is, price controls are seldom the right answer
Socialist governments tend to be interventionist. It is in their nature, though it is by no means the sole preserve of the political Left. There are times when active intervention is necessary (the case is most easily made for support from the authorities in moments of crisis: the central banks and their monetary policies are a case in point). But imposing price controls on otherwise open markets based on political dogma is a strategy that is seldom without consequences, mainly because in a competitive global environment susceptible to exogenous pressures it is impossible to control all the levers. Open markets may not be perfect but they usually find the right solutions in the end, albeit with the risk of hiccups in the process. If politicians get to the point of making some sectors so unattractive they become un-investable for no better reason than political point-scoring, the reality is that in the long-term nobody wins.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
Authors
Investment Manager, Jupiter Independent Funds/Merlin
Investment Manager & ESG Investment Director, Independent Funds/Merlin
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