John Stepek: Today we’re focusing on Europe – what’s going to happen next?
Pau Morilla-Giner: It’s always hard to tell with politicians – they don’t necessarily care about the economics, they want to be re-elected first and foremost, so it’s hard to second-guess them. But I think Germany is waiting until the last minute before it will say there is no option left, other than to do some sort of collective pooling of liabilities for Europe. It’ll probably extract a price for that from some of the other governments in the form of specific fiscal measures. Up until that happens, expect more volatility.
Julian Pendock: What we need is good old-fashioned creative destruction. If you take it back to nature, when people try to prevent forest fires from breaking out, they just end up creating a huge tinder box, so that when a fire does eventually start, the flames leap out of control and you have a big problem. In the same way, by trying to stem the natural ebb and flow of business cycles, central banks and politicians have allowed huge problems to build, and now they are wasting time, money, and credibility trying to sort them out with short-term fixes.
Electorates are not as dumb as people think. They see that QE [money printing] raises the prices of commodities and doesn’t fix anything. It’s time to stand back and let what happened in the Asian crisis in the 1990s unfold: survival of the fittest. Weak companies went to the wall or stronger firms bought them. Only then will you have laid the foundation for a proper cycle that doesn’t rely on the next shock-and-awe policy.
John: Yes, when all this happened in Asia, the International Monetary Fund (IMF) effectively told them to suck it up. Yet now the view is that “democracies can’t withstand such harsh austerity measures”.
Julian: Well, that’s because the Europeans run the IMF – you didn’t have that political conflict of interest in Asia.
Andrea Williams: The real test will come in the first quarter of 2012. Italy has a huge amount of bonds to re-finance. The test will be what the market charges for that. But I don’t believe the euro will break up. The consequences would be too horrendous. I think that ultimately the only way out is for the European Central Bank (ECB) to print money.
Our Roundtable panel
Global strategist, Société Générale
Pau Morilla-Giner
Director of equities, commodities & alternative investments, London & CapitalJulian Pendock
Founder and CIO, Senhouse CapitalAndrea Williams
Manager, Royal London European Income Fund, Royal London Asset ManagementChris Wright
Manager, Premier European Optimum Income fund, Premier Asset Management
Dylan Grice: I agree with all of this. We’re coming off the back of a 30-year credit inflation. This idea that there has been a great moderation and that central banks should be applauded for maintaining price stability is nonsense – there has been inflation all over the place, it’s just that’s it’s all been outside the consumer price index. And today we have the balance sheets to show for it – we are completely over-indebted.
Logically, following a 30-year credit inflation you need a 30-year credit deflation, but that’s not a vote winner. So I think the ECB will be forced to print. That’s not to say that I think it should print – printing money is not a solution for anything – but it buys politicians more time, so my guess is that’s what’ll happen. However, I do still think there is potential for a euro break-up, because you have a delicate situation and someone might just mess it up. You can easily see a scenario where the Germans overplay their hand.
Andrea: But the whole legal framework of a euro break-up – all those contracts written in euros – is just a nightmare.
Dylan: That doesn’t mean it won’t happen. I don’t think it’s likely – the ECB will probably come up with some kind of funding operation to stem the flow. But even then, they’re not going to do unlimited QE. They may fund an IMF-type rescue mechanism, which will still impose a depression on the rest of Europe. You might stem the panic, but you’re still not out of the woods.
Andrea: But the longer they leave it, the bigger the issue becomes. They should have nipped it in the bud a year ago. Now the markets are frozen and banks can’t finance themselves, so the key is to get that bond yield down in Italy and Spain. The only way to do that is to commit to putting up whatever money it takes to get confidence going again, which then becomes self-fulfilling.
John: But even if the ECB prints money, Greece is clearly insolvent. What do you do about that?
Andrea: Greece is a unique situation, though. It should never have been allowed in. Spain had a housing bubble and it has to make adjustments to the banking system. But at least there’s a tax system that works. Yes, it’ll be painful, but there is a way forward based on pension reforms and labour market reforms.
Chris Wright: As for Greece, you do what’s already being done. You appoint technocrats. You stop democracy.
John: Surely people will start to get a bit upset if that continues for long.
Chris: Well, it will be presented in a much gentler manner, but democracy has failed to create a sustainable tax-paying society in Greece, because they are not prepared to do it. Put it this way – it’s much easier to have a technocratic government than to find a mechanism for leaving the euro.
Dylan: I don’t think there will ever be a formal mechanism for leaving the euro. What will happen is that you won’t be dealing with the Greek technocrats, you’ll be dealing with the mob, who will just take control. They’ll say: “We are not giving you your money back and we are setting the exchange rate for drachmas into euros at ‘x’ and the central bank is going to print 100,000 drachmas.” The treaties and legalities won’t matter – history is just a long list of broken treaties, after all.
Chris: But then their banks go bust.
Dylan: Yeah, but then they’ve got two things in their favour: capital controls and a printing press.
Chris: But these days you can move capital just by pushing a button. The money might all be gone in half an hour.
Dylan: You do have to do it before people cotton on to the risk.
Chris: It’s not going to happen. I still believe there is no mechanism for leaving. What we really need is for the banks to admit they’ve got it very wrong. We need half the French bank system to be recapitalised, and the Spanish.
Julian: I completely agree. Deposits sitting with the ECB keep going through the roof because the banks just don’t know how bad their own balance sheets are. So it’s time to show and tell – clear it up, then let confidence come back.
Chris: And then we’ll have creative destruction occuring more rapidly.
Julian: A lot of this goes back to politics again, rather than economics. People don’t like vulture funds, but they perform a very necessary role. The hedge funds want to buy assets off the banks, and the banks want to de-lever – but politically, the banks can’t be seen to be handing hedge funds profit on a plate. So they aren’t discounting these assets enough to interest the hedge funds, and you’ve got stalemate.
Chris: But the banks can work through this – they worked through the Latin American debt crisis in the 1980s.
Dylan: They had a massive wave of credit inflation behind them back then though.
John: Let’s assume the ECB does print. Will stocks rocket?
Chris: For about 15 minutes.
Andrea: I think the printing needs to be coupled with ‘fessing up’ by the banks.
Pau: I just don’t think the ECB will do it unless Germany has enough evidence that other countries are falling into line.
Julian: But remember that the streets of Berlin are hardly paved with gold either – their debt-to-GDP ratio is about 80%.
Dylan: And if you look at all the stuff that’s off-balance-sheet as well, from financial sector contingent claims to unfunded pension promises, then the whole continent is bust. This idea that Germany is incredibly solid is just nonsense. A full percentage point of Germany’s GDP growth over the last 12 months has come from the Chinese credit bubble, which looks like it’s about to crack and unwind. So I don’t think the Germans can be quite as sanguine as everyone makes out.
Julian: Yes, the Chinese and the Japanese are giving up on their bunds as well as other European government debt.
Dylan: This is why, ultimately, the printing press will be used as a political sticking plaster. It’s the only way you can get new capital in – although that’s a total abuse of the word ‘capital’.
Andrea: Yes, she’s walking a thin line, Merkel. She wants the bad boys to take their medicine. And they’re taking it. She’s got a technocratic government in Italy and Greece and a change of government in Spain. But she doesn’t want to push it too far or she will send it over the edge. So I just can’t see any other solution.
Julian: But I don’t think it’s a solution. The euro was supposed to make economies converge; it made them diverge. People say moral hazard is not relevant. But it’s more relevant than ever. We can hope to prevent revolution in the short term by using the printing press. But it’s hard to say, “get stuck into equities”, because the problems are still there. If they allow proper restructuring, that would be the most exciting time for investors.
Pau: But as fund managers we need to deal with what will happen, not what should happen. I agree: take the pain now, have maybe five years of misery, but sow the seeds for success. However, politically, who is going to do that?
John: So where is everyone investing?
Pau: There are two main dangers for equities. One, growth is going to be at best anaemic, at worst horrible. Two, credit availability is going to become a big issue. As deleveraging continues, small and mid caps will suffer. So for us it’s all about defensive sectors like healthcare or consumer staples. Stocks with no leverage, high levels of income and indirect exposure to growth in emerging markets – meaning very large multinationals that have at least 50% of their net income in these markets. In the pharma sector, AstraZeneca (LSE: AZN) has all these properties. And in consumer staples, Diageo (LSE: DGE) and Procter & Gamble (NYSE: PG). All have resilient revenue streams, low financial leverage, high dividend cover, fantastic income generation abilities, and are well-positioned to profit from growth in emerging markets.
John: What about gold?
Pau: Everybody asks me: “Is gold in a bubble?” I think not. Gold is a mirror of what’s going on in other markets. If you have bubble-type growth in the monetary base, gold will reflect that. It’s an alternative currency at the moment, and it will continue to trade like that, particularly if Europe joins the printing press fraternity. But it’s going to be as wild a ride as it gets because now everybody and their mother is investing in these gold exchange-traded funds.
Dylan: Are they? What is the ownership of gold? Most people I know don’t own it. That’s been changing over the last few years, but we’ve come from an absolutely vicious bear market in gold. So far all you’ve seen is a rediscovery of the value of an under-stocked medium of exchange, and that’s all. I think it is very far away from bubble territory.
Chris: But we’re all talking about the break up of the euro and how it’s all going wrong. If we’re doing it, everybody is. It’s all over the FT. Why isn’t gold going up?
Julian: If it’s in the press, it’s in the price.
Chris: It’s been in The Sunday Times – it’s past being in the press.
Dylan: In 2008, gold got hammered. When I write about gold, one of the common replies I get is: “It has no intrinsic value, it’s useless. I can understand why you might buy copper or oil or grain, but gold doesn’t mean anything.” I think this represents a fundamental misunderstanding of the importance of a medium of exchange. As a species our defining characteristic is that we trade with one another. If you are going to trade with one another, you need to have a reliable medium of exchange.
Julian: But I think where the exchange argument falls down is that, if we get to a stage where paper currency is no longer accepted, then the chances are the shelves at Tesco’s will be empty because the system has broken down. At that point, waving a lump of gold at people is not going to do a lot of good.
Dylan: There is no such thing as a perfect currency. In fact, on pretty much any metric you choose, paper currency wins hands down in terms of being the ideal store of value – you try buying a Mars bar with gold. The one drawback is that paper currency is controlled by central banks – and we’re moving into a world where that can be a pretty big drawback. So there’s no such thing as a perfect currency – if you’d bought gold in 1980 and held it for 20 years, you’d have been broke. But there is a time and a place for every asset, and my judgement is that this is a good time to own some gold.
John: What would you buy now, Julian?
Our Roundtable tips
Investment Ticker AstraZeneca LSE:AZN Diageo LSE:DGE Proctor & Gamble NYSE:PG Nestlé VX:NESN Zodiac Aerospace FP:ZC Piaggio IM:PIA Novo Nordisk DC:NOVOB Casino FP:CO Neopost FP:NEO Handelsbanken SS:SHBA Pepsi NYSE:PEP Microsoft Nas:MSFT Intel Nas:INTC Anheuser-Busch BB:ABI DNB Nordic NO:DNB Novartis VX:NOVN WPP LSE:WPP
Julian: Most people are either out of Europe now, or shorting it. I was speaking to a US fund manager last night. He said they’ve just given up. “This guy Berlusconi, what’s up with that?” They can’t get their heads around it. So it means there are great global companies available in Europe often for a lot less than their US peers or emerging-market counterparts.
Nestlé India for example, trades on 44 times earnings, with a 0.5% yield. Whereas Nestlé Global (SIX: NESN) is on 15 times earnings with a 4% yield. While these staple companies look boring, they’re not, because it’s the economics of distribution that count, not what happens to input prices. So with emerging-market growth, profits can go up fast as revenues rise and you start to offer the more expensive things in life – Haagen-Dazs ice cream and the like.
Then there are a couple of stocks that show you don’t have to be big to be a leading niche player globally. There’s Zodiac Aerospace (Paris: ZC), for example. I’d never buy airlines because, in most cases, their core competence is destroying shareholder value. But by buying Zodiac, the airlines’ crazy capital spending becomes your revenue, because they outfit all the aircraft interiors. One last firm I always mention is Piaggio (Milan: PIA). It makes Vespa scooters. In 2006, its biggest market was Italy. Now it’s India, and it is making inroads into Indonesia and has opened a second factory in Hanoi, to keep up with demand in Vietnam. It’s an iconic brand – the firm is small, but global. So Europe is not all doom and gloom – and even Italian companies can be very well run.
Andrea: As Julian says, you want to maximise your emerging-market exposure. There’s Novo Nordisk (Copenhagen: NOVOB) in the drug sector. Obesity is becoming more of a problem globally and its diabetes franchise has a very strong market position. Casino (Paris: CO), a French food retailer, makes 50% of its profits from emerging markets – mainly Brazil, where there is decent wage growth.
I am screening companies for where I think earnings forecasts are too optimistic. Many analysts are not assuming any slow down in revenues, yet we saw that happen to many companies in only 2009. Take Neopost (Paris: NEO), a French franking machine company. That’s on eight times earnings. If you put some stress on the top line, that goes up to ten, which is still not expensive. They are also gaining market share in the US and product upgrades are continuing.
I am not too defensive as I feel that global GDP growth is still reasonable. I do own utilities and telecoms, but I fear a tax hike for some of these companies in cases where governments are trying to raise revenues and see them as easy targets. So if you own them, make sure they have strong balance sheets with decent dividend cover so your yield is protected. We are generally avoiding banks, although we do have Handelsbanken (Sweden: SHBA). It is Sweden’s biggest bank and it has a growing operation in Britain. The dividend yield is over 6% and it has a 15-year record of dividend growth.
John: Dylan?
Dylan: Finding stuff that’s cheap is easy – finding something that’s safe too, and so has a higher probability of representing some kind of genuine value, is harder. Right now, our screens aren’t finding much that’s cheap and safe in Europe. I don’t think I’ve ever seen such auniversal consensus against one asset class as there is against financials right now, but I’m still not convinced – mainly because I’m not quite sure how significant this 30-year credit inflation has been. How do banks perform in a world that is deleveraging? I suspect not very well.
I also don’t feel comfortable being too close to government, because I agree that there is going to be a tax grab for wealth, and utilities and telecoms are in the firing line, as are miners. That leaves you with the big international firms. They’re more capable than anyone else of tax arbitrage. They generally don’t need credit inflation and they have robust balance sheets. They also happen to be quite cheap – companies like Pepsi (NYSE: PEP), Microsoft (Nasdaq: MSFT) and Intel (Nasdaq: INTC) in America. In Europe, Nestlé is interesting, as is Anheuser-Busch (Brussels: ABI).
Chris: Of the market cap of Europe, 22% is not euro-based. So there is a lot of attractive stuff out there. Norwegian bank DNB Nordic (Norway: DNB) is very strongly capitalised, and trades on a price/earnings (p/e) ratio of 7, and a yield of 6%. Of all the major drug firms Novartis (SIX: NOVN) has probably got the best top-line growth. It can also take out costs if it ever chooses to do so. British opportunities include advertising group WPP (LSE: WPP) – I’ve never seen it on a p/e so low, generating so much cash. It’s got £8bn in market cap; it’s creating a billion in cash a year. It’s got a billion in debt – it could effectively buy itself back in ten or 11 years’ time.
John: So what about Britain? How long can our ‘safe haven’ status last?
Andrea: David Cameron and George Osborne moved fast to promise adjustments after they were elected, so themarket’s given us the benefit of the doubt.
Julian: But people do seem only to have the capacity to look at one thing at a time. So perhaps by the time the market is done with the eurozone, they might turn their fire on Britain or the States.
Dylan: The one difference is that we have a printing press as a backstop. But ultimately, austerity in the States or Britain is no more popular than in Italy or France. The government balance sheet looks similar. The off-balance-sheet looks similar.
Chris: This raises an interesting point – in theory we say that the ‘safe’ yield is the government bond yield. But when governments are highly indebted and the likes of GlaxoSmithKline, WPP and L’Oréal are not, then why shouldn’t we price government bonds off a safer corporate bond? We had a crossover in yields between equities and bonds in Britain in 1959 and it crossed back over two or three years ago – so why can’t we get a crossover in European bonds, between corporations and governments? It’s got to happen.
Julian: Yes, I remember working in Indonesia when a lot of the companies’ balance sheets were all but bullet proof – cash flows were immense – but the government was bust. Why use a risk-free rate on a bust government when the corporations are fine?