Every month we invite the best investors we know to tell us what they would – and would not – put their money into now. This week’s panel conists of: Patrick Evershed, manager of the New Star Select Opportunities Fund; James Ferguson, economist and stockbroker, Pali International; Chris Hiorns
co-manager, Amity Sterling Bond Fund, Ecclesiastical Investment Management; Charles MacKinnon, chief investment officer, Thurleigh Investment Management; John Pattullo, manager of Preference & Bond fund, Henderson Global Investors; Tim Price, director of investment,PFP Wealth Management.
Merryn Somerset Webb: Patrick, last time you were here you warned us that things would get a lot worse, didn’t you?
Patrick Evershed: Fifteen months ago I predicted a horrendous credit crunch. Back then everyone thought I was nuts, but within a couple of months it looked like I was right. Today, I am even gloomier than I was then, largely due to the huge amount of debt in Britain. Individuals are more in debt than they have ever been and the budget deficit is out of control too. The Government will have to cut spending and put up taxes. The financial system is a mess and I think we have got inflation coming our way. Factory gate prices in China are rising at 10%-15% a year, and with the pound down 20% against the Renminbi, we’re importing all that inflation. So wherever I look, I’m pretty gloomy.
Merryn: James, you probably want to say ‘I told you so’ too?
James Ferguson: I do. Back in January, I said that if you were still holding bank shares, you should expect to lose 80% of your money – given how horribly over-leveraged all the banks are. That’s beginning to look conservative. But there is a point on which I have to disagree with Patrick: inflation. If you look at the things that have really been driving prices – oil, energy and other commodities – they’ve all broken down. Metals are now making a negative contribution to inflation and even agricultural crops are well down; wheat is down over 40%, for example. That will work its way into the numbers by February or March of next year. The only way inflation can keep going is if it somehow feeds into a wage-bargaining round. And that I just can’t see. Real wages are falling in America and in Britain too. Last month, producer price index (PPI) inflation in Britain dropped its most since 1980.
Patrick: But it’s high compared with last year.
James: Yes it is. But look back to 1990. Then we had late-cycle inflation at the beginning of the 1991/1992 recession. In November of 1990, US PPI was over 7%. By 1991 it was negative. Without wage inflation, price pressures can disappear fast. You can’t be sure we won’t see wage inflation, but I think there’s a lot of evidence here that the developed world will, within a year, be looking at deflationary recession, not stagflation.
Patrick: I don’t think I really disagree with James – not on energy prices anyway. But let’s not forget that in the early part of the decade Gordon Brown spent a lot of time boasting of very low inflation. But it was only low because the prices of the things we were importing from China were falling so much. That’s not the case anymore: with the pound falling and factory gate prices in China rising, the cost of textiles and electronics, the sort of things you buy in the shops, is now going to start rising quite sharply.
James: You’re assuming people are still going to be buying things from the shops.
Merryn: Does anybody think that things might get better anytime soon?
Charles MacKinnon: Do I think things will get better? Yes, I do. I think that in 12 months we will look back and see this as a time of opportunity. The Fed has made it clear that it’s working to stop the rot in the financial system so that a bottom can be found and the economy can continue to work. That should prevent a Japanese-style, 16-year recession.
I’m not saying equity prices will be higher in 12 months, but there will be stocks that will do well and I can’t see the market materially lower, say 20% lower, from here. I am a believer in the idea that, as far as there is such a thing, this is a normal crisis. If you look back over the last 50 years or so and consider the bad periods, they range from 1974 when the market was down 38%, to, say, 1998, when it was down 17%. You’ll see that there is a much greater likelihood of markets rising the year after a fall than of falling. I should point out that I focus more on Europe and America than Britain.
Patrick: Looking back at the UK, the thing that worries me is that the savings ratio that has averaged around 8% for the last 100 years or so is now zero. People who have left university in the last 12 years aren’t on the housing ladder. They aren’t saving anything, no pensions, and they’ve got debt. They need to start saving an enormous sum. And their saving is going to hit consumer demand.
James: Here’s an interesting thing. If you look at the Nordic banking crisis in the early 1990s, you can see that one of the major causes was the negative savings ratio. This is a natural consequence of cheap credit and asset inflation. But the corollary of that is that when credit bubbles unwind the assets go down and the savings ratio goes up. So I think it will happen naturally. People thought they were saving when they took out a big mortgage. Obviously, now they will go back to more old-fashioned savings.
Patrick: Last time the savings ratio fell to a very low level it recovered back to about 14%, but that came with negative growth of something like 4%. As savings ratios go up, you get recession.
Charles: I would strongly oppose the idea that the savings ratio is the lowest it has ever been. Go back to the 1920s, for example, the levels of debt were staggeringly high. But they weren’t recorded because so much was informal (non-recorded) debt. It’s merely that we are now better at tracking these things.
Patrick: The 1929 crisis was pretty severe.
Charles: That’s why I say this is normal – these things happen.
Patrick: 1929 was pretty abnormal and I think this is probably worse.
James: On the plus side, not everything that is bad for economies is bad for equities. Warren Buffett makes the point that if you break the last 100 years down into the periods when the economy was growing strongly and when it wasn’t, it’s pretty clear you made your money in the latter periods. Why? Fundamentally, one of the most important kickers for equity valuations is the p/e and, at the end of the day, interest rates. ABN Amro has come up with a similar finding – that it’s mature and low-growth economies where you actually get the best share-price performance. Now, most people until very recently would have said, “Oh, that’s ridiculous – look at China!” But look at China now. The market is off 50%-plus. There are problems with fast economic growth. It tends to be inefficient and does not maximise margins. So from an equity investor’s point of view, there is nothing wrong with slower growth, assuming it doesn’t come with inflation – and I don’t think we’re going to hear much more about that.
John Pattullo: I must say, I’m in your camp now. A couple of months ago it looked very different. But now the speculation has been taken out of commodities and oil inflation expectations can fall, which ultimately means you can cut rates and get back to a more normalised situation.
Tim Price: This just doesn’t feel like a normal crisis to me. If you view the world through a prism whereby credit availability has driven markets over the last 20 years and where that credit availability ran into a brick wall last summer – and isn’t coming back any time soon – it looks bad. I would suggest that most commercial banks are still approaching technical insolvency.
James: Indeed they are.
John: Some good news – when it comes to housing in the US, some areas are stabilising. Not Florida or Miami, but some areas.
Tim: The great thing about having 52 states – someone, somewhere is always stabilising.
James: Still, it brings us back to the point: things could be worse here than in the US.
Charles: No, I don’t think that. We are a fantastically open economy. There will be players – sovereign wealth funds and so on – from the outside who will come in to provide cash and keep things going. There will be a point at which real estate becomes very cheap – and there are institutions in the Gulf who will invest in the UK.
James: Not with the kind of currency risk they are getting if they invest in sterling. This is a real banking crisis now and I think the only way out is government-sponsored – just like it was with the Nordic crisis and in Japan. The banks will need a one-off deal where they get capital from the government and trade their way out of trouble.
Tim: I think one of our problems is that we’ve got this deposit protection for £35,000. There are proposals to raise it to £50,000. I think they should be cutting it to £10,000. That would at least force people to make a rational decision. At the moment, the government is effectively supporting all kinds of crappy banks.
Patrick: That is totally unfair – the average man in the street has absolutely no idea what he is doing. If bank analysts don’t know what they are talking about and neither do the non-executive directors, and in some cases possibly even executive directors, what can you expect of ordinary people?
Charles: If they don’t know, they can deposit their money in the Post Office. [Editor’s note: Post Office savings are backed by the Bank of Ireland. Savings in BOI are covered up to a limit of €100,000 (the Irish government has recently increased the compensation limit on savings in Irish banks – in the UK, the FSCS still offers a guarantee up to £35,000). Only National Savings & Investments and Northern Rock offer a 100% British government guarantee at the time of writing.] Anyway, we are wrong to assume that everyone is a fool. They aren’t. They are just tempted by good rates. They should be told – be aware, banks are risky, if you don’t want to take risk, you put your money in the Post Office, which is a government agency. You don’t get a free biro and you don’t get nearly as much interest, but you get your money back. People can make that choice.
Merryn: Shall we move on to what the retail investor does in this environment, the Post Office aside?
Patrick: Buy healthcare companies and support services. I am invested in Healthcare Locums, (LON:HLO) which ought to do well with an ageing population. Also support services – Velosi, (LSE:VELO) which does testing for oil rigs and oil pipelines. Very specific stocks. Companies which should keep growing however miserable the economy gets.
Merryn: James, would you buy anything?
James: Stocks? No, no, not yet. Now is the time to get rid of any commodities you might have left – we are leaving inflation behind. That late-cycle, inflationary, commodity-sponsored, decoupling argument was always total tosh. That’s obvious now. Then definitely go for bonds. Now, there is an issue about dilution – too many new bonds are being issued – and I am worried about that, but I think that as we go into disinflationary recession, it is still bond-buying time. Then in, say, six to nine months, when we can see where earnings are sustainable and where they are not, it might be time for equities. Right now, all the analysts in America are still forecasting 15%-plus earnings growth. Everyone knows it is nonsense, but until we’ve actually seen where the hits come, it’s very difficult to move. But once we have, we go for it. I do not believe equities have seen a big bubble the last few years. The bubble was in credit, in things you buy with credit – property, private equity. Private equity only worked because it used excessively cheap debt to buy excessively cheap equity. Take away the debt and the model falls apart.
Merryn: Anyone got a defence of private equity?
Charles: Yeah, yeah. I’m busy pouring money in. I think the opportunities for private equity over the next two years are pretty good. I think that if you have got a group of investors who have key-point access to capital, there are very, very significant opportunities in the marketplace now to buy assets from people who have been leveraged out of existence.
James: But that’s not really private equity. They are using their access to capital and credit lines to make a long-only fund.
Charles: There are still opportunities for classic private equity too. If there is a company that is badly structured, if you’ve got any better way to access better debt, I think there is a huge opportunity. I think that 2008/09 will give some of the best opportunities ever to buy things at fantastically distressed prices.
Patrick: This must be the time to go in and hoover up distressed shares. You can buy reasonable growth companies now on p/es of 3, 4 and 5. Extraordinary.
Merryn: But is now the time to buy them?
Patrick: Yes.
Merryn: They could stay on those fantastically low p/es for ages.
Charles: But that’s really why I would go on the private equity side rather than the public side. I would far rather actually own a business than shares in a business. I also think the banks will go back into private hands – commercial and investment banks will move out of the public markets via private equity.
Chris Hiorns: I’d look to be in bonds at the moment. Sovereign bonds have done a lot of the running already and I think the investment grade bonds are good value.
Charles: I agree – for me bonds have got to be 15-20% of your portfolio.
John: Corporate bond spreads have never been wider. You might argue that’s for good reason, but the market is currently trading at spreads discounting a 17% default rate over the next five years. The worst ever five-year default rate since the 1970s is 2% cumulative. So if you look at it in terms of risk-adjusted returns, corporate bonds trump equity and private equity right now and they will trump cash assuming rates come down with inflation.
Patrick: Buying corporate bonds 15 months ago might have been risky – yields weren’t high enough – but there is now a huge risk premium in the yield. That makes this probably the time to be buying them.
Charles: I would rather have less money in gilts and use that extra money to try and get extra return out of owning the equities – where, as you pointed out you can make ten times your money.
John: But equities aren’t discounting 1929 yet, whereas the corporate bond market is.
Merryn: Does anyone have any specific tips?
Patrick: Well, Oxford BioMedica (LON:OXB) has gone through a very bad period. Its shares are at rock bottom. But they’ve come out today with some results for ProSavin, a drug to treat Parkinson’s disease. The trial results are good. Very early preliminary tests look very favourable.
Chris: Much of the earnings in the UK equity market come from abroad and the sharp decline in sterling means that a lot of companies are going to be making more money simply because of transaction effects. So however grim your outlook for the UK economy, the UK equity market may not be so bad as we think. Obviously pharmaceuticals is one area where a lot of earnings comes from abroad. I would have said oil and mining, but with prices going through the floor not any more. But certainly engineers may do better than we think.
Charles: I think I would also be buying into the US at the moment. I would buy iShares S&P500, (LON:IUSA) the index fund tracking the S&P 500. I just think that actually that is going to be a great safe haven. Also interesting is Jupiter Financial Opportunities, a fund run by Philip Gibbs, which can short shares too, something he has been doing very aggressively. I’m also buying the iShares BRIC, (LON:BRIC) that’s at £15 down from £24. I think that Brazil is going to continue to grow.
John: I would suggest buying strategic bond funds with UCITS III authority (that have the ability to use some derivatives). We have steered through the crunch so far and I hope we can keep doing so.
Tim: I would consider shares in the premium global bank, HSBC (LON:HSBA). I think it probably has the best risk management of any of the major banks, so as a relatively low-risk way of playing at least short-term improvement in the financial sector, HSBC is as good a way of doing it as any.
James: This is still the time to be in bonds. Spreads on investment grade bonds look to me very appealing, as a non-bond specialist. I’m dying to get into equities, but I think it’s a 2009 story, I really do.
• This roundtable met before the Lehman bankruptcy and AIG bailout. However, we have contacted all our participants and all say there has been no substantial change to their views since last week.