MoneyWeek regularly invites the best investors we know to dinner and ask them where they would – and would not – put their money now. Here, four experts discuss the outlook for oil, Japan, China, inflation – and whether we’re heading for recession
Merryn Somerset Webb: What’s the most interesting thing to you about today’s markets?
Jeremy Tigue: How strong they are. The mini bear market we saw in May seems a distant memory now. In retrospect, this makes sense: the downturn came out of the blue and some of the reasons people thought up to justify it at the time didn’t really work. The unwinding of the Japanese carry trade and the rise in the oil price may have been bear points, but they weren’t new ones. I think it was just that people realised that the assumption the market would continue to rise just as it had done for the previous three years was a bit complacent. That led to a sharp sell off, but now the dust has cleared and it’s clear the fundamentals are fine, we’re back to the races. Firms have never had it so good. We’ve seen three years of double-digit earnings growth. That’s something that, back at the bottom of the bear market, no one ever imagined might happen.
MSW: Three years of double-digit growth makes you think it unlikely there will be another.
JT: It’s true that it can’t go on forever, but from a market point of view that doesn’t really matter given how far p/e ratios have come down. At the peak of the market in 1999, the average p/e in the US was 26 times and large parts of it were on much higher valuations. Today, share prices are at similar levels, but the p/e is only 15 times. Things aren’t hugely expensive – they’re not massively cheap, but they’re not expensive and, in many cases, thanks to the fast rise in earnings, they’re no more expensive now than they were at the beginning of 2003, when things were looking pretty grim.
MSW: But if you expect profit growth to be much lower from here on in, where’s the upside? Surely there’s no reason to think the market should be on a p/e of any more than 15?
JT: No, there isn’t. In general, shares are fairly valued: if earnings go up 5% rather than 15%, then the stockmarket might go up 5% too – but there isn’t much more there. It’s not very exciting, but it’s not a disaster and being invested in it isn’t very risky. I think the same is true pretty much around the world. Unless you look to individual emerging markets such as Thailand, where things might yet blow up, it’s hard to see where there is a huge amount of risk for investors at the moment. The only really big risk I can see is a resumed rise in the oil price. If its recent fall reverses and oil goes back to $80, things will slow down.
MoneyWeek roundtable: where is the oil price headed?
MSW: Does anyone see oil back at $80?
James Ferguson: I’m really torn on oil. It’s at the bottom of its trading range, so it is at a point where you would really expect a rally. But the scale of its recent fall feels like it is warning us that the oil bull is over. A number of commodities have been making new highs recently, so clearly the commodity bull as a whole isn’t over, but oil isn’t something I’d bet on. I’m not sure I’d want to be holding commodities at all actually. If you had bought commodities two years ago and still owned them today, would you have made or lost money? I’ll tell you. You’d have lost it. The CRB is up 10% since then, but you’ve got a 10% roll yield annually – or you have had over the last 12 months.
TP: I’ve just finished reading James Kynge’s account of the rise of China, China Shakes The World, and it seems to me that, if Chinese growth is even remotely the same over the next five to ten years as it has been over the last 15 to 20, then there’s no way oil prices won’t hit $100 a barrel.
MSW: So who would still be buying the big oil companies?
JF: Actually, I would. They’re just too cheap to leave. It is true that in my experience it often doesn’t matter how cheap something is – if momentum goes negative, you get hit. You may get hit less, but you get hit. However, when it comes to big oil, I still find myself wanting to buy, regardless of momentum. I’ve rarely come across anything in the market as cheap as Shell (RDSA) and BP (BP) are now.
JT: Longer term, if you are a believer in peak oil, which I think I am, they are also worth having. We just aren’t finding as much oil as before, so it is common sense that production will reach a peak at some point.
Epsen Baardsen: But not finding enough oil is surely also a problem for the producing firms. They’ve got the problem of having to try to replace their reserves, something they can’t do cheaply. But if they don’t, they are wasting assets. That’s why they haven’t gone up that much.
JF: An awful lot of people – some crackpots, some not – think that new technology means most of our depleted oil fields can be opened up again.
There are also untapped areas, such as the Falklands, which may well come on-stream. So I’m not sure the wasting asset argument stands up. Big oil is just out of favour for no really good reason. In a few years, we’ll look back and wonder what on earth we were thinking letting them get so cheap. Look at the likes of BT and Marks & Spencer: they fell out of favour, everyone drifted off, then next time they looked they’d doubled and not even on anything in the way of new stories. I can’t see why Shell and BP can’t too.
EB: There’s another reason: the production sharing agreements they signed in the mid-1990s. When they were producing in certain countries, say Nigeria, they would sign an agreement that would guarantee them a certain rate of return – around 20% with oil prices at $20-$25 a barrel. This was great when prices were low, but when they signed they never anticipated oil ending up at $60. And the deals are written such that at these prices the country in question gets a much higher percentage of the excess return than the oil firm. I’m not anti the big oil firms – in a bear market I would expect they would outperform certain other shares – but, given that they don’t actually get all the profit from high oil prices, I don’t think they will double anytime soon.
MoneyWeek roundtable: will UK inflation get worse?
MSW: The other issue on our minds is inflation. In the UK, the retail price index (RPI) has just hit an eight-year high. Is there worse to come?
JT: Maybe. China has been the great disinflationary force in the world and that’s going to come to an end soon and push prices up.
MSW: Already China is less of a deflationary force than it was even a few years ago – we keep reading about rising wages for workers in Chinese factories.
Tim Price: And for managers, and not just in China. I saw a Bloomberg story suggesting that Indian technology firms are having trouble recruiting. India is one of the major off-shoring, outsourcing centres of the world and, if wages are rising there, its disinflationary impact won’t take long to hit further afield.
JT: Inflation will rise, but it’s not so much a worry now as it will be in five years, I think. I also think it will be dampened by another part of the globalisation story. Consumers are much better informed than they used to be – they shop around a lot more – so the ability of companies to increase prices is just not there in the way it was in the past. People won’t buy if they think the price is too high.
JF: You know, I wouldn’t bother worrying about inflation at the moment. The way the cycle is currently going in the US, I’d say it’s the least of our worries. I don’t think most economists understand what’s going on in the US, or if they do they’re hiding it pretty well. There’s a fundamental difference between leading indicators and lagging indicators. The latter tell us what has happened, so aren’t of much predictive use, and the former tell us (as much as anything can) what will happen next. Yet everyone only ever talks about lagging indicators – such as jobless numbers – when there’s nothing more backward-looking than employment data. Look at the leading indicators and you don’t see growth ahead, you see recession and deflation. Obviously, the suggestion that there is a deflationary recession ahead is contentious, but consider the CEO Sentiment index, which has a great track record of predicting recession. Right now, it’s at very low levels. There’s also the fact that consumer loan demand in the US is at record lows. America looks great if you look backwards, but if you look forwards, it just doesn’t.
JT: So what’s actually going to cause this recession – the housing market?
JF: Probably. In the US, 70% of GDP comes from consumption and in the last quarter, over 80% of all consumption was driven by mortgage equity withdrawal (MEW). So if MEW goes to zero, that job’s done. Recession. If you look at the last time a consumer-credit bubble blew up – Korea in the mid-1990s – they exported their way out, but I can’t see the US doing that. The problem with a consumer-debt-financed bubble is that it eats up future growth. Then when the party stops, it’s payback time.
JT: Surely the Americans can get out of this. They just cut rates back to 1%.
JF: Cutting rates after a crash doesn’t work immediately. In the UK, from 1990 to 1996, interest rates fell every single year. Yet house prices also fell every year. Once you’re in the situation, interest rates alone aren’t enough. You’ve got to have a nice fiscal package to go along with them. This is what happened in the US after the dotcom boom. Not only did they cut rates savagely, but they also, as luck would have it, had a pre-prepared tax-cut package. Together these did the trick. But this time, where do you go? The US is running a huge deficit so there’s probably no fiscal package. All they have is rates.
MoneyWeek roundtable: how healthy are UK equities and the housing market?
MSW: How does this make you feel about the equity market, James?
JF: I’ve been positive on stocks for a long time, but not anymore. I don’t think stocks are expensive, but I do think there is a sentiment hurdle that has to be dealt with. In the US, whenever GDP growth drops below 1.5%, profit growth goes negative – yet the consensus is still that America will keep seeing double-digit growth. There needs to be a style shift. The same was true in 1990. Then the S&P dropped 20% in six months, after which people started to think the bad news was in the price, and with rates falling they were happy to buy back in.
I would be very happy in that same situation to do the same this time round – but buy now? No. Not until it’s clear everyone understands the situation.
MSW: Is James a bit extreme, Jeremy?
JT: Not if all the things James thinks will happen transpire. But there are many reasons why they might not. I’m not an economist, but is MEW going to fall as much as that? Might wages rise and keep consumption going for a bit longer? And is it right to talk about the US housing market as one market when it is so local (what happens in Manhattan is very different from what happens in Missouri)?
JF: I can’t see wages going up – they haven’t in real terms for years. People have been financing their lifestyles entirely out of their homes. Up until now that has been voluntary, but it’s getting to the point where they have to do it to pay the bills: they don’t want to, but they need to. Soon they’ll need to – but with house prices falling, they won’t be able to.
MSW: There’s also the question about whether you can generalise on housing.
TP: You can certainly say the same thing about the UK. In the UK as a whole, prices aren’t rising anymore. Then you’ve got pockets of central London that may never be cheap.
JF: I’d accept that there are sticky patches and then bits of catch up and slow down, ¬ but overall the market moves as one. And – back to the US – in September new house prices fell 10%, just like that. That’s not unprecedented – they fell 11% in the early 1970s – but in most people’s memory it’s unprecedented. So to say that everything is fine, that it won’t spill out into the rest of the economy, is amazing. And with this trouble brewing, it makes no sense that volatility is at all-time low levels and that Barron’s has cover stories calling for the Dow to be 13,000.
MSW: OK. So where is the good news?
JF: Well, recession is fantastic news for bonds. It’s boring, but there’s nothing wrong with bonds. You want to avoid any high-risk stuff, but for very good risk – such as government bonds – it couldn’t be better. I know it bores the hell out of most people, but whether they are aware of it or not most of their savings are probably in bonds. So this isn’t all bad for most people, unless they’re all invested in very high-risk, cyclical stuff, in which case they are going to lose money.
MoneyWeek roundtable: investing in Japan
MSW: What about Japan?
JF: Right now, things don’t look good.
I had had high hopes for the domestic economy, but unfortunately it is running out of steam just as global demand looks to be dropping. There’s also the fact that we have a Bank of Japan Governor who says his plan is to hike rates.
JT: Every time you feel bullish about Japan, I think you should just go and lie down until the feeling passes. That’s been the message of the last 16 years. Still, I don’t think that rates will be rising now. The Governor says the next move is going to be up, but he hasn’t said when, has he? It just keeps getting pushed further into the future. So if what you say unfolds, there probably won’t be an increase in interest rates for a long time.
JF: That’s exactly the sort of thinking that would have had you absolutely convinced in 1997 that, although the Japanese government said it was going to hike sales tax, it surely wouldn’t if it looked like it would destroy any chance of recovery. They did, and it did. Will they be so stupid again? Who knows?
MSW: Tim, you are generally quite bullish aren’t you?
TP: Yes. All the things that James is flagging up just look symptomatic of the kind of wall of worry that markets have to climb from time to time. Other Anglo-Saxon economies have had rocky patches in housing: the UK has come through it, as has Australia and so may America. And as mentioned earlier markets are not expensive. They’ve risen a long way, but are not, by most accepted matrix, pricey.
JT: Still, it is hard to pick out an area that is particularly compelling, now that the correlation between global markets has risen so much.
JF: A few years ago it was much easier to differentiate between markets, wasn’t it? Germany was looking ridiculously cheap, for example, as was France, so there wasn’t much doubt that Europe would rise. The UK was also cheaper than the US. The problem is that nearly all markets have now reverted to the mean: they are similarly priced and, in the main, fairly priced.
MSW: Espen, is Eclectica still heavily invested in commodities?
EB: Not as much as we were. Instead of taking long positions, we’re looking for niche-type trades – selling volatility on natural gas, for example. We love soft commodities, but we end up getting into that market via fertiliser companies, such as Agrium (AGU in Toronto) and Yara (YAR in Oslo). They’re not cheap – 30 or 40 times earnings – but your alternatives are pretty minimal. There are not that many good ways to play this market.
MSW: You’ve been looking at the telecoms sector again, I gather?
EB: Yes, we’ve been looking at names such as cable company Global Crossing (US:GLBC). Everyone was laying cable in the late 1990s. Then, in 2001, it became clear that there was massive over-capacity and the stocks collapsed. There still is quite a bit of over-capacity, but a lot of it has been made redundant – once abandoned, it costs hundreds of millions to reactivate and no one’s going to do that. Also, demand is rising too – apparently one of those streams of video on YouTube uses up the average person’s full worth of email in terms of actual space – and prices are stabilising. Cable & Wireless (CW) and Colt Telecom (COLT) are also beginning to look interesting.
MoneyWeek roundtable: expert share tips
MSW: Any other good tips?
JF: I’ve got a storming one, but it sits very uncomfortably with everything I’ve said so far. If you are going to buy into this one, you’ve got to rush in and then be ready to rush out as the rest of the market begins to understand the recessionary dangers ahead. The story is about stainless steel.
Asian stainless-steel prices dipped at the end of last year and the beginning of this year. Then, in the second quarter of this year, they went vertical. In the first quarter, prices were averaging something in the $2,500 a tonne area. Now they are over $4,000. None of this has turned up in the earnings or the share prices yet and there is very little analytical coverage, so it’s a great time to get in.
There are four Japanese companies in this space. Mory (5464), Nippon Metal (5479), Nippon Yakin (5480) and Nisshin Steel (5407). All of them have come out with amazing second-quarter numbers, or indicated that they are going to do so, but the market hasn’t really noticed – they were given them as half-year numbers and the first quarter was a bit rubbish. However, if you annualise the second quarter, then two of the four – Mori and Nippon Metal – are trading on less than four times earnings.
MSW: So you are suggesting people buy quickly and be ready to sell quickly too?
JF: I’m suggesting that anyone who thinks I’m talking nonsense about the economic scenario should just buy them, because it’s a fabulous opportunity. If you’ve got companies whose earnings can only get better into the second half – who are already effectively on four times – then there has got to be some money to be made.
MSW: Tim?
TP: I’m going to be boringly predictable and say that I’m still happy holding the diversified miners. I still think their price is cheap for the long-term. From a fund perspective, I continue to like British Empire and Caledonian Investments.
MSW: And Espen?
EB: One more stock tip is US-listed Corn Products (CPO). It has no leverage to higher corn prices – its business is just to convert corn into high fructose corn syrup, which is used in things like Coke as a sweetener. In Europe, we use sugar for this (partly because it’s subsidised), but in the US it is all about corn syrup. The basic story is this: in the early 1990s, in anticipation of the NAFTA agreement and of Mexico suddenly becoming a huge new market, the company massively overbuilt production capacity. However, when the time came, Mexico – for various reasons – blocked the import of high fructose corn syrup, with the result that the price collapsed. Ten years on, this has changed. Capacity has tightened and Mexico and the US have come to an agreement on fructose: soon, Corn Products really will be exporting and will be at 100% capacity. Their margins are really
going to rise – I can see the shares rising 50%-60% in the next 21 months. Recession or no recession, the Americans and Mexicans are still going to drink Coke, and lots of it.