How great a risk is inflation? Could it push investors into precious metals? And will 2017 be the year in which the euro finally breaks up? John Stepek chairs our Roundtable discussion.
John Stepek: What’s the biggest risk for investors just now?
James Harries: Valuations across most asset classes are fairly full. If you start with a high valuation, the chances are that your expected return is going to be relatively low. So the opportunities are probably rather fewer than they have been at other times.
Bob Catto: Not only that, but geopolitics looks about as bad as I can ever remember – China and the Spratly Islands, Turkey, Syria, Russia. And we’ve got a guy in the White House who spends his time tweeting! What could go wrong?
Nick Davis: Yes, often it’s the “unknown unknown”: you start a year with the risks in focus and markets try to price in those risks, and then the things that people say won’t or can’t happen – as 2016 taught us – actually happen. And I’d agree on valuations.
Jim Mellon: Ignoring geopolitical risks, which we can never forecast, the biggest risk is inflation. Very simplistically, inflation equals money times velocity. We’ve had a great big room, being stuffed with ever more money, but no velocity – no animal spirits, no inclination to lend, and plenty of slack in developed-world economies. But the slack is going, commodity prices are rising, and animal spirits are returning. US banks are fixed and lending is increasing. Too much money plus rising velocity gives us inflation. Products may not go up much in price, but services will, because of wage pressure. So I think we could get 4% or 5% inflation.
James: I would take the opposite side of that bet. I think this is just another inflationary scare. We’ve still got too much debt, and deteriorating demographics. I’m also concerned about global demand, so I expect commodities to roll over too.
Jim: I don’t see commodities as particularly relevant, because I don’t think the inflation will occur in manufactured goods – it’ll be wages. We’re going to see a backlash from low-paid, gig-economy workers. It’s already happening. There’s a $15 minimum wage in some US states now. That’s a 30% increase in the last two years. And yes, maybe the workers are pricing themselves out, because higher wages encourage automation. But for now, I think inflation is coming in the service sector, which is a much bigger part of the economy than manufacturing.
John: It’s a big year politically for Europe. Any thoughts on how it’ll pan out?
Jim: Brexit is a sideshow compared with what’s going to happen in Europe in the next one to five years. The common currency is unsustainable, and the politics increasingly reflect that. But as to which way the elections will go this year, I don’t know.
I’d have to bet that Marine Le Pen is not going to win in France, because the other parties will join together in the second round to stop her. But Holland might be interesting. In Germany, Merkel will probably scrape back in, but she’s a diminished power.
Nick: Everyone says Europe has to change, and I think it will, over the next five to ten years – in terms of reform, lots of things can happen.
Jim: But how can it reform when it requires 27 members to agree to it, and when the people who run the institutions are unelected and entrenched?
Nick: People said the Germans wouldn’t agree to quantitative easing (QE). Then they did QE. People said the European Central Bank wouldn’t be allowed to do bailouts. They have. Things can change, even in Europe.
Jim: But would you agree that on the day the euro breaks up, there’ll be no announcement? Because if you show your hand, you’ll get the Greek treatment. It’ll just be a member saying: we’re leaving – my liras are in circulation as of tomorrow. So we don’t know – a country might already be preparing to leave.
Nick: But when I look five years back, Europe clearly stood out as dysfunctional, whereas today the UK has Brexit hanging over it, and you’ve got Donald Trump in the US. I see risk in lots of different regions, not just Europe.
Charlie Morris: On Brexit, basically, unless you believe that the US is much stronger than we realise, or that Britain is much weaker, then I think we’ve seen the bottom for sterling now. What’s interesting about that is that the recent Merrill Lynch surveys show that fund managers are record “underweight” the UK. But if the pound goes up then the whole “everything British is bad” theme reverses. So you sell British exporters and you buy domestic stocks. It’s the opposite of the original Brexit trade – so everything that was terrible in June 2016 is a “buy” now. Retailers, for example – on the lower end, there’s Sports Direct (LSE: SPD). At the upper end you’ve got Marks & Spencer (LSE: MKS).
John: What about Next?
Charlie: It’s gone down a lot, and you can make the case that it’s still a great company. But on a price/sales basis it’s still expensive relative to its history.
John: Where are the other big opportunities today?
Jim: I’m bullish on Japan. I think the Nikkei is going to go to 25,000 this year and the currency will be about neutral because the Japanese yen is probably undervalued now. Exports are benefiting from the weak yen and corporate governance is improving. Japanese firms are doing everything that US ones did in the last 15 years: buying back stock, paying special dividends. And in a context of continued negative interest rates or no return on Japanese government bonds and bank deposits, why wouldn’t you – as a Japanese saver – invest in firms that are already paying out higher dividends and can afford to pay even more?
John: What about gold?
Jim: If I’m correct on inflation, then we’ll see a rush into precious metals. One reason gold came under pressure last year was the demonetisation of India. It removed 85% of cash in circulation, which is basically the money supply, since there’s very little credit in India. That had a big impact on gold. But that’s now resolving itself – I expect the gold price to be over $1,500 an ounce by the end of this year.
James: I’m positive on gold for the opposite reason. I think gold is a way to short the perceived control that central banks have on the economy. Jim thinks central banks are losing control on the upside in terms of inflation. I see them losing control in terms of not generating a self-sustaining recovery, which means that ultimately they’re probably going to have to do even more in terms of quantitative easing and the like, which will push the gold price higher.
John: What about the gold miners?
Jim: The old saying is that you rent these stocks, you don’t own them. But some of the mining stocks were fantastic last year. I’ve been buying shares in Nicaragua-based Condor Gold (LSE: CNR). It sits on what is potentially a five million ounce deposit, and someone will buy it – I’m pretty sure of that. The market cap is around £30m-£40m.
Bob: There’s a gold miner in the Philippines I like, Metals Exploration (LSE: MTL). The market cap is £101m, debt is $72m, and it will produce 110,000 ounces per year at an all-in cost of around $695 per ounce. It is very cheap indeed, and there’s room for growing the asset – it’s got a ten-year mining life as it stands. In general, I think that small cap is undervalued versus large cap. And a lot of the best opportunities are in small sectors, like the palm oil sector. You saw the recent bid for MP Evans.
The other obvious quoted stock is REA Holdings (LSE: RE), which has a much bigger estate than MP Evans. I also like energy storage because it is the Holy Grail of renewables. The sun doesn’t shine in the middle of the night and the wind doesn’t blow on very cold days – so without storage, it doesn’t work. Redt Energy (LSE: RED), which has a market cap of around £74m, makes a flow battery that is 35% cheaper than the leading company in the world, which is German.
Jim: Doesn’t Tesla make those storage batteries too?
Bob: The lithium battery is great for your laptop, your car, or your mobile – but if you want to store serious amounts of energy, you need a storage machine, not a battery. It makes a container that is modular, so you can have 100 of these together and store megawatts. So it’s an entirely different business to Tesla. It’s not for individual homes – it’s for big farms, villages and so on, particularly in places like California and Africa, where the cost of solar has collapsed.
John: James, what are you investing in?
James: You can buy some high-quality businesses at more attractive prices than you could before, such as pharmaceutical giant Novartis (Zurich: NOVN).
John: Despite Trump’s threats about drug pricing?
James: Well, that’s one of the reasons why Novartis has done poorly, and why it’s better value than it has been for a long time. On a long-term basis, you’ve got a nicely diversified, financially productive, high-quality business. The return on capital is improving because it’s not just doing good science, it’s also doing good business. I also like Philip Morris (NYSE: PM). It’s a fantastic franchise, but it hasn’t done terribly well because of the perception that its earnings would be squashed by the stronger dollar. We expect a reversal in the dollar, so that gives an opportunity to buy that very long-term franchise.
Finally, something a bit different: Vonovia (Xetra: VNA). This is a company that owns German residential property. It’s trading at quite a significant discount to its net asset value (NAV), so it’s a cheap way to invest in an asset that’s already inexpensive. And it also gives you a call option on European politics – if the euro breaks up, then you end up owning a cheap deutschmark-denominated asset.
Bob: That’s a great way to buy the deutschmark.
Jim: And property is still cheap in Germany relative to here. If you’re a young person in London, 50% of your income goes on rent. In Berlin or Hamburg it’s about 25%. And because they’re getting no return on their bank deposits, property ownership is rising in Germany – it’s set to go from around 50% to around 60%, more or less where we are now.
Nick: The worst-performing sector in Europe last year was telecoms. The market got a bit bored with them because they were expecting consolidation and it didn’t happen. But we think they’re cheap, defensive assets. Quite a few offer 6%-9% free cash-flow yields, which should continue to grow for the rest of the decade. In particular, I like Deutsche Telekom (Xetra: DTE) because its US business is doing well and you have the German exposure too.
John: What else are you investing in, Bob?
Bob: Water. Water anywhere in the world is worth a lot of money, but especially in southern California. In the Mojave Desert there’s a natural aquifer owned by a firm called Cadiz (Nasdaq: CDZI). Cadiz wants to pipe that water to southern California. Trump has said he wants to invest in infrastructure; this is “shovel-ready”. The project has been held up by the US Bureau of Land Management that has suggested Cadiz needs an environmental permit to put a pipeline alongside a railroad for 16 miles. But I think that will be overturned soon.
Jim: I’m with James on the pharmaceuticals. Gilead Sciences (Nasdaq: GILD) is dirt cheap. Growth in its hepatitis C franchise is slowing, but that’s accounted for by the price – it’s on seven-times earnings, and I think it’ll do some great stuff in oncology. And I’m not too worried about pricing pressures in the US. The US has the biggest pharmaceutical industry in the world because it pays for innovation, and I don’t think that will change much.
The other is a new oncology company that we’ve set up here in the UK – SalvaRx (LSE: SALV). I am an investor and non-executive chairman. It’s small – £10m market cap. It’s got two very interesting projects. The most important one is with a company called Intensity, which focuses on cancers that benefit from immunotherapy – blood cancers and melanoma being the most obvious.
Its treatment is designed to intensify (hence the name) the effect of existing immunotherapy. It’s a treatment for patients with terminal cancer, which means that rather than going through all three phases of clinical trials, you try it out on the sick patients immediately to see if it works or not. So it’s like a binary option really – high risk, but potentially high reward.
John: Thanks everybody.
• In the original version of this article it was incorrectly stated that Intensity had dosed its first patient in clinical trials. Intensity expects to dose its first patient shortly at which point a further notification will be made by SalvaRx which will contain full details of the trial including the timeframe for results.