John Stepek chairs our panel of experts and asks where they would – and would not – place their money in today’s markets.
John Stepek: What do you make of Standard & Poor’s warning on America’s credit rating?
Marcus Ashworth: S&P have done us a decent service for once. The deficit is now a key issue in Barack Obama’s re-election campaign, whether he likes it or not. In that sense it plays into the hands of the Republicans and the Tea Party. But they don’t have a credible contender, except perhaps Mitt Romney – certainly not Donald Trump.
Of course, there are other things to consider too. Quantitative easing (QE2) ends in June and I don’t think there’s anything in the pipeline that’ll convince congress to approve QE3, even though Federal Reserve chief Ben Bernanke and other – though by no means all – Fed members probably want to do more.
Nick Greenwood: I’m intrigued by the timing. We’ve been in a “good news is bad and bad news is good” era – because bad news gives the central banks a reason to turn the liquidity taps back on. Could the downgrade become a reason for launching QE3, just as everyone had given up hope? This game of buying cyclical stocks pumped up by printed money can’t continue forever. But it might take a while for the tide to turn in favour of big-name value stocks.
Pau Morilla-Giner: Yes, that this move will probably turn out to be quite positive for markets is another sign of how dislocated the world is just now. In terms of investment, cost of capital is our biggest concern. With rates so low, nobody is paying attention to what really matters – slowing earnings momentum. When rates rise, that will be a problem. But I don’t think that’s going to happen yet.
Aye Idehen: I agree. S&P is telling the politicians to fix the problem. Do I worry about it? Of course. The US is the world’s largest economy. And you need to be careful how you repair your fiscal house, because you need growth to do that. But my main concern just now is China.
John: Why?
Our Roundtable panel
Head of fixed income, Espirito Santo Investment Bank incorporating Execution Noble
Nick Greenwood
Fund manager, CF Miton Select Assets Fund, MAM FundsAye Idehen
Head of equity research, Kleinwort BensonPau Morilla-Giner
Senior portfolio manager, London & Capital
Aye: The economy looks alright, but loan growth is at 18% or so (depending on which numbers you look at) to generate GDP growth of around 9%, so leverage is building up, along with potential bad debts. I’m not suggesting China is over-leveraged right now, but at some point you have to think about how you deal with that.
John: What would that mean for commodities? Are they looking toppy?
Pau: This is what happens when you have very cheap money. As liquidity spreads, you get down to the more illiquid assets, which are more subject to bubbles. But we need to discriminate. Some valuations make a lot of sense when you look at how low inventories are. In other cases, though, it’s just down to people trying to store value wherever they can. In base metals, China accounts for the overwhelming majority of demand – nearly 90% of incremental demand in the copper market, for example.
Oil is different. Oil is trading on scenarios, rather than fundamentals. It’s only the very small probability of Saudi Arabia getting caught up in the Middle East turmoil that’s keeping oil so high. There is actually a lot of oil around – inventories are the highest they’ve been in six years.
John: What’s a fairer price?
Pau: I think Opec [the oil cartel] probably wants to see oil at $80 to $85 a barrel. As for other commodities, the gold story is also different. It’s about currency debasement and the fact that we now have very weak central bankers. Gold loves weak central bankers and hates strong ones. The last time it really capitulated was when you had Paul Volcker as Fed chief saying: “I am going to do absolutely everything to tackle inflation”. While everyone in America talks about how great he was, his approach was far from painless and, at the time, it certainly didn’t make him popular.
Aye: On gold, investors just lack confidence in fiat money. They don’t trust the institutions that issue it. Everyone is engaging in competitive currency devaluation.
Marcus: Speaking of currency, I think China is going to revalue the yuan higher. And that’s what Bernanke and US Treasury Secretary Timothy Geithner have been pushing for. This is the end game, with China finally admitting: “You’ve beaten us. We can’t control our own inflation”.
And this is all part of the plan. Bernanke’s ultimate aim is to devalue the dollar. There are knock-on consequences, because it is an extremely crude economic policy. But the only way the US is going to recover is through having a very weak currency. Perhaps in the fullness of time – say, five, ten or 15 years – Bernanke will be hailed as the saviour of the universe because he broke the Chinese over this. But the net result will simply be more inflation.
John: What will that mean for Britain? Our inflation is too high already.
Marcus: Rates can’t be hiked in Britain, the economy is too weak. We know what Bank of England governor Mervyn King said before the election – that whichever party won would be hated for a generation. Well, we’re already seeing that in the way the coalition has been treated. I’m amazed the European Central Bank (ECB) has hiked rates. Sure, inflation is very sticky in Europe and it’s hard to have much effect on it. But the net impact for the peripheral countries is catastrophic – and they are not going to give Portugal its €80bn.
John: Why not?
Marcus: We’ve got the joint IMF/EU audit of Greece coming up in June. The rules say Greece can’t go into the European Stability Mechanism (ESM), which kicks in from 2013, unless they restructure, because they’re not capable of paying their existing debts. So why would you give Portugal e80bn when you know that one of its partners in crime is literally a few weeks later going to go straight into restructuring? So in the end, there will have to be a grand restructure whereby Portugal, Greece and Ireland get to a position where they can afford to pay back their debts, before Spain gets dragged down with them.
John: What about the French and German banks holding Greek debt?
Marcus: I think, behind the scenes, the banks are being told either to sell as quickly as they can, or to reserve as much as they can for the inevitable. This is also why the ECB has had to stop buying bonds because, of course, it’ll take a hit to its capital too. It has already recapitalised twice and it will have to recapitalise again, because it has been the only real buyer over the last 18 months or so. Also bear in mind that the Financial Stability Facility isn’t funded yet, let alone the ESM, so in reality there is not yet actually any money there to fund these bailouts.
Aye: So why is the euro still so strong?
Nick: Don’t underestimate the drive of the political elite in Europe. They have invested so much in this project over the last 30 or 40 years. They won’t allow it to fail, even though it will probably mean a big transfer of wealth to those three countries.
Marcus: But look at the True Finns – they’ve just got 19% of the vote. That’s the right wing of Europe kicking back.
Nick: That’s inevitable. But there is just so much political capital invested – there is no way these guys can let the gravy train stop.
Aye: Could the euro’s strength be down to the Chinese selling out of the dollar?
Marcus: The Chinese are clever. They’ll probably be moving assets out of US Treasuries. But they’re putting it into physical assets in the States – not buying an expensive currency in a slowing economy. Sure, they bought some Portuguese bonds, but if you look at what they have overall, they are underweight Spain and Portugal and all of those things. They’re just tinkering – it’s pure politics.
John: Getting back to America – could we be underestimating its recovery potential? US house prices look cheap now. If that market finally bottoms out, do they really need QE3?
Aye: The US housing market is definitely the last part of the jigsaw puzzle. But the problem is unemployment, which is at 8% or 9%. Banks aren’t being quite as strict in terms of credit standards, but if you haven’t got confidence, and you can’t find a job, and you have just come out of one of the worst housing market recessions ever, you’re not going to feel like taking out a mortgage.
Marcus: Plus they have this incredible blockage in the system. This mortgage foreclosure crisis means the banks really don’t want to lend because they’ve got such an overhang of property and such a potential legal burden.
Nick: Politically speaking, the authorities are too scared to allow the housing market to clear because it will clear at much lower levels than now. Sure, if they keep undermining the currency and housing becomes even cheaper, then America will have a big competitive advantage once the market does clear. But I can’t see it happening this year.
Marcus: But then, that’s where the real money is made. Absolutely no one can see it going any way but down, and there is practically no means for those people who want to sell to do it. Yet you’ve also got the very cheap cost of funding. Hedge fund manager John Paulson has done well throughout this crisis – he’s got gold and a lot of Californian property. Of course, you’ve got to buy where you see the value. Detroit may not be the place to look, but certain parts of the coast will do well. I think over the next three to five years you could double your money, maybe more.
John: We must look into that one a bit more. Where else would you invest just now?
Marcus: We’re mainly looking at high dividend, free-cash-flow-producing companies that make things which have a sustainable future, without government interference or reliance on government contracts. Telcos are an example. I like France Telecom (Paris: FTE) and China Mobile (HK: 941) – over 595 million subscribers. Elsewhere, I still like BP (LSE: BP), which is a bit brave.
John: That is very brave. But how did they mess up Russia so badly? Why announce the deal before they had it nailed down?
Marcus: It doesn’t work like that in Russia. It’s about who has the biggest stick at the time. But if Vladimir Putin sees BP walk away from the Russia deal, he will make sure something comes in to sweeten it. Also, BP’s shareholders want to sell a lot of its assets at what are very reasonable prices, so I think the share price is pretty well underpinned. Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT) should continue to do well. They might get a bit of a knock because commodities look overvalued just now, but they’ll come back.
Nick: I have three very specific investment trust tips. The whole funds of hedge funds area is having an ‘Emperor’s New Clothes’ moment. They charge huge fees, they didn’t defend on the downside when the markets crashed, and they haven’t performed on the upside in the rebound. Everyone has had enough. And that’s why you should buy them. They’re trading at big discounts – typically, you are buying 100p worth of assets for 80p – and in most cases, they’re going to be wound up and the money returned to shareholders.
One I’d suggest is Thames River Multi Hedge (LSE: TRMA). About a month ago the board said it would not be in shareholders’ interests to hand their money back. Then, two weeks later, the board said, “Actually we’ll have a vote on whether we continue to exist”.
Marcus: So you are voting for death.
Nick: Yes. And it’s still trading on a 15% or so discount to net asset value [NAV]. Another opportunity is Greenwich Loan Income (LSE: GLIF), a leveraged fund of collateralised debt obligations (CDOs). Investors are terrified of leveraged CDOs, so its assets are about 77p, while the share price is 40p.
But the way I see it is that any leveraged loan fund that was around in the fourth quarter of 2008 and is still around now has been through the mother of all stress tests. It pays 1p a quarter in dividends and that’s after the manager has taken 2% of gross assets. There is a discussion to be had over the level of these fees which leaves potential to up the dividend quite substantially. And there is a UK small cap fund run by Schroder Ventures called Strategic Equity Capital (LSE: SEC). It only survived last year’s continuation vote by agreeing that every year it will be tested to see whether it has outperformed its peer group. The test happens between April and the end of June. The thing is, everyone has a bad year, so at some point it will fail. When that happens, you get the NAV (which is currently around 99p), not the share price, (which is about 87p).
John: Pau?
Our Roundtable tips
Investment Ticker France Telecom FP: FTE China Mobile HK: 941 BP LSE: BP Rio Tinto LSE: RIO BHP Billiton LSE: BLT TR Multi Hedge LSE: TRMA Greenwich Loan LSE: GLIF 4 Strategic Eq. Cap. LSE: SEC ETFS Palladium LSE: PHPD Kraft NYSE: KFT Siemens DAX: SIE Tullow Oil LSE: TLW AMEC LSE: AMEC Xstrata LSE: XTA Sumitomo MM JP: 5713 Japan Steelworks JP: 5631
Pau: Palladium is very interesting. Although it’s a precious metal, it’s not what you’d buy to protect against currency debasement or hyperinflation. But it’s still a good story. On the demand side, emerging markets need it as their industries modernise. The supply side is easy to understand: most palladium comes from Russia stockpiles or South Africa. So you don’t have to monitor many things to make an informed bet. You can buy it via a physically backed exchange-traded fund, such as ETF Securities Physical Palladium (LSE: PHPD).
On equities, I agree with Marcus. You’re looking for free cash flow and high dividend yields. You also want some indirect exposure to emerging markets – but not direct exposure, because emerging markets are tightening right now. Just because a country is solid from a fundamental perspective, that does not mean its equity market will perform. That tends to lead you to defensive global conglomerates that will benefit as and when our currencies devalue against those of emerging markets. Investors often see these as being solely US firms, but when you look at their earnings, the main source of growth is Asia. There’s names like Kraft (NYSE: KFT) in the US, and in Europe firms like Siemens (Dax: SIE).
Aye: I like the energy sector. You’ve got integrated oil companies – ‘big oil’; the explorers; and oil services firms. I’m not keen on the integrated companies – they have a lot of problems with volume growth. But BP (LSE: BP) is the exception. Even with Russia, the risk premium in BP is too high. So I’d have it in my portfolio.
But my preferred way to play oil is via the explorers, specifically Tullow Oil (LSE: TLW) and the oil services guys – such as AMEC (LSE: AMEC) in Britain. Materials is also an interesting area. The sector is tricky, in that it’s driven mainly by China, so you have to be very selective. There is a lot of scrap copper coming into the marketplace just now, but I remain a great fan of the metal despite these juicy prices and believe we will see supply problems. To play copper, I like Xstrata (LSE: XTA), which is also interesting because of Glencore’s large stake in the company.
Marcus: No one has mentioned Japan yet. I’m a bit of a “sell in May and go away” kind of guy at the moment, but Japan is so close to rock bottom – I think the floor on the Nikkei now is 8,500, probably even higher – your downside is very limited.
Nick: I know what you mean. Japan is a trading market, not a buy-and-hold market. Shareholders are well down the pecking order and that won’t change – it’s a naturally socialist society. However, you tend to get these trading opportunities every five years or so, and I think one is coming up. That’s because Japan is also a very consensual society and after a natural disaster, it’s easier to build a consensus and push through reforms.
Then what happens is that some people in the Western markets say: “The Japanese are finally getting Western-style capitalism!” – and they start buying. As it’s the Western investor who decides the direction of the Japanese market, that creates momentum. Because most investors are underweight Japan, they start to hurt, so they close those positions, you get a lot more buying of Japan, and up it goes.
Marcus: I think this quake is far more fundamental than a lot of people realise. I think inflation is coming and the sales tax is going to rise – there will be a wholesale change. Does that mean higher values for equities? When it’s all over, very possibly. I mean, I’m hugely bearish on certain situations. I think the supply chain problem is worse than anyone’s saying, so Korea and Taiwan will get a longer-term leg up and Japan will suffer a permanent loss of GDP. I also think the nuclear situation is far worse than is being admitted. When the wind changes and Tokyo radiation levels rise, there will definitely be a scare factor. But when that hits, maybe it’s a chance to invest.
John: Have you got any specific plays that you’d recommend?
Marcus: Sumitomo Metal Mining (JP: 5713) has the largest copper foundry still working in Japan. I believer that will continue to do well. And there’s Japan Steelworks (JP: 5631), which makes all the vital plumbing for nuclear reactors. Nuclear power stations will need these big companies to come and sort their problems out. Companies will start to make more money from that demand and from maintenance and repair of reactors than they ever will from building new ones.