Merryn Somerset Webb: Things are really looking nasty in the US. Is recession now a given?
Chris Taylor (Neptune Investment Management): That depends on how bad the debt crisis really is. The normal annual run rate of bank write-offs is about $500bn to $600bn a year, which the system can handle. Over the next 18 months we reckon there will be the best part of another trillion coming. It’ll be one-third the same kind of CDO-related write-offs we’ve seen already, one-third mortgages and one-third all other forms of credit: credit cards, corporate loans, auto loans.
Credit-card default rates were abnormally low at the end of 2006 in the US, due to some changes in bankruptcy laws, so it will only take them getting back to average to cause trouble. It’s the same with corporate loans and bonds: the recent default rate has been around 1% (thanks to too much cheap money and the continuous drops in interest rates), virtually the lowest it’s ever been – its normal rate is more like 3%. It’s likely to head back that way now.
MSW: So you would be pretty bearish on the US then?
CT: Yes. The financial system hasn’t got much spare capital these days. Everybody has been fiddling things to boost their returns on equity so they can get their share prices up and cash in their options. The result is that the banks have been run on too thin an equity base. How does that effect the real world? It hits borrowing terms and conditions – you get less, you have to pay more for it, and there are more conditions attached to the loan. Across the board, everything tightens up.
The good news is that the corporate sector doesn’t look too bad – it has never had it so good in terms of cash on the balance sheet and return on equity. Also good news is that right now the Government budget deficit is only 1.5% of GNP. Usually what causes a recession in the US is the corporate sector, but that isn’t going to be the case this time. This time the worry is the consumer.
Jonathan Compton (Bedlam Asset Management): Right. Consumer spending has to fall. There is absolutely no way on God’s planet that the banks in the English speaking world can increase the rate of lending growth in 2008. These write-offs are hitting Tier 1 capital levels – and that means that lending growth absolutely must slow – there is no other option. So the consumer will be squeezed.
It isn’t always easy to see what’s going on in markets. You spend most of your investment life in a fog, but sometimes the light is suddenly bright – that’s now. By Christmas next year my godchildren will know what Tier 1 capital is and why lack of it means spending is falling – I’m sure of that. So short McDonald’s. The places where low-income people spend will be first to go.
MSW: So all US-based retail related stocks are in trouble?
JC: Yes. And here’s the interesting bit. If Americans suddenly start saving, the dollar could recover really fast as the current-account deficit shrinks. In fact, it is already shrinking fast. The spadework is there for the dollar to recover. You’ll get recession and financial crisis initially – there’s no lifeboat for the US right now – but six months out, the dollar may well snap back. The peak for nasty stuff will be March – that’s when the most subprime mortgages reset to higher rates.
MSW: What do you do about that, as a global investor?
CT: Avoid it! And with a combination of cash, hedging, and the right countries and sectors, you can.
MSW: Should we be looking to Asia? Can its economies decouple from the US?
Taher Badshah (Kotak Mahindra Investments): India’s economy can. But in the short term its markets probably can’t. A huge amount of money has poured into stocks in the last six months and people are sitting on very good returns in those regions. As things get tough elsewhere a lot of that money is likely to be pulled out in the near term. We’ve had $15-odd billion come in over the space of the last month and a half. At the margin, about $5bn will probably go out. It’s likely to pull the market down by another 10% – it’s already down 10%.
Our panel
Chris Taylor
Investment director and head of research at Neptune Investment Management
Ed Cartwright
Japan hedge-fund analyst at KGR Capital
Jonathan Compton
Managing director of Bedlam Asset Management
Taher Badshah
Investment adviser to Kotak’s offshore funds
But the real economy probably won’t suffer so much. Only about 15% of GDP is connected to the US. It’s a very inward-looking economy driven by domestic consumption. And in that sense it may benefit from the slowdown in the US. Why? Because that will mean a slowdown in the oil price and that is beneficial to emerging economies.
JC: I’m not convinced on this. The market in India has to get hit. It’s got a yield of only 1.5%. We don’t really know what earnings are, so we can’t look at p/es, but we know it’s on a price-to-book ratio of seven times – that’s the highest in the world. And as for the economy, the rising rupee – it’s as strong as a horse – is not exactly helping. If I was running a hedge fund, this would be my favourite short after China.
CT: I’m with Taher on this. There are two issues. Do the stockmarkets decouple? Probably not, because they are significantly overvalued as well as dependent on money flows coming from US investors. But the economies are a different matter. Look at the big figures. Global dependency on US imports is much lower than it used to be: there’s now huge growth in the volume of trade within emerging market regions – China and its neighbours, India and its neighbours, as well as between the blocks. And that’s the bit that’s sustainable.
Look at the size of these economies. China, give or take $3trn, Russia $1trn, India roughly $1trn, Brazil damn near $1trn. That’s $6trn growing at least 15% in nominal terms – $900bn incremental GNP every year. The US growing at 4%, 5% throws off only five or six hundred billion. These things have hit critical mass – the US is no longer their make-or-break factor. And US imports aren’t actually going to collapse: all light bulbs will still be imported from the Far East, for example.
JC: I see it from the other direction. Sure, these economies are growing, but China’s GDP is still slightly smaller than California’s, and India’s is slightly smaller than those of the UK and Ireland and Portugal put together. They just aren’t big enough to save the world.
MSW: Would you buy any of these emerging markets?
CT: No, but that’s because they are too expensive.
MSW: What about Japan?
Ed Cartwright (KGR Capital): I spent last Thursday afternoon with Nikko Asset Management and they say that domestic investors in Japan are still moving their money abroad. They won’t buy Japan. They are buying in Australia and New Zealand and looking for yield. I’ve been extremely bearish on Japan for over a year now – anyone who was not and invested in 2006 has paid very heavily for it in the face of massive hedge-fund redemptions and the flight of retail investors.
Domestic retail investors still hate their own market. The collapse of Livedoor last year and the margin calls they got hit with then were the last straw. You can’t ignore the hatred there. There was a moment in January 2006 when the market was rising nicely, when people thought Japan might be OK as an investment. Then Livedoor. And that was that. A rising yen doesn’t help either.
JC: What you have just given me is confirmation of what I know is the case: Japan – and the yen – is a no-brainer as a contrarian investment.
EC: Actually, I don’t entirely disagree. The consensus is now rabidly bearish. We are also now seeing the wholesale capitulation of the hedge-fund industry in Japan. Money has been flowing out fast. Look at Fidelity’s small- to mid-cap fund. It went from $700m to $2.6bn at Christmas 2005 when everyone was into Japan. Now it’s back down 600 or 700 again. So I do believe, for reasons I cannot justify other than there is so much bad news in the price already, that if you really want to buy Japan today and you buy the top one or two hundred stocks by market cap, it might just work out. It’s a long-term nightmare, but a good short-term trade.
JC: Of the G10 countries, which one exports the least? Japan. Of the G10 countries, which has the highest savings? Japan. Of G10 countries, which one is actually cheapest to live in now? Often, Japan. It makes sense to me to buy Japan. This could be the market that is fantastic because it doesn’t go down. It might return zero on a 12-month view but other markets will go down and in the meantime your British punter will probably see gains 10%-15% on the currency.
MSW: What else can we buy right now?
JC: Oh, easy. Telecoms – particularly fixed line. Look at BT (BT/A). It’s yielding 6%. So are most other fixed-line telco firms. They aren’t going to cut dividends, so you are effectively getting bond-style income, only higher. Easy, easy money.
CT: The telcos are far too unloved, given what good cash generators they are. They may have been blasted over the last five to ten years by deregulation and by mobile phones, but if you are going convergence (providing households with both mobile and fixed-line capacities in one bill), you need the land-line capacity to deliver it, and that’s what all the ex-national monopolies have.
They’re also good at going into corporate services: if they supply the global telecoms backbone to, say, RBS, they don’t really care what it costs, it’s fractional. You’ve got to go BT and you’ve got to go Cable & Wireless (CW/) in the UK.
EC: Vodafone has had a huge move up. What would you do with Vodafone?
CT: Get rid of it. If you look at analysts’ predictions, they hinge on one thing and one thing only: India. That’s where they see revenue growth and they’re just crossing their fingers that there are profits too.
JC: France Telecom (FTE:FP) is, I think, yielding 6.6% and has great results. Malaysia Telecom (T:MK) also looks fantastic now it is spinning off its mobile division.
TB: I think the thing in India at this stage is financial services. Indian banks really aren’t much exposed to the structured credit risk. That makes us a little safer in the current scheme of things. If the economy can maintain even growth of, say, 7%-8% over the next five years, most people’s basic needs will finally be met. That would mean that a surplus of income available for investments and financial products would just rise. The market is developing at an unimaginable speed.
CT: I’m also interested in pharmaceuticals. Each and every major pharmaceutical company could have gone for two to three times its market price for a private-equity deal had the private-equity boom not come to a end. There’s cash on the balance sheet; property that they’ve owned since the year dot; and the cash flow is phenomenal, so you can re-gear it.
Problem is that they don’t have the products. The bits of the pharmaceutical industry that are going to make you real money are the generics and the biotechs. I would say go and buy five or six US biotechnology-based firms. They can make gang-buster products for themselves in a way that pharmaceutical companies can’t. Own five or six of them – two or three may do nothing, two will work reasonably well and one will do you very well. But they will work better than the big pharmaceutical company.
JC: Of the big ones, Bayer (BYR) is interesting. It’s on 9.5 times earnings. Unbelievably cheap. And, this is a different subject, agriculture is another place to be. Look at fertiliser firms – whatever China does, it needs to have more fertiliser. So Mosaic (MOS:US) makes sense.
EC: Well, there’s one country that nobody’s mentioned: Australia. It’s had six years of consecutive growth. Howard is gone. And I’ve actually made more money with my personal investments in the last 12 months there than anywhere else.
One fantastic smaller company that I still hold is AJ Lucas (AJZ:AU). It specialises in water in New South Wales, a precious commodity, but more importantly it is a world leader in sideways drilling for gas. It leads the market in Australia and is increasingly heavily involved elsewhere. It’s tripled already, but it could triple again.
TB: My favourite stock is Indian engineering group Larsen & Toubro (LT:IN), which has done fabulously well. We really only look at two areas to invest in in India – infrastructure and financials. And within the infrastructure space, this is one. A second pick would be GMR (GRRG:IN), an airports manager and project management company. They aren’t cheap, but they are moving at a pace that is absolutely incredibly, not just within India, but beyond the country too. Lastly, we like a mid-cap company called Tanla Solutions (TANS:IN) – it’s essentially a content aggregator for mobile phones. Tanla Solutions is already the fifth-largest content aggregator in the UK and it is now looking at the American market. This company is going to be a safer bet than most of the IT services names in India and it is relatively cheap as well, at only 15 times earnings.