John Stepek chairs our panel of experts and asks where they would – and would not – place their money in today’s markets.
John Stepek: At the start of last year, the big debate was over inflation versus deflation. Do you think the argument has been won yet?
Tim Price: New York hedge fund QB describes this best – we currently have monetary inflation and credit deflation. There is an ongoing stimulus from central banks, which is distorting prices. But there’s also massive deleveraging by banks, corporations and households. So I don’t think the situation is necessarily any clearer than it was a year ago.
James Ferguson: I think the environment is clearly still very deflationary. The only reason it doesn’t appear deflationary is because of the aggressive policy response. Even so, European core consumer price index (CPI) inflation is around 1%, and US core CPI is also very low.
Steve Russell: We don’t deny that the background is deflationary. But this is precisely what will lead to inflation in the end, via quantitative easing (QE) and the debasement of currency. When? I don’t know; but we’re closer now than a year ago. And when it comes, it will be sudden and quite shocking.
Tim Guinness: I am far less gloomy than many. I think the adjustment you needed in the US – moving the savings rate from 0% to 6% or so – has happened and we will be surprised nearer the back end of 2011 at the bounce in the US economy. I’d be amazed if inflation doesn’t rise to 5%. Interest rates will have to follow. But I don’t think we will see runaway inflation.
Max King: Economic growth, despite a lot of scepticism, has been steady in the developed markets and pretty good in emerging markets. Monetary policy is very loose. That’s good for equities, and it’s been very good for gold. But in the longer term, yes, I think there are inflation concerns. And if inflation does become a serious problem, that will undermine risk assets. It may not be a worry for 2011, but certainly for 2012.
Jim Mellon: The biggest stimulus of all has been in China, and we have to look at what’s happening there. There’s a very clever guy who has set up a hedge fund and raised over $1bn to short China over the next five years. I think there’s some merit in what he’s doing. The Chinese are much more sensitive to inflation. The price of a bowl of rice means a lot more to the bulk of the population than it does to anyone around this table. And Chinese inflation is almost out of control. The Chinese will do all they can to stop it, including slowing the economy right down. A lot of the inflation we’ve seen in the world has been in commodity prices, most of which has been driven by Chinese demand. So you could see quite a big decline in some of those commodities over the next year, including, possibly, gold. We have just sold most of our assets in China.
Our Roundtable panel
Head of strategy, Arbuthnot Securities
Tim Guinness
Chairman and CIO, Guinness Asset ManagementMax King
Equity portfolio manager, InvestecJim Mellon
Chairman, BurnbraeTim Price
Director of Investment, PFP GroupSteve Russell
Investment director, Ruffer LLP
John: That’s quite a big bet.
Jim: Everyone has been predicting a slowdown in China for years. I could be wrong. But I’ve taken the view that asset prices are high enough. I don’t know what we are going to do with the money, but I think China is a difficult and dangerous place to invest at the moment.
Tim P: But if you’re in cash, it does raise the currency exposure issue. There is a dearth of sound currencies out there.
Jim: Well, how about the Singapore dollar?
Tim P: I agree, but these aren’t really mainstream currencies: Singapore dollar, Canadian dollar, the Swiss franc perhaps.
John: Would you buy the pound?
Jim: Yes, why not?
Max: I think the euro will fall apart. Weak countries will leave, and that will leave a strong euro, which will go up. The deutschmark sort of euro.
Steve: I don’t think it’s clear-cut at all that the euro will fall apart. It might. But there is plenty of scope to muddle through. The Germans have enough skin in the game; it gives them a weak currency and a guaranteed weak or stable currency export area. I think they are more likely to bail people out and make it work.
Max: This same story has played out a number of times: in Asia in the late 1990s, in Argentina in 2001, in the UK in 1992 – yet every time it seems to be a surprise. The European authorities are experiencing a mixture of denial and delusion.
Tim P: Governments will fight until the last taxpayers’ pound, though, won’t they?
Steve: I think this is where investors are underestimating risks right now. We’ve just had a multi-decade period of very little government interference. Now we’re likely to see much more of that. And we’re not talking bank regulation – it’s capital controls, potentially rent controls in the West. The ultimate is gold confiscation – the authorities will resort to this if they need to, but only to stop people escaping from their monetary system, where they have control of the printing presses and the currency. I am not putting forward a “pro-euro” view – I’m saying that I don’t know what will happen. But they will fight tooth and nail.
Tim G: I’m with Steve. The European Central Bank (ECB) and the Germans will fight to hold the euro together, and they will succeed. We look at this from a very Anglocentric point of view. There is a very simple game going on here that we aren’t really recognising. They are using this crisis to force Portugal, Spain, Italy and Greece to become fiscally responsible.
Jim: Like herding fish.
Tim G: You think that. But I think they are going to win because they have levers. The EU will start saying: “We’re not going to dole these subsidies out unless you have a balanced budget”.
Jim: That’s fair enough. But Ireland doesn’t receive subsidies. Why stay in the euro? There is absolutely no benefit for them – 75% of their trade is with the UK. They are burdening every person in Ireland with a crazy amount of debt, which they can’t afford to repay and they are pushing their country into a deflationary period that will last for a decade at least. If they just left and devalued their currency, it would be like Iceland, and they might recover faster.
Tim G: But they’ve got a choice. They either do as you suggest and see the ‘new punt’ devalued by 40%, or they accept a 30% cut in their standard of living. Because what’s happened in Ireland is that from 2000 to 2008, pay went up by 40%. What they’ve got to face up to is that they’ve got to give 30% of that back.
Max: The point is that there is no way out of the fiscal crisis in continental Europe without growth – and there is no growth.
Steve: Well, yes, there is no way out of your fiscal deficits without growth, but nobody said it had to be real growth. Nominal growth does it just as well. And that’s why we think inflation is inevitable. It’s the only way out unless you are willing to wear a hair shirt for decades. Nominal growth – albeit very small real growth and quite a lot of inflation – will start to bail out the fiscal deficits. And they disappear remarkably quickly when it does. If you look back at each cycle, it’s only about two or three years once it gets going. So I think some of these problems will wither away.
Max: I just can’t see the Germans tolerating inflation.
James: My biggest concern is that while politicians want inflation, it’s actually very difficult to create it in this environment. The Irish don’t control the printing press, so it’s very hard for them to do. Elsewhere in the West, we have QE, which is the way to do it. But you also run the risk, as a central banker, that if you do it to excess – whatever that is – you lose all credibility. At least Mervyn King has theoretical arguments to justify it. He’s been arguing in recent speeches that his role as a central banker is to monitor the quantity of broad money. And so he’s doing QE to ensure that this quantity of broad money doesn’t shrink, because that’s the pure definition of deflation. He’s not saying: “I am going to buy growth with QE”. But I think Ben Bernanke is much less theoretically clear. He seems to say, well, we will just keep doing it until things get back to normal.
Tim P: There’s no way the Bank of England can credibly pull out QE2, because inflation is already above target. They’ll be writing letters to the Treasury until the cows come home.
Tim G: You’ve got rail fares going up, energy prices going up.
James: But these things are staples. You’re talking about food, energy, heating, travel to work – these are not discretionary items. So, I think, what we’re getting is an increase in the cost of living that actually has a deflationary impact on people’s disposable income and their discretionary spending.
John: But manufacturers are saying that they are unable to find skilled workers. That sounds inflationary.
James: The reason manufacturing is doing so well, apart from in the US, is because of inventory building. Everyone gets really excited, but then we turn round two quarters later and that inventory build has not only gone, it’s created a drag. Inventory building helped boost US GDP growth in the third quarter from an underlying 1.2% to 2.5%.
If this inventory building drops away in the next two quarters, we go back to 1.2%. And if inventories have been overbuilt, that will actually detract from growth. So maybe we get sub-1% growth. That could be quite a surprise in the first or second quarter of next year.
John: What does all this mean for bonds?
Max: The bond story is fading. The US yield is back over 3%, the German bond yield is heading that way, and the UK’s is as well.
James: In a recent Barron’s survey, 62% of respondents thought the best-performing asset class in the next six to 12 months would be equities. Of respondents, 62% – probably the same ones – thought bonds were in a bubble. Only 3% thought bonds would be the best-performing asset class. Bond bears argue that it’s consensus to be bullish on bonds, and anti-consensus to be bearish. Yet I can’t find anyone anywhere whose views don’t border on being rampantly anti-bonds because they are very worried about inflation.
Max: I think that bond markets are facing a slow puncture rather than a bubble. But the fund flow is telling you that the world is massively bullish in bonds.
James: That fund flow went entirely into corporations; none of it went to the governments.
Tim P: That’s a hugely manipulated market because central banks are buying [bonds]. I’m not sure anybody here could make a compelling case for buying G7 government debt versus selective G7 market equities, which already yield more.
James: The fact is that the Fed or the Bank of England actually buying bonds changes the environment. We go from a very deflationary environment, where things look like they might slow down a lot, to all that being negated by policies. The bond market very rationally says: “If you are going to try to create inflation by buying bonds, then I’m going to sell my bonds to you”. But can central banks succeed in creating inflation? While I won’t deny that anyone who goes mad with the printing press can create very destructive inflation, you have to ask – are these people that stupid, or that mad? If they’re not, then we are actually more likely to face a very difficult, more cyclical environment, where they tap the accelerator, then tap the brake, and they are not quite sure which one they tap.
Jim: But in those circumstances bonds are still not compelling, because the yields are very low and the risks, I guess, are quite high from policy changes at work.
John: So what would you invest in now?
Jim: One argument to say that bond yields can keep falling, even from these levels, is that it happened in Japan. But the Japanese had absolutely no alternative for generating income. Their stocks yielded nothing and nor did their bank deposits.
Tim P: In an outright deflation that’s still not a bad outcome.
Jim: Exactly. But that’s not the situation we have now in the West. In the developed world, as Tim pointed out, the yields on stocks are better than on government bonds. That’s in complete contrast to what happened in Japan. So I agree with Tim – you buy selective high-quality dividend-yielding companies. But there are all sorts of pitfalls out there. One is the euro, and the other big one is what might happen in China. The Chinese effect will be most magnified in the base commodity producers, so I would not be an outright bull of metals and the like right now.
Steve: That view worries me – because I totally agree. Big multinational high-yielding stocks look fantastically cheap in the West. I’m not happy that it’s such a consensus view. But it does seem that on a point-to-point view, be it one, two or five years, something like Vodafone, yielding 5% or 6% and pretty damn safe, should come out the other end.
Jim: But BP was exactly like that at the beginning of last year – pretty damn safe, nice dividend yield, unimpeachable – and look what happened.
James: Which is why you always have 16 such stocks rather than just one.
Max: I’m not sure about that. The consensus call is to buy the high-yielding cheap mega-caps. But those were value traps last year and this year. I think you want to buy the emerging growth companies. That’s what’s paid off this year – the Weirs and the GKNs and the Aggrekos of this world. Simply buying cheap high-yielders is again, for a third year running, going to be a recipe for underperformance. On China – I respect the braveness of Jim’s call, but we have a China fund that we are just bringing to London. We look at the price-to-earnings ratios (p/e) in the low teens, and we do not take a gloomy view on the Chinese economy.
Jim: I’m not saying that China won’t grow over the next decade. But I just sense that China is producing far more steel than it can consume; China’s property is unaffordable for just about every strata of society; and China’s banks have expanded credit by 40% this year, and 50% last year – this is all unsustainable.
Max: But there are great value stocks in China. So the idea that China could have much slower growth and yet you can still make great returns on individual stocks is entirely plausible. This has been a fantastic year for active stock-picking. If you had been in the wrong fund in China, you’ve done very poorly, and if you’ve been in the right fund, you’ve done very well. This has been the best year I can remember for active stock-picking.
Investment Ticker Carbine Res. ASX: CRB Manx Financial LSE: MFX Hiscox LSE: HSX Scot. Mortgage LSE: SMT Baillie Giff Japan LSE: BGFD BP LSE: BP OMV Dax: OMV Devon NYSE: DVN Chesapeake NYSE: CHK Trina NYSE: TSL JA Solar NASDAQ: JASO Atlantis Japan LSE: AJG Vodafone LSE: VOD Tesco LSE: TSCO Johnson & John. NYSE: JNJ Hansteen LSE: HSTN Deutsche Wohn. Dax: DWNI Yell LSE: YELL Charter Int. LSE: CHTR C Fund of Canada TSE: CEF/A
John: Let’s have your individual tips.
Jim: Carbine Resources (ASX: CRB) – a nice, racy name. It’s a mining firm in Burkina Faso, which is the new hot gold area. It’s on the same seam as fellow miner Ampella and it’s just raised funds. That’s one for the Christmas stocking, a very small investment. I will also suggest some of my own companies. We have a company called Manx Financial Group (LSE: MFX), which owns a bank on the Isle of Man called Conister. It doesn’t lend on property, it only lends against assets – cars, hi-fis and that sort of stuff. So it has a zero default ratio and it’s recently made a very good acquisition. It’s got almost as much cash on its balance sheet as its market capitalisation and I really like that.
Lastly, Hiscox (LSE: HSX), which is the best of breed of the London non-life insurance companies. It’s on one-times book value, very cheap historically. Sooner or later rates will rise in the insurance world, and they will do very well. And it’s got a nice dividend yield.
Max: I’m a bit wary about going for individual themes, because I think next year is going to be very good for global markets. So I think you should stick to global equity funds with active stock pickers. There are a number of good-quality investment trusts out there, such as Scottish Mortgage (LSE: SMT). If you want to stray into themes – everyone thinks there is an emerging market bubble. But there is no sign of that in their valuations, so I think you want to stick with general emerging markets. Japan has done very nicely in the last couple of months. My favourite fund there is the Baillie Gifford Japan Fund (LSE: BGFD). And I still think there is a bit of neglected value in property and private equity. But the main thing is to be in global equities.
Tim G: There is still huge value in energy stocks. There are the boring integrated stocks – BP (LSE: BP) and OMV (Frankfurt: OMV). BP is on a p/e of 5.9 and OMV is on 5.8. I then have a couple of US gas stocks: Devon (NYSE: DVN), the lowest-cost producer, and Chesapeake (NYSE: CHK), which has been very successful in the shale land grab and is on eight times earnings. There are also a couple of slightly off-the-wall Chinese solar stocks: Trina (NYSE: TSL) and JA Solar (Nasdaq: JASO) on p/es of 6.2 and 4.8.
John: Is it a good time to invest in solar?
Tim G: The whole alternative energy sector has been probably the worst-performing sector, full-stop, for the last three years. But I think it bottomed in July. The solar sector specifically saw a huge price war, due to overcapacity. Prices have basically halved. But as a result, demand has more than doubled, leaving the survivors in a much better place. JA Solar for example, is the lowest-cost Chinese manufacturer and with their equipment, you can produce electricity in America, in good sunny places, at prices that are now not much more than the retail price. This is a huge change.
And speaking of Japan – I’d like to throw in Atlantis Japan (LSE: AJG). I’m completely biased, because I’m the chairman. It’s a small-cap investment trust. We’re doing a restructuring and the discount has closed from 19% to around 10%, but it’s going to go to 5%. It’s a no-brainer. And Japanese equities now yield over 2% against bonds at 1.2%.
Steve: I think Japan is exquisitely poised to make further gains on the one month of good performance it’s had in the last five years! So we’re very keen on that. The Japanese are starting to understand that if they get nominal growth, the fiscal deficit will cure itself. The Bank of Japan is starting to come under extreme political pressure. Don’t hold your breath, but it’s a great place to lock away right now.
I still like the big multinational mega caps – Vodafone (LSE: VOD), Tesco (LSE: TSCO), Johnson & Johnson (NYSE: JNJ). And we’ve recently fallen a bit in love with German property. All countries – such as the UK – where property is seen as the be-all and end-all of investment, have experienced successive long periods of negative real interest rates, because that’s what makes property great. Germany now has negative real interest rates. It’s down to the southern Europeans. They quite rightly want to get their money out of their home countries, so they dump it into Switzerland. The Swiss don’t want it, so they dump it back into the euro. But being Swiss, they don’t want any old euro – they’ll only accept German government bonds, which pushes down yields. So this could be very interesting. There is a company called Hansteen (LSE: HSTN) and one called Deutsche Wohnen (Dax: DWNI).
MK: Hansteen is only partly in Germany – about 30%?
Steve: Yes. It’s not an easy theme to play. But for the first time in about 50 years, the conditions for German property might be right. My last idea is a bit off the wall. We think directories publisher Yell (LSE: YELL) might actually be worth something – and if it is worth something, then it’s worth a lot more than it is now. But it’s not certain, so it’s only for risk takers. Also, we would still recommend squirreling away index-linked bonds – index-linked gilts and inflation-proofed Treasuries (TIPS).
James: I like the high-yielding, safe large-cap stocks as I suspect we will run into some big headwinds next year. I think we’re going to see a big inventory issue in the US, which may end up being an issue for us too. If growth turns out to be lower than people had expected, that’s when investors will turn around and start looking for yield.
Tim P: I’m with Tim Guinness on energy – the world is running out of conventional energy and it’s going to get more and more expensive to produce. I also like infrastructure and support services. Max has name-checked my usual suspects, Aggreko and Weir. So I thought I would try diversified manufacturer Charter International (LSE: CHTR). It’s UK-listed, but operates globally, so Europe, North America, Asia Pacific, shipbuilding, power, construction – a little bit of everything. And gold and silver are still our ‘must-own’ investments. There is now a slowly building global mistrust of fiat currency, helped by debauchery of the currencies, as indicated by QE, QE2 and probably QE3 and QE4. Probably my favourite investment there would be Central Fund of Canada (CN: CEF/A), a Canadian bullion fund denominated in Canadian dollars.
Max: I think the gold bull is in its final stages and will probably peak next year. The final stages are often the steeper stages and I expect gold will go higher, potentially quite a lot higher, in the short term. But I would expect to be out of the gold trade by the end of next year. However, I reserve the right to change my mind.
James: I think what we are all wrestling with is the fact that we normally spend our time looking at the underlying environment, and investing accordingly. I am very comfortable with saying what I think the underlying environment is. But overlaid on that is an increasingly desperate and irresponsible policy layer, where people will do things that you don’t really necessarily expect.
Max: I sort of think the US will end up doing the right thing. They usually do – eventually.
John: But what is the right thing?
Max: I think they will cut back quite hard on the fiscal deficit as the US economy starts to pick up, and that will justify the quantitative easing.
Steve: That’s perfectly true. You see what the UK is doing. We can’t raise interest rates, so we’ve got to do the fiscal side.
Max: What’s your view on gold?
Steve: Still positive. Not as positive as it was, and I would prefer index-linked bonds because they do the same thing from our point of view. But gold is just a mirror of how worthless people think currencies are, and currencies can probably slide a lot further in people’s eyes. So, no numbers, but it could go parabolic. The problem is that if it does, it’ll then collapse right afterwards.
Jim: As it did in 1980.
Tim G: There is a danger we get too obsessed by the very strong run in the last ten years. If you go back to the 1960s, gold was $75 an ounce. It’s now $1,400. It’s gone up 40 times. If you look at the oil price – that has increased from $2 to $80 – 40 times. It’s a similar story for London property prices. So I don’t see $1,400 as a scary number.
Jim: Don’t you think that the way to look at gold is observing headlines? The more you see adverts on TV like ‘Sell your wedding ring’ – the closer we are to the top.
James: Ah, but those ads don’t say, “Buy gold” but “Sell gold”. I agree if you are talking about the cover of Time, but not if you’re talking about those TV ads.
Jim: You’ve now got vending machines for gold. Central banks are buying gold. India bought 200 tonnes and China 300.
Tim P: Institutional participation in the market is almost zero.
Tim G: There’s nobody in my village who owns gold.
Jim: Not that they are telling you. It might be in their garden.
Max: The gold price and equities don’t go together historically. They go in opposite directions. So if you’re a long-term bull in equities, you have to be looking for a peak in the gold price pretty soon. If the gold price is going to be $5,000 an ounce in five years’ time, equities will be in trouble.
Tim G: I think that we have another five years of sideways range-trading in equity markets. And I think you can legitimately say ‘I don’t particularly want to play’. However, what I’m afraid will happen is that we’ll have a very strong market for the next two or three years and then another correction in 2013/2014. We will test 1,000 in the S&P again and that will be about the end of this long period, a 15-year period, of the secular commodity bull and equity bear market.
Max: It’s quite possible. I think markets will test their all-time highs next year. I don’t expect them to break through, and it is quite possible that thereafter they might keel over. But that’s in 2012 or 2013 – I’m not sure which year. But 2011 is fine.
• This article was originally published in MoneyWeek magazine issue number 518 on 23 December 2010, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.