Many investors expect that government debt will be the safest investment of 2009 – but at MoneyWeek’s Roundtable, not all of our experts agree. Our panel this week ismade up of: James Ferguson, chief strategist at Pali International; Espen Baardsen, analyst at Eclectica Asset Management; Robert Talbot, chief investment officer at Royal Asset Management, and Jim Mellon, chairman of Burnbrae.
John Stepek: 2008 was a tough year. What surprises do you think 2009 might hold?
James Ferguson: Probably the biggest surprise, given everyone’s now so bearish, is that the first quarter, and maybe the first half of 2009, might not be too bad for stocks. Even though we are probably about to get some savage earnings downgrades, the market has fallen far enough that some may surprise on the upside.
Espen Baardsen: We have fallen so far that we are going to have a short rally, no doubt about it. But I think we will continue down the slippery slope of hope. That’s what happens in bear markets.
Robert Talbot: I think there will be a significant step up in bankruptcies in the early months of the year. As we get into spring, there will be a sharp rise in equity capital raising as a lot of firms return to the markets to raise fresh equity to repair their balance sheets to see out the recession in 2009. We’re also moving inexorably towards what is referred to as quantitative easing. With interest rates at, or near, zero, central banks and authorities around the world will need to do other things to inject liquidity into the system. They will buy up assets, from government bonds to corporate bonds and maybe even equities at some stage.
Jim Mellon: It’s quite difficult to forecast surprises, obviously! But the things making the front-page news now are likely to be the things that will change. For instance, in July the front-page news was that the price of oil was going to go up and up. It peaked at more than $140 and now where is it? Today’s big story is the run on the pound. So I think the first surprise will be that the pound will rise to maybe $1.70 against the dollar, because it’s going to have a natural bounce back.
As for quantitative easing, that is changing my mind about the eventual deflationary outcome of this slump because I don’t think there’s ever been so much hype about money creation in the history of the world. So instead of deflation, by the end of next year we could have the beginnings of really rapid inflation, which could get out of control, particularly in America. That makes the US dollar vulnerable, so the surprise could be that gold goes to $2,000 or $3,000 an ounce by the end of next year.
Espen: I think inflation will come along much later than that. There’s so much excess capacity that the amount of money the authorities will have to print to create inflation will be huge. I think deflation for at least the next couple of years.
James: I’m even more long term than Espen. Inflating the stock of money, which is what we’re talking about here, is highly inflationary in a normal environment. But this is not normal, this is a banking crisis. When you lose your banking sector – which you do when the banks are overextended and have to retrench – you lose the velocity of money almost overnight. And banks won’t stop at zero loan growth – they will claw back loans they’ve already made. That’s incredibly deflationary. The banks tip firms and households into bankruptcy, their assets go to auction and buyers at the auction can’t get any bank credit, so we get lousy prices. This is Japan writ large – the government spent huge amounts on fiscal stimulation there, yet ten-year government bond yields went down to 0.4%.
Espen: Ben Bernanke [the US Federal Reserve chairman] has said that the Great Depression was all the Fed’s fault, but because they know the mistakes they made then, they’ll never let it happen again. That’s rubbish. The Great Depression happened because you had such a levering up of the economy. In this case, you have had a far greater levering up than in the 1920s. So how are you going to de-lever without having this debt deflation spiral? There is no easy solution. If you are not going to allow unwinding to occur – if you are going to try totally to offset it with public debt – then maybe we will just stagnate for 20 years, which isn’t any better. I would rather have a really bad time and then recover than have miserable zero real growth for 20 years.
Jim: I’m a financial pessimist in these matters, but I just feel that because the governments own the banks now, they can probably direct the spray of money to bankrupt households and companies.
James: But they can’t, because they don’t own the banks.
Jim: They do here.
James: Well, they don’t really – that’s nationalisation. From a political point of view it’s very unattractive to nationalise the banking system, because although it solves your problem right now, it doesn’t solve it when you come out at the far end. Anyway, it doesn’t matter who owns the banks. The real problem is that they are woefully undercapitalised, so whoever does own them has one of two choices. You can inject a huge amount of capital, enough not only to absorb the natural losses they’ll make in a recessionary downturn, but also to recapitalise them to the level that makes them not bankrupt…
Jim: … or the government buys back all their rotten assets.
James: Yes – either the banks contract their risk assets, or give them to another entity to do so. If the government splits banks into good and bad banks, which was the Nordic banking crisis solution, then they can hold on to those assets right through the cycle. But unfortunately it’s still too early really to know where the bad assets are, so the banks aren’t in a position to make that kind of decision.
Robert: Actually, I think the banks have a pretty good idea of where the dodgy assets are and what valuations they should ascribe to them. So I think it is quite reasonable to expect a split between a good bank and a bad bank next year. The other point is, if you do get round to full quantitative easing, you can bypass the banks. You can send money to every household in the country, saying here’s the money, we want you to spend it.
Espen: So the Fed issues a cheque for $5,000 to every person with a social security number.
Jim: It won’t be that, it’ll be a shopping certificate.
John: But doesn’t this sort of intervention store up problems for the future?
James: You have two problems – an initial one and another way down the track. Your initial problem is the extent to which your government debt is held by foreigners. They don’t like the look of this because they know that governments don’t default by not paying the coupon, but by paying you in a devalued currency. According to a study in the FT, 75% of net fixed-interest instruments in the UK bought by foreigners in the last four years were sold in the last two months.
So a large amount of this process has occurred already – hence the drop in sterling. And the problem you store up for much later is that all this quantitative easing increases the stock of money. When we have an environment with a very low velocity of money, that stock of money increase is not inflationary because the transmission mechanism of the banking system is gone. But when that comes back, if the velocity of money returns and that big stock of money is still there, then you have an issue. But is it likely that we will go back to the same velocity of money? Will the banks lend like they used to, or people borrow like they used to? Will the regulator let them? Not likely. So I think the risks here are still very deflationary, not inflationary.
John: How will all of this affect the man in the street?
James: For the average person, 2009 is the year when the credit crunch will really hit home. The banks are going to pass on the pain. The first thing people will get is letters from their bank manager saying ‘I want that loan back’, or ‘your credit-card limit has just been reduced’. After a decade of saying ‘yes’, from now on the banks will be saying ‘no’.
Espen: There is enormous spare capacity globally. That’s what will hurt the average person most – unemployment. When unemployment is rising, people who have jobs find they are competing against the unemployed. Even if you keep your job, your employer may say ‘this guy over here who is unemployed is willing to work for 25% less than you – you have to take a pay cut’. Of course, if your salary is paid by the government these are probably good times. But you might wonder what your pension is going to be in 20 years’ time.
James: The trouble is the government has guaranteed you a pension – unfunded.
Espen: But will they be able to pay it?
James: That’s the interesting thing. Will we get a brain drain? Many private-sector workers have seen their pensions and prospects wiped out. I think a lot of them will think, why go to all the effort and risk of rebuilding it to pay public-sector pensions in the future, plus whatever overhang we are going to have from the debt we build up while we are trying to stimulate the economy? I think financially literate people might well turn around and say ‘I can’t see there is much left over for me’.
Robert: There’s not a lot of financially literate people in this country.
James: There’s bound to be a lot of people with reading time on their hands.
John: So what should we be investing in?
Jim: If James is right, definitely government bonds. But I take an opposite view. The deflationary argument is so well established that perhaps deflation won’t be as bad as people think. In those circumstances, what you actually want to be is long property. There may well be further downside in UK housing, but I think residential property in general is getting to the point where it might be interesting. My top pick is Germany. Berlin residential is up 8% so far this year – I’ve just been in Germany looking at it all. If you want to play that, I’ve got my own vehicles, which I’m not going to mention, but there’s Puma Brandenburg (LSE:PUMA) or there’s Develica (LSE:DDE), which invests in commercial property. They’ve all got long-term fixed debt and long-term fixed cash flows.
And I think you want to be long commodities. Even at depressed prices, a lot of companies are still making money and are in tremendous positions to buy up lots of stuff. I especially like uranium. I was an investor in a company called Uramin, which was sold in September of last year. Niger Uranium (LSE:URU) was a kind of spin-off from that. The shares traded at 80p and they are now 4.25p – it sells at its cash value but it also owns 17% of a company called Kalahari, which in turn owns 39% of Extract. I can tell you – because my partner is the best uranium man in the world – that this has got the best uranium deposit we’ve seen in the last 20 years.
Espen: But who would want to build a uranium mine now?
Jim: Why do you say that?
Espen: It’s the lack of capital. No one is going to want to invest when you can get corporate bonds at ridiculous yields. Why would I want to take a risk on something that could happen in five or ten years’ time? Why would anyone build a nuclear power plant right now?
Jim: Because they are very long-term projects. We can argue about whether nuclear power is a good thing to be investing in at the moment, but it’s basically all paid for by governments.
Robert: It could fit into the fiscal spend.
Espen: I think it’s a great thing – don’t get me wrong, I think nuclear power will be the future – it’s just that I’m not sure on the timing of it.
Jim: In September of last year, my partner sold Uramin for $2.4bn in cash – luckily I was his co-investor – and he is saying buy this, so I have to listen to what he says – I think he knows this business better than anyone. And uranium is the only commodity that is going up, which is telling you something. So that’s my number-one recommendation. My second is BP (LSE:BP) – I know James likes it as well. A 6% yield that’s going to stay there while government bonds go down to 1% – why wouldn’t you buy it?
Lastly, I own shares in Billing Services (LSE:BILL), which I have recommended occasionally here. It’s held up reasonably well and paid a 20p dividend of return of capital last year. It’s selling at less than one times this year’s cash flow; it’s got the monopoly in its business in America, which is mature but extremely strong – it does 95% of all the billing for telecoms companies in the States; and all its earnings are in US dollars translated back into pounds.
The share price is 8p – management is buying back a lot of stock and I think it will pay a 10p dividend next year. So I know you can offer people machines that turn water into wine and no one will buy them these days, but it strikes me that whatever happens to the economy, these are good investments.
Robert: I think corporate bonds have to be part of your portfolio. When rates are going down to 1%, the prospect of getting a 9% yield from a good portfolio of investment-grade corporate bonds has to be a pretty good risk/reward bet. They are suffering at the moment because too much stock has been in the wrong hands and people have been distressed sellers at almost any price.
John: Would you buy a fund rather than individual bonds?
Robert: Yes. Of course, I am going to plug our own fund, but I think there are a number of reasonable investment-grade corporate bond funds out there. I would go for one with a diversified portfolio rather than one that tries to go for a very narrow portfolio, because I just don’t believe that you are being paid to take that type of risk. I also believe there is a reasonable insurance policy in buying index-linked bonds. You can get a more-than-3% real return from ten-year gilts. It seems to me a bit of a no-brainer, unless you really, really do believe we are facing deflation for many years to come.
Espen: We hold US [index-linked] bonds that mature in just two and a half years, with a real yield of 4.5%. And you know what? I hope I lose a lot of money in these, because I’m unleveraged. If deflation is so bad that I lose a lot of money in this – in nominal terms, of course, because in real terms I am guaranteed to make money – then how much further are property and equity prices going to fall?
Robert: That’s why I say they have to have a place in virtually anybody’s portfolio.
John: Would you still back ordinary government debt too?
Espen: Yes. Last time I was here [August 2008], James and I said we thought gilts were the best bet for a British investor. I have ones that I still hold, maturing in 2027 or so, that continue to yield 4.5%. I think the price will keep going up and the yield’s still good. I still like the 30-year bond in Germany as well.
James: I am with Espen on government bonds. I think we will be surprised by how long that bull market goes on. There’s no yield that can’t halve. I can also see a lot of troubles for the euro coming up. There are a lot of horrible skeletons in the closet in Europe. Many of the good bits of Europe rely on exports and there is going to be no one left to export to. So I can see a kind of ballet of competitive devaluation between a lot of the currencies.
There may be a stockmarket rally into the New Year, but I would use that to sell any bank stocks you still hold, because the dilution hasn’t really started yet. The best performers will be equities that can masquerade as gilts – those with very low operational gearing, very low debt gearing, highly liquid, extremely reliable, such as GlaxoSmithKline (LSE:GSK) and Cobham (LSE:COB).
[For more of James’s blue-chip tips, see What should you buy in 2009?]
How to buy bonds
One of the easiest ways to get exposure to a range of bonds is via exchange-traded funds (ETFs). For exposure to gilts (though we’re not keen on straight government debt – see: So, inflation or deflation?), Tim Price of PFP Wealth Management suggests the iShares FTSE Gilt ETF (LSE:IGLT). For index-linked gilts, you can buy the iShares £ Index-Linked Gilt fund (LSE:INXG), or for international exposure, try the db x-trackers II i-Boxx Global Inflation-Linked Total Return Index-Hedged ETF (DAX:XGIN). And for corporate debt, Price suggests the iShares £ Corporate Bond ETF (LSE:SLXX).