Our experts discuss today’s global economic situation with John Stepek – and tell us where they’re placing their bets.
John Stepek: Let’s start with gold. It has had a brutal fall. What now?
Killian Connolly: We hold gold because we think that more and more money will be injected into the system by central bankers and politicians who see inflation as a way to shrink debt levels. Indeed, we’ve now seen the Bank of Japan launch quantitative easing (QE). We believe that gold tracks the creation of broad money: since 2000, the gold bull market has coincided with monetary inflation, both in terms of base money and bank lending.
So, in fact, the last few weeks have added to the investment case, as far as we’re concerned. Yet both gold and gold miners have plunged. We don’t know exactly why, but we don’t think it’s because there’s going to be less money in the system. So we still think our thesis is valid – governments will keep adding liquidity – and we see it as a buying opportunity.
James Maltin: One problem with gold is that it’s very, very hard to value. You are trying to second-guess central-bank policy – is there going to be more QE, or not? So when you get a big, sharp drop like this, people ask, Where is its fundamental value? And that’s very hard to answer. That’s why it has the potential to fall so quickly. At least with equities, there’s a fundamental valuation you can latch onto. Gold doesn’t have that.
Marcus Ashworth: I think it’s actually reasonably straightforward. You could easily argue that the economic news has been getting worse, and there’s the whole political crisis in Europe. But gold has not been reacting. With QE driving equities and bonds higher, gold just needed something to tip it over the edge – the story about Cyprus possibly selling its gold may have been it.
David Esfandi: You say that the economy has been getting a lot worse. And yes, there’s a lot to worry about. But compare it to where we were six to nine months ago. The US wasn’t delivering on growth, we didn’t know what was happening to China politically, and Europe was a total mess – it still is, but it’s not as bad as it was back then. All three of those pillars of growth are in a better situation today than they were.
Our Roundtable panel
Head of fixed income, Espirito Santo Investment Bank
Killian Connolly
Portfolio manager, PFP Wealth ManagementDavid Esfandi
Managing director of asset management, Ashcourt RowanJames Maltin
Investment director, Rathbone Investment Management
Marcus: Well, possibly the US is in better shape, but even there the recent data…
David: I do think the US will start to disappoint – destocking in Europe will hurt. But the UK is showing some green shoots. In China, the political landscape is more solid than it was, too. Markets deliver when things go from bad to worse, and from worse to ‘okay’. That’s why they are climbing this wall of worry.
John: It’s not just gold, though, is it? It’s oil, copper – most commodities have slid.
Marcus: Yes, you’re getting huge volatility – is that really a good sign?
Killian: Well, maybe we shouldn’t be so afraid of volatility, If anything we should embrace it, rather than keep trying to interfere in the economy and capital markets, to stop prices from falling. For whatever reason, no one is trying to stop the fall in gold at the moment! But we see gold as a currency rather than a commodity, which is why we look at it in parallel to money growth.
Marcus: Maybe you should look at it in terms of Bitcoins!
Killian: There’s no difference between Bitcoins and 97% of what you define as money. A lot of the problems that people have with their perceptions of Bitcoins are problems they should also have with the current monetary system.
John: Let’s talk about Japan. It’s up a lot – can it keep going?
James: I’m not a specialist, but it seems clear that Japan is massively under-owned. People always like to throw money into markets as they start to rise, and anyone who’s missed Japan’s rise is feeling a bit burnt, so no doubt there’ll be people allocating to it rather late in the day. And it is cheap – Japan’s been in a structural bear market for a very long time.
You could argue that the Japanese have been through a lot of the problems that we’re now dealing with in the West, and we’re going to have this possibly deflationary period for some time. Of course, that’s why all this QE is going on.
David: What’s exciting – assuming that we do have a structural shift of money into Japan – is the valuation element. Look at the sheer lack of coverage that smaller Japanese companies have on a global basis. It’s uncovering those midcaps that will be the real opportunity. There are some really good funds that I think will excel, such as the JO Hambro Japan fund.
Marcus: Having lived in Japan, I’m sometimes too close to these things. But technically, foreign ownership of the Japanese market is at levels not seen for years – it’s leapt like a salmon. That’s not to say it won’t carry on and do a lot more, because Japan remains significantly underowned by global funds. But investors are not seeing the risks in the trade. I think the yen will go through 105 and 110 to the dollar, maybe even more. But the stockmarket is due a reality check.
Some very big stocks have been seeing huge swings – two of the largest utility companies moved by 21% and 10% today alone. They’ve bounced on the hopes of the nuclear reactors starting up again in the summer, when they still can’t even collect the water properly at Fukushima. So there’s an awful lot of risk priced into this market.
The new Bank of Japan chief Kuroda surprised everyone, and people have got used to being permanently disappointed by Japan. However, not many people have given much thought to how he is going to do all this QE. You would think that Japanese Government Bond (JGB) yields would have swung lower by now, given that he is planning to buy so many JGBs. But, in fact, it’s gone the other way.
That’s a very, very worrying sign. If the Bank of Japan loses control of what is the second-largest bond market in the world, then whatever else we talk about tonight is irrelevant. Because the wealth system will come crashing down. So I think the market’s got ahead of itself. The Nikkei is cheap by many measures, but we are probably due a correction.
David: A crash or a correction?
Marcus: A correction. That will be a real test for Kuroda. We’ll see what he delivers then. The other problem with encouraging inflation is that every single Japanese person is used to seeing their quality of life marginally improve each year. Their salaries don’t change, but goods become ever so slightly cheaper. This will stop. And when it does, people might start voting against the government. What with rising energy import costs, the sales tax going up to 10% in the next year or two, and all this QE fuelling asset bubbles, you could start getting huge resentment from the Japanese population. The point is, the trade is not all going to be one way.
David: But I don’t think we’ll get a crash from Japan any time soon. These problems will be brewing for the next five to ten years, not one or two.
Marcus: I’m not so sure. I think it’ll either work, or it can go very wrong very quickly. It’s such an extreme experiment – two to three times the scale of what’s happened in the US, or even the UK. We’re in completely uncharted territory.
John: What about the UK?
David: I think we’re making steady progress. I like to look at the terms on loans to real-estate companies. There has been a marked improvement in the last couple of months. Average-sized property companies with good track records are able to borrow at 60% loan-to-value for around 6%. This is the first time since the crisis that UK banks are being aggressive in terms of getting these loans.
James: Is that the ‘funding for lending’ money coming through?
David: It’s tough to say, but I think it’s a sign that people are slowly but surely moving on. It also demonstrates the need for the banks to start generating some income. I’ll not say everything’s rosy, but I’m pretty comfortable about the UK.
Marcus: I agree that the UK is bumping along the bottom, and it’s probably going to be better than some of the data currently suggest. However, sterling has collapsed and we’ve not seen any real jump in the export sector. That is a worry, surely. We haven’t had any of the benefit of having our own currency and central bank. Does that mean we’re going to get Japan-like QE courtesy of incoming Bank of England governor Mark Carney, and will there be more weakness from sterling? And will that have any effect, given that it hasn’t so far?
David: I do think something drastic will have to happen at some point. But things are bumping along, and where that happens there is opportunity.
John: What about the US?
David: I think the US data will start to disappoint, but it will be fleeting. And I don’t think people have quite paid attention to how bad some of the data has become in Europe. Destocking in Italy and France has hit 2009 levels. If – and this is the big if – they manage to pull through, there could be a real scope for surprise in Europe. Money is looking for opportunities in equities, but Europe is where no one wants to go. So we are spending lots of time monitoring the data there to see if that is the next move.
John: Do you think that European Central Bank head Mario Draghi will just print money, and everything in Europe will go off to the races?
Killian: I’m not sure it’s that great to have a weak currency – they say it’s good for exports, but remember that to make a lot of these exports, countries have to import raw materials. So those costs increase as your currency weakens. But the process of weakening the currency also monetises the debt, so maybe that’s why governments are on board with it. Japan now says it’s going to print as much money as possible. So Europe surely has to play ‘follow the leader’.
Marcus: It’s more subtle than that. I don’t think Draghi has got as much freedom as the market gives him credit for. He railroaded the Germans last summer with his ‘anything it takes to save the euro’ speech. And in the last nine months we’ve seen a massive short squeeze in the eurozone.
Everyone was on the wrong side of the trade, everyone was short, and there was a lot of pain. But now Draghi has been boxed in. He can’t lose the support of the Bundesbank [the German central bank] completely, and it’s very evident that the Dutch, Finns and Germans in particular have changed their minds again on bail-outs. They think that they’ve solved the crisis, and so now they can take a hard line with the likes of Cyprus.
What’s scaring everyone now is the prospect that Cyprus might be a template for other bail-outs. If so, you can expect states to take every single last red cent from investors before they hand over a cent of bail-out money.
John: Then I suppose it’s a question of how long it takes before someone walks.
James: This is the reason why, although Europe might look cheap in certain areas, there are huge risks. But at the same time, there are some world-leading businesses within Europe which are not going to be too bothered about any of this.
Marcus: Completely right. But when it comes to where to invest, I think the trump card of cheap energy makes the US hard to beat. We pay four or five times more for energy in the UK than they do in the US. It’s even worse in India and Japan. That hands a huge advantage to America. Natural gas is definitely the fuel of the future and the US is getting a massive head-start. In the short term, the US has plenty of problems and politically anything can happen. But in the longer run, you’ve got to be bullish on the US.
James: But it’s hard to tip the US when it’s trading at an all-time high.
John: So where would you invest now?
Our Roundtable tips
Investment Ticker JOHCM Japan n/a Dollar Fund n/a Rio Tinto LSE: RIO BlueCrest All LSE: BABS St Modwen LSE: SMP Aggreko LSE: AGK Sell Brammer LSE: BRAM Resolution LSE: RSL Tate & Lyle LSE: TATE Dalton Melch n/a Newmont US: NEM Barrick Gold US: ABX
James: Our goal is to preserve the real value of our clients’ capital. We aim to ensure that the money people give us is there should they need it, and to grow it in real terms. We’re looking at non-sterling, index-linked government bonds via the CG Real Return Fund, run by Peter Spiller at CG Asset Management.
It holds mainly US, Swedish and Japanese inflation-linked bonds. It’s done very well and we’re slightly cautious because of that, but it’s been a good investment. It is closed to new money, so we also like CG’s pure Tips (Treasury Inflation Protected Securities) fund, The Dollar fund.
John: Why non-sterling?
James: We’re slightly more bearish on the UK than David, and are happy to diversify out of sterling. And on a trade-weighted basis, the US dollar has until recently been trading at its lowest level since the abolition of the gold standard in the 1970s. That’s changed a bit recently, but it still looks pretty cheap.
Marcus: What yield are you getting? Must be negative just now.
James: Yields in the UK are negative, but if inflation is going to take off and surprise the market, as we think it will, then one should be prepared to accept a small negative yield on the basis of what the market is currently pricing in. On UK equities, the interesting thing is the divergence between shares seen as ‘safe’ and more cyclical stocks. I don’t know when the valuation differential between the two was last as wide as it is now.
John: So safe stuff is expensive?
James: Well possibly; take Diageo. It’s around 18 times earnings. Not so long ago it was at ten or 11 times. That’s not to say that it’s not a very good company. And if you look at what happened in the early 1970s, these sorts of shares were on 40 times earnings and they still outperformed over the next decade. So you could argue that there’s a long way to go. But at the moment I think it just seems a bit expensive.
John: So you’re tempted by the cyclicals?
James: I think the miners are starting to look interesting. Rio Tinto (LSE: RIO) justifies further analysis. But we also look at alternative investments where fortunes are not necessarily dependent on the direction of the stockmarket, such as BlueCrest AllBlue (LSE: BABS).
This is a hedge-fund pursuing a range of different strategies. It has underperformed recently, but remains a good diversifier and provides protection in the event that equities hit a rocky patch.
John: Marcus?
Marcus: St Modwen Properties (LSE: SMP) is a property developer. It has this new development in Covent Garden. It’s very cheap compared to its peers – it trades at 90% of its net asset value. Also, our analysis suggests that the Covent Garden development is worth £24m an acre, and it’s in the accounts at £15m. So if you’re a believer in central London real estate, it’s the one to go for. I also like temporary power generator Aggreko (LSE: AGK).
One thing I particularly like is Aggreko’s exposure to Africa. Everyone thinks that Asia’s amazing and has a fantastic future. But there’s a shift now towards the likes of Mexico and Southern America, and also sub-Saharan Africa. In the longer run, Africa is where it’s all about. Everyone thinks Nigeria, for instance, is corrupt and there are all these problems, but I really think it can only go one way – up.
John: But the end of the commodities super-cycle and a potential slide in oil – that’s not good for Africa, is it?
Marcus: I think what is good for the world is good for Africa, in that it needs a successful world economy to buy its goods – and a realistic oil price is just what the world needs. Anyway, I think Africa is coming of age and that’s why you must buy Aggreko.
As for one I’d sell: Brammer (LSE: BRAM). It’s a distributor that does a lot of European business. It’s been doing well because people are trying to pick the turn in the European cycle. But that’s exactly why I hate it. People have tried to run it up and I think there’s significant downside. The shares dropped by 40% this time last year when the European crisis hit. So if we see more trouble in Europe, they have the potential to move to the downside very nicely.
John: David?
David: I like Resolution (LSE: RSL). It is a life insurance company with a large “back book”. They have changed their strategy recently from one of industry consolidation to efficiency focus. I think there’s going to be a move from some of the more defensive stocks into the likes of financials. So Resolution should benefit from that. Also, the stock is trading at 60% of book value. If you wound the company up tomorrow, I think it could fetch 80% of book value. So it’s grossly undervalued and it pays a good yield.
I also think we’re in the middle of a re-rating of food producer Tate & Lyle (LSE: TATE). It has shifted focus from the bulk sugar ingredients market to artificial sweetener. It has an 80% share of the sucralose market. Earnings have been quite volatile, and half of the business is poor. However, that business is becoming less important as the company migrates to the higher-value sucralose market. We’ve seen the likes of Diageo re-rate to 18 times. Tate & Lyle is on 13 times or so. I can see one or two points of multiple expansion, but I’m also confident that the evolution of the company will result in a more stable earnings profile.
If you’re bearish on Europe then you should consider Dalton’s Melchior European Absolute Return Fund, run by Leonard Charlton. It’s a pure long-short European fund.
Charlton’s shorting ability at GLG was astounding, and he has very good knowledge of Spanish and Italian mid-cap companies, which is where we will get many bankruptcies if things go bad. The fund has an excellent Sharpe ratio. If Europe doesn’t surprise on the upside, that’s a good way to protect yourself. I couldn’t speak more highly of that fund.
Killian: If you agree with our view on gold, then I’d buy Newmont Mining (NYSE: NEM). If you buy physical gold itself, you pay a dollar for a dollar’s worth of gold. But with Newmont, if you take into account its probable and proven reserves, and its operating profit margin of 42%, then you are getting around $9 worth of gold for each dollar of investment.
Similarly, Barrick Gold (NYSE: ABX), has about $12 of gold per dollar invested. Also, the HUI index – which tracks gold miners – is at a historically low level compared to the gold price. The ratio normally mean-reverts, which suggests that gold miners should rise assuming the gold price stays roughly where it is or goes up.
Marcus: Isn’t the problem with miners that costs are rising, and they can’t get as much gold out of the ground as they could before? So holding the physical thing in your hand is going to be worth more than something which is increasingly expensive to mine.
Killian: But in the longer run I’m getting way more bang for my money buying the gold while it’s in the ground, in clearly stable countries. The price/earnings (p/e) ratio for Barrick is around 5.8 and for Newmont it’s 9.7, so they’re not expensive. We think you should still have some of your portfolio allocated to gold because we think there’s going to be monetary inflation. It could drop another 10% or 15%, but since 1971, gold has proven to be thebest asset in those sorts of environments.
We’ve been part of a currency experiment for the last 40 years, yet everybody believes that because gold has dropped 27%, it’s not worth holding onto. But the question is: do you really believe that central banks are not going to put more money into the system? We believe they will. So we’ll hang on to gold. People are very disparaging about it, but other than since 1971, for 2000 years it has been the backbone of the monetary system.