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’s your take on S&P’s writedown of the US?
Tim Price: It feels like a bit of a sideshow. Poor old Warren Buffett has been wheeled out like a member of the Politburo to say: “Not only is the US a triple-A, it’s actually a quadruple-A”. Oh dear. The US has too much debt; it’s the largest debt market. Get over it.
John: So what’s behind the recent volatility in markets? Europe?
Andrew Beal: It’s about policy credibility. The market is throwing its toys out of the pram and screaming to policymakers to do something. Every time the Europeans try to do something, it’s incredibly underwhelming.
John: But to take the Austrian economists’ view – that if you have a big credit bubble then you just have to endure the bust – is there much they can do?
Andrew: If you look back at the Asian crisis, that’s exactly what happened. Most of the economies suffered a pretty vicious mark-to-market; huge losses were crystallised, and economies fell off very quickly, but they then recovered rapidly too. The big difference for Asia was that you had massive competitive devaluations and you had the rest of the world to export your way out. That doesn’t seem to be so much of an option for the West.
Our Roundtable panel
Managing partner, Armstrong Investment
Andrew Beal
Portfolio manager, Henderson TR Pacific Investment TrustTimothy Hay
Lead manager, Somerset Capital ManagementTim Price
Director of investment PFP GroupJames Syme
Senior fund manager, JO Hambro Capital Management
Patrick Armstrong: In the eurozone, they will inevitably get the bailout fund to €1.5trn-€2trn, which will be enough to give the market confidence in Spain and Italy. That will lead to a eurobond and fiscal integration across the eurozone. The markets will keep pressing until that happens. It could take six months or three years. But as long as Germany wants the eurozone, that’s what will happen.
Tim: I’m not so sure. Just about everything that is happening in the eurozone is against democracy and whatever laughable construct the Maastricht Treaty was all about. I’m not convinced German voters will stand for it indefinitely.
John: What about this idea of Britain as a safe haven? Should we buy gilts?
Patrick: Not me. Retail price index (RPI) inflation is running at 5%. It’s probably going to hit 5.5% over the next three months. UK gilts yield 2.6%, so they could destroy 3% of the real value of your wealth. The end game for all governments and central banks in the West is to monetise the debt, because that’s an easier option than growth-destroying austerity measures.
John: Have you got gold?
Patrick: Yes – it’s harder to create gold than it is to print money. We’re not buying gold right now, but I don’t see a scenario where we will be selling, even if it’s up a few hundred dollars from where it is.
Tim: I don’t disagree with the monetisation point, but do you think there is a possibility that the West just continues turning into Japan?
Patrick: Of the US’s $14.3trn of debt, $7trn is owned by foreigners. That’s the difference between America and Japan, I think. Japan is owned by people and corporations in that country, whereas destroying the value of the dollar results in a net wealth transfer to every American citizen.
John: At what point would you sell gold?
Tim: When there’s tangible evidence of brain activity on the part of Western politicians. So I think that’s a good few years away.
Patrick: When we see positive real yields on bonds, that’s when we’ll get worried about gold.
John: What if the Federal Reserve just bites the bullet and raises interest rates?
Tim: America can’t afford high rates.
Patrick: The deficit balloons if interest rates go up – it becomes unmanageable. Federal Reserve chairman Ben Bernanke has an elegant solution: create inflation, say it’s transitory,and that it’s going to disappear next year. That’s how you destroy the real value of your debt. You don’t create real economic growth, just nominal growth, and all of a sudden debt-to-GDP stabilises without any real economic growth. Bank of England governor Mervyn King has been doing it for two years now. Every three months he says: “inflation is 5% – but don’t worry, this time next year it’s going to be 1.5% to 2%”.
John: Can Asia decouple from this turmoil in the West?
Andrew: You need to differentiate between economies and equity markets.
With the recent flare-up, correlations are back to one [ie, everything falls together]. But if you look at the fundamentals, Asia’s problem has been one of too much growth, not too little – worries about overheating, inflation, etc. So a bit of softness in exports and commodity prices is probably just what Asia needs. Yes, a severe slump would have a negative impact. But if this is about a sub-par recovery in the West and no worse, that seems relatively positive for Asian economies and, ultimately, Asian equities.
James Syme: Remember that lower growth and commodity prices will have a markedly different impact on different countries and their equity markets.
Timothy Hay: Yes, Brazil faces some serious headwinds, and not just from commodity prices. Sure, 40% of its index is commodity-related but I don’t think the central bank is ahead of the curve on inflation, or that the government is willing to cut spending, or is really in control of what is happening. Up until Monday last week, Brazil was one of the most expensive emerging markets.
Tim: It’s down 30% this year.
Timothy: I don’t really see any catalyst for it to get out of the hole it’s in. The central bank rate in Brazil is 12.5% and inflation is at 6.5%, so investors assume that everything is OK. But the rate consumers actually pay on their new
television or their mortgage is 6% or so – it’s lower than inflation. If you talk to Brazilians, they are using one credit card to pay off another. I’ve seen that film before and it doesn’t end well.
John: Asian currencies have been a one-way bet for a while. Will that continue?
Andrew: Outside Japan, the economic fundamentals for Asia look reasonable. You don’t have the issues with leverage or government debt that the West has. So why shouldn’t the currencies continue to rise? Also, the Asian model has been to keep currencies cheap and sell cheap stuff to Americans. That doesn’t work anymore. They need to get control of their domestic economy and domestic interest rates. The way to do that is to let their currencies float. If they did that, we think they would strengthen further.
John: Do you think China will float the renminbi any time soon?
Andrew: No. They’ll do what bureaucrats the world over do and move within a very narrow targeted rate.
Tim: But they’ve been widening the peg?
Andrew: Yes. They have allowed the currency to appreciate quite a bit since moving to a more flexible system in 2005. I think they will continue to do so. But you won’t wake up one morning and find they’ve moved it 20%. That’s not the bureaucratic mindset. The bigger picture is that Asian policymakers have realised that Americans and Europeans cannot buy any more cheap stuff. They need domestic markets for these goods.
James: One thing must happen eventually: the Hong Kong dollar can’t stay pegged to the US dollar if the Americans keep doing what they are doing. Whether they will follow a basket of currencies, or peg it to the renminbi instead, I don’t know. But using the US dollar as a benchmark looks increasingly less credible. The day they come off it will be a major sign that America has entered the next phase of its huge cycle of history.
Andrew: As a Hong Kong resident you can shift Hong Kong dollars into renminbi, so big balances of renminbi are building up. It’s not a huge leap to imagine the renminbi starting to be accepted as currency in Hong Kong: informally, it already is. It’s a good hard currency to own, particularly if the alternative is the Hong Kong dollar or the US dollar.
John: Are you worried about a crash in China?
Andrew: There are certainly some massive misallocations of capital. If, as the bears envisage, that continues without any adjustment, then you could build up some nasty imbalances. But I’m more bullish. Over the last 20 years the Chinese system has shown it can adapt. As an economy overall it has added a lot of leverage over the last few years. But the last two years have been all about trying to control and manage that credit growth, and they are showing signs of being reasonably successful in doing so.
James: It’s tempting to look at the symptoms and then diagnose the same illness that gave rise to those symptoms in the West. But it’s not the same. Its very high savings rate is a structural strength. China isn’t dependent on external capital to keep itself going in the way that Spain, South Africa and probably now Brazil are. It’s not just producing low-value-added goods or commodities – the economy is going up the value-added curve rapidly. As for this fear over loans made by banks to local governments,I don’t think the fundamentals point to a banking system blow-up. I can’t believe the gradualist Chinese will turn round to banks and say: “You broke it, you own it – good luck”. It’s inconceivable that they would risk the social effects of any kind of problem in the banking system. This isn’t to say there aren’t any horrible misallocations. But the idea of an Irish-style banking/property bust in China next quarter is not credible.
Timothy: As China moves up the value chain, that also offers opportunities for smaller markets, such as Vietnam and Bangladesh. Even in Mexico, you are seeing the maquiladoras [export assembly plants] benefit as people like Cessna look at China and decide that, given wage inflation, industrial relations, respect for intellectual property rights and the cost of transportation, they can put a factory in Mexico and produce at a cheaper cost than in China.
James: There could be losers too. I can’t see why bulk carriers – ships – are still built in South Korea. It’s a metal box with an engine in it and a house on top – China has loads of steel, loads of cheap labour and loads of coastline. South Korea should perhaps be building the jack-up rigs and the gas carriers, the complicated stuff. But something as basic as that, which as a business moved from Japan to South Korea decades ago, that should be moving on, at least to China and maybe even to the Vietnams of this world.
John: So, what will be left for the West?
James: There will be some flow back the other way. It’s hard to play as an investment, but the rise of the emerging market tourist is going to be massive over the next 20 years.
Andrew: It’s a theme we’re playing quite aggressively in Asia.
James: If you go to St Mark’s Square in Rome in 20 years’ time, the make-up of the tourists will be different. Just as we saw the rise of the Japanese tourist during Japan’s boom, so as China, India, Russia, the Gulf, and Brazil get richer and their currencies strengthen, their citizens will look at Italy and think: “Given what the euro has done against my money and given that I’m getting 5% real wage increases every year – why don’t we go to Rome? It’s so cheap!”
Andrew: There’s finance too – all the things London does well. The trouble is, they don’t employ vast numbers of people.
Tim: There is a case for the small band of Western, or even British-based, industrial businesses that produce goods that these countries are using. Here at least you’ve got more robust intellectual property defence and accounting and corporate governance standards. So having exposure to businesses that are nominally British but in reality sell to emerging economies seems to me like a great compromise.
John: So – most important question – what does this mean for UK house prices?
Tim: Thumbs down.
John: But will inflation do the job, or will there be a plunge in nominal prices?
Andrew: I buy into the idea that we are all a lot poorer, but will only realise it over the next ten years as the things that we believe make us wealthy underperform inflation. Property is one of them. So, real price depreciation, but not nominal.
Patrick: Unless Mervyn King starts following his mandate and raises interest rates in line with inflation, you could see property prices tank.
John: Let’s move on to share tips.
Our Roundtable tips
Investment Ticker Wealthy Nations Bond Fund n/a Cen. Fund of Canada TSX: CEF/A Kazakhmys LSE: KAZ SABESP NYSE: SBS CCU NYSE: CCU FEMSA NYSE: FMX HDFC Bank NYSE: HDB Baidu Nasdaq: BIDU Randgold Resources LSE: RRS iPath Vix US: IVO ProShares Treas NYSE: TBT Lyxor Dividends LSE: DIV Gome HK: 493
Tim: My broad-based themes include buying high-quality government debt through a fund like the Wealthy Nations Bond Fund (contact Andrew Clark, Stratton Street Capital, 020-7766 0888), and gold and silver bullion through the Central Fund of Canada (TSX: CEF/A). I see how cheap markets like Brazil and Russia have become, they’re on single-digit price to earnings (p/e) ratios. On specific stocks, I did a quick screen of the FTSE 350, and mid-cap resources businesses are once again very cheap. For people who like to live on the edge a little, there’s Kazakhstani copper miner Kazakhmys (LSE: KAZ) on a forward p/e of four, an Altman Z-score of nearly five, and dividend cover of nearly 12.
Timothy: I think you’re on dangerous ground in Russia. If you buy shares in a company that does relatively well, then the Federal Security Service (FSB) or one of Putin’s cronies is going to come knocking on your door demanding 50% of your firm. It’s the Wild West there.
John: So where would you invest?
Timothy: I like SABESP (NYSE: SBS), the Sao Paulo-based water firm in Brazil. It trades on six-times earnings with a yield of over 4%. It should benefit from a change in its tariff structure, which will allow it to make a return on its much-needed investment programme. Elsewhere in Latin America, CCU (NYSE: CCU) in Chile has suffered from rising input costs. But it has 85% of the beer market in Chile, as well as a strong wine division and a good beer division in Argentina. It had come off a long way before the crisis and it’s come off a bit further now. But people are not going to stop drinking beer – if anything, they will drink more.
One firm I really like, but which is not valued quite as attractively, is Mexican beverages conglomerate FEMSA (NYSE: FMX), which has the Coca-Cola franchise. It also has a phenomenally good convenience store brand called OXXO, which now has 9,000 stores from a base of 2,000 three or four years ago. It is gradually expanding through central America into Columbia. You can pay your gas bill in the store, and it has tie-ups with the banks, so it’s looking at taking deposits too. It’s a bit expensive now, but I’d recommend it for the long term.
James: We like HDFC Bank (NYSE: HDB) in India. It’s a proper bank, such as we used to have here a long time ago, with a big branch network, and a loan-to-deposit ratio of 77%. It takes deposits, then lends at an interest rate where – even when you write off its small level of non-performing loans – you’ve got money left over. Within the Indian banking sector it looks incredibly strong, and well run.
A bit more post-watershed is Baidu (Nasdaq: BIDU). It’s basically the Chinese Google – it makes money from advertising revenues. Since Google gave up trying to compete in China, it’s got an 80% share of the Chinese search market. I’m sure competitors will claw that back from 80% to 60% in, say, three to five years’ time. But if you look at the explosion in mobile search with Google, and then at the way smartphone sales are trending in China, the market will be so vast by then that it won’t matter. And remember that the Chinese government does not want to give up control of internet, television and telephony to foreigners. So you could never replace the position Baidu is in now. It looks expensive; it’s sold off down to 30 times next year’s earnings. But look again at Google: it has as many daily searches now as it was getting a month in 2004, and a lot of that has come from mobiles.
Andrew: Baidu is now one of our largest positions.
James: My third tip is a gold miner with growing output, Randgold Resources (LSE: RRS). It’s one of the best-run firms I’ve ever come across. Its main producing assets are in Mali; it’s also got a rapidly-growing mine in Côte d’Ivoire and assets elsewhere. Next year it will probably produce a million ounces of gold at a cash cost of around $600 an ounce. Two years after it should be up to about 1.5 million ounces at a slightly lower cash cost.
John: What about you, Patrick?
Patrick: Shorting the volatility index (VIX) makes sense now. It’s just a mean-reverting index. The VIX is at 33 today. That will fall towards 20 in the next few months, as central banks and policymakers make everyone feel happy again. Barclays has a listed note, iPath Inverse Jan 2021 S&P 500 Vix Short-Term Futures ETN (US: IVO) . It is short a rolling one-month VIX futures contract. Of course, if the VIX goes like it did in 2008, you could lose everything you’ve invested. But anytime the VIX hits 40, we think it’s a good time to sell.
We are also short US government bonds as of today. Retail investors can do that through the ProShares Ultrashort 20-Year Plus Treasury index (NYSE: TBT). It’s quite volatile, but we think inflation is going to be the end game for Western central banks and governments. With ten-year bond yields at 2.2% or so, it’s a good time to be shorting the bonds that everyone else is panicking into.
The other is implied dividends on the Euro Stoxx 50 index. This year’s dividend yield is over 5%, based on the index value of 2,315. Looking ahead to 2015, the market is currently pricing in that dividends will fall by 9% a year, every year for the next four years. Even if you assume every bank and financial stock cuts its dividend and never pays again; that every cyclical stock cuts its dividend by 50% and never grows them again; and that healthcare, consumer staples, telecoms, and energy stocks just maintain dividends and never grow them, you still get a dividend of about that level.
A retail investor can buy in using an exchange-traded fund (ETF) called Lyxor ETF Euro Stoxx 50 Dividends (LSE: DIV). It doesn’t give you the 2015 dividend; it gives you an equal rating in the next five years’ dividends, but each of them is below fair value in our opinion.
Andrew: I’ve already mentioned Baidu. I also like electrical retailer Gome (HK: 493) in China. It has a chequered past: it had a corporate governance blow up about two or three years ago. But Bain Capital has come in, and the board has been shaken up. They have completely restructured the store format and spun out underperforming ones. It trades at a deep discount to the rest of the sector too. The big picture is that China is building ten million or more social housing units a year over the next few years. Those will need TVs, air conditioners and so on, so the overall market is growing very fast.