Money could be about to flood out of bonds and into equities. How likely is it to happen, and how can you profit? John Stepek talks to our Roundtable panel of experts to find out.
John Stepek: As stocks surge, everyone’s suddenly very excited about the ‘great rotation’ – money flooding from bonds into equities. What’s your take?
Ana Armstrong: We firmly believe in that rotation. We have been rotating towards cyclical stocks since the end of last year, including some of the car companies with good exposure to emerging markets, such as BMW and Volkswagen. We are also shorting German and French bonds.
Killian Connolly: The issue for me with stocks is valuation. Much as I’m fearful of putting capital into British and American debt, I’d also like to get my capital back. The FTSE is up at 15 or 16 times earnings. With the economic headwinds we foresee – even if they don’t all play out – we’d prefer to be elsewhere.
Jan Luthman: We feel the switch from bonds to equities will gain momentum, because as more money leaves bonds, it’s that much harder for quantitative easing (QE) to keep a lid on bond yields.
John: But if cash comes out of bonds, interest rates will rise – presumably that won’t be fun for equities?
Jan: Equities like GlaxoSmithKline are yielding significantly more than their sterling bonds. It’s extraordinary. We haven’t seen this since the early 1950s. Relative to current gilt yields, equities are stunningly cheap. So I think your worry about rising interest rates putting a lid on the equity party is overdone. If we had a bond fund, which we don’t, our worry would be of a log jam when everybody heads for the exit at once.
Marcus Ashworth: But if money does come out of bonds, it won’t necessarily go into equities. Bonds and equities went up in price together, and I fear they will go down together, because if the wall of money comes out of bonds, it’s going to be Armageddon as the bond market is so overpriced. But saying that, demand for bonds is unreal. A few weeks ago I was incredibly busy placing five-year peripheral European bonds paying less than 5% a year. Last year we couldn’t give them away at 18%. What has happened in between? Nothing.
So while I worry about the bond markets – we all do – we have to understand that, with the state of the underlying European economy, there’s no way that rates can be raised. And in the US, the Federal Reserve owns so much of the bond market that by definition it will bankrupt itself if it raises rates. So I worry about how far ahead everyone’s getting with this ‘great rotation’ story.
Our Roundtable panel
Head of fixed income and macro strategy, Espirito Santo Investment Bank
Portfolio manager, PFP Group
Partner, Co-head of UK equities (macro), Liontrust
Jan: I just think it’s going to be forced on us by higher inflation. The US, Europe, Britain and, to a lesser extent, Japan are all playing the same game. We’re trying to manipulate our currencies downwards, and we are going to start importing inflation. For now it’s disguised because we’re all sinking together, and we’re one another’s main trading partners. But at some point it will come out of the shadows and bite us really hard. At that point you’ve got a choice: do you allow higher inflation to set itself in place permanently, or do you choke it off with higher interest rates?
Marcus: You’re right, ultimately, the market sets bond prices. The central bank can set its base rate, but it can’t set market rates, and that’s something that can get out of control.
Killian: There’s a difference between price inflation and monetary inflation though. Higher input costs might drive price inflation – if you’re getting energy from outside Europe, for example. But central banks will continue doing what they’re doing until we get monetary inflation – until commercial banks are actually creating deposits through loan origination. And they’re not going to do that anytime soon. So I think we’re just going to end up with open-ended QE.
Ana: Exactly, central banks don’t seem to be very concerned about inflation at all. These governments have huge amounts of debt, so inflation works quite nicely for them. They can grow their way out, but they have no growth. They can default, but they’re not going to do that, because they can print money. The most likely option is that they create inflation.
Jan: I would make a distinction between high-cost and low-cost economies. The big question is, where is the growth going to come from in high-cost economies?
Ana: Global growth is around 3.6%, which has been the norm over the last 25 years. The difference is that 80% of that now comes from emerging economies.
Jan: Exactly. There’s a major global readjustment going on. The cost of production in Britain Europe, the US and, to a lesser extent, Japan, is still way out of line with the cost of production in low-cost areas. Until we can price ourselves back into competitiveness, we will face rising unemployment. We’re masking it in Britain by keeping zombie companies alive – what I call ‘the son of kicking the can down the road’. But it’s a real problem. The parallels with the industrial revolution are striking.
John: In what way?
Jan: Then we had a restructuring from agriculture to industry. Ultimately we became a wealthier, better-fed society. But it took 60 or 70 years. In between, you had huge social suffering as tens of thousands of people were stripped of their ability to earn a living. That is exactly what’s going on right now.
We have hundreds of thousands of people who’ve had the ability to earn a living taken from them. There are no replacement industries for them yet, and there won’t be for decades. How do we, as a society, cope with this? That, I think, is what politicians are grappling with. And they are desperately trying to keep kicking this awful can down the road, because if they don’t, we will have huge unemployment.
Look at the zombie firms – there are 70,000 firms in Britain that can’t even afford to pay the interest on their loans, and another 100,000 that can’t afford any repayments. Pull the plug on them and unemployment isn’t two million, it’s four million.
Marcus: But where are the replacement industries?
Jan: If you go back to 1810 or so, everyone was tearing their hair out because we were stripping people out of the agricultural economy. “Who’s going to grow the food? Who’s going to buy all this stuff that you’re producing in the factories?” Nobody foresaw the huge structural change in terms of railways and ultimately aeroplanes, cars, radio and the rest. That’s the position we’re in today; we don’t know what tomorrow’s industries will be. But there will be some, because we advance, we invent. It’s what we humans do.
John: We all seem to agree that central banks are happy to see inflation rise. But when will they be forced to tackle it?
Jan: If I were a politician and I had a choice between five million unemployed or rising inflation – it’s not a hard choice.
John: But where’s the tipping point?
Jan: To me, the inflation that’s coming will be particularly painful – especially for private-sector workers – because we won’t get wage inflation. I’m older than everyone around this table and the 1970s was pivotal to me. Indeed, 26% inflation is terrifying. All you want to do is to spend your money as soon as you’ve got it because you know next weekend prices will be 10% higher. It was really scary. That, to me, is breaking point. But I don’t think we’re going to see hyperinflation.
Ana: We still have excess capacity and pretty high unemployment in developed economies. That is keeping inflation under control. However, in the US, banks are starting to lend and consumers are more confident. That will be inflationary. But here, banks are still not keen to lend.
Marcus: Yet inflation in Britain has been very sticky. When Mark Carney takes over from Mervyn King in the summer as Bank of England governor, the plan as far as central-bank policy goes is to blow the barn doors off.
I think the coalition government realised last summer that they were not going to get growth coming back in time to get re-elected in 2015. So now they’ve decided to go 100% for growth – they went after Carney, and they’ve had a carefully played debate on the idea of dropping inflation targets.
Everything they’re now trying to do with infrastructure and the planning process is about trying to breathe some life into the economy. At the end of the day, it’s all about housing. Labour held power for 13 years because house prices kept going up.
David Cameron, George Osborne and the rest know that they can’t let house prices drop because then they’ll be out. But we have to be very careful about how much power we give Carney because if he goes all out for growth then we will have serious issues several years down the line. Lots of people in Canada will tell you that there is a big problem brewing there.
So Carney’s moving out at the perfect time – he gets all the credit but none of the downside. Meanwhile, in the US, when Ben Bernanke steps down we’ll get Janet Yellen, who is even more dovish than he is. So central banks everywhere are set to keep going for growth, regardless.
John: If America is in better shape then presumably the dollar has more of a natural floor under it – so if anyone can get away with it, America can. But what’s going to happen to the pound?
Marcus: It has to go down, it should go down, it will go down.
John: How far?
Jan: We lived through parity with the dollar in the early 1980s and the world didn’t end. Here’s a small comparison: our statutory minimum wage is around £6.18. In the US, it’s $7.25. So we’re more than 30% out of line already. Add in our social security benefits, healthcare, and state pension benefits, which our American cousins can’t even dream of, and we are way out of line with the world’s wealthiest, largest, most efficient economy. We could fall a long way.
John: Meanwhile, in Europe everyone seems to be taking European Central Bank (ECB) governor Mario Draghi at his word, believing that the euro has been saved. Does anyone think that’s optimistic?
Marcus: Draghi is the best thing Europe’s got. The moment his word gets discredited, it’s all over.
John: What might do that?
Marcus: There’s a delicate balance – Draghi is careful to keep the Bundesbank [the German central bank] on side. But over Cyprus, for example, you’ve got Draghi saying that Cyprus needs to be bailed out, to keep the eurozone united. Germany isn’t keen on the idea of subsidising shady Russian money. The amounts may be small, but the principles are too important to breach as far as it’s concerned. So keep an eye on that battle.
Also, with the Italian elections just ahead, something’s bound to come out of the woodwork. Then there’s the euro itself. If it continues to strengthen, it will kill any chance of recovery in the eurozone – it’s even starting to impact on the German economy. So the euro has to enter the currency wars somehow.
John: On that note, the plunge in the Japanese yen is the other big story.
Ana: Japan clearly needs a weaker yen, but how successful it’ll be remains to be seen. Also it has a serious problem with demographics: over half of American debt is held by foreigners, whereas most Japanese government bonds (JGBs) are held by the Japanese themselves, and they’re all getting older. I’m not sure this story has a happy ending.
Marcus: Well, 93% of Japanese debt is owned by the Japanese, but there’s been a major shift in terms of which Japanese own that debt. Retail investors are now actually net sellers of JGBs. Who is buying? The big Japanese banks – they know the government’s going to have to do QE and buy lots of JGBs, so they have hoovered them up.
The trouble is, it means Japan’s banks are all exposed to bonds. So if interest rates go up in Japan by 50 basis points, we are in major trouble: 100 basis points and it’s all over. Could it happen? The main thing keeping yen so strong is the natural current account surplus. But that’s been kicked away: since the earthquake, Japan has had to import huge amounts of hydrocarbons. It has upped sales tax too. And it is steaming ahead with QE.
The Japanese have decided they can’t beat the Fed, so they’re have to join them. All of this is going to blowtorch inflation into the Japanese economy. And if that happens, they will kill themselves and the rest of the world.
This strategy might have worked ten years ago, but now they’ve got a more than 200% debt-to-GDP ratio. Having said that, the weak yen will help Japan’s exporters claw back ground from the Koreans, and that’s why – for now at least – I am a huge bull of the Japanese stockmarket.
John: It’s already moved a fair bit.
Marcus: I reckon the Japanese market will be 40% higher within two quarters. If the yen went to 110 tomorrow, that’d be too quick, it’d be terrible. But say it goes to 100, and it doesn’t happen too fast – the net impact on the export sector will be huge.
In terms of stock ownership, Japan is all about foreign investor sentiment – about 70% of trade volume comes from foreigners. So the middle-America big funds will pile in and buy the names they know, the Toyotas and the Sonys. We saw this at the back end of 2005 – it rallied 40% in four months.
John: Let’s move on to tips. Ana?
Our Roundtable tips
Investment Ticker LMVH FP: MC Richemont TQ: CFR BMW GR: BMW VW GR: VOW Coca-Cola US: KO Gold ETF LSE: PHAU Silver ETF LSE: PHAG Plat ETF LSE: PHPT Aberdeen LSE: ADN BHP Billiton LSE: BLT Rio Tinto LSE: RIO Glaxo LSE: GSK Statoil NO: STL Sanofi FP: SAN Petropav. LSE: POG Digital Garage JP: 4819 Premier Farnell LSE: PFL
Ana: I’d hold a basket of luxury goods with exposure to emerging markets: companies like LVMH (Paris: MC), Richemont (Zurich: CFR), BMW (Xetra: BMW), Volkswagen (Xetra: VOW), even Coca-Cola (NYSE: KO): it is the market leader of fizzy drinks in China. These companies’ customers are not especially price-sensitive, so they can pass costs on.
The gap between the successfully positioned car companies and their rivals has widened in the last year. One other thing we haven’t yet mentioned is precious metals. 80% of the change in the price of gold has been correlated with the size of the Fed’s balance sheet, which is still growing. If you’re worried about inflation over the next few years, gold typically serves as a hedge.
On that basis, silver is worth buying too. Platinum is interesting. Growth in the car industry should stay healthy, and the Chinese want to boost energy efficiency. For that, they need platinum, 70% of which comes from South Africa. However, the mines there are suffering power shortages and strike action, and some of the biggest producers are cutting back. Platinum supplies have fallen to a 13-year low. This will hit earnings at these companies, but the platinum price could well rise.
John: So buy platinum rather than miners. Jan?
Jan: If you believe in the bond/equity switch, and you believe that sterling will, like most high-cost currencies, depreciate relative to the emerging markets, then Aberdeen Asset Management (LSE: ADN) has to be a play.
It’s run a long way, but it’s still got a huge amount of fixed interest under management. If that switches across, it goes from low-fee bond funds to high-fee equity funds, which is a big boost to the bottom line. If you believe in the resurgence of US manufacturing and what that means for raw material and energy consumption, and you reckon China’s recovery is believable, then BHP Billiton (LSE: BLT) or possibly Rio Tinto (LSE: RIO) fit the bill.
We tend to the view that the real long-term driver of resource demand is the need for security of supply. So owning resources in what you might call “ethically uncontentious” areas – as Rio does – is a fantastic long-term play.
Ana: China seems to do nothing wrong, which is a little bit hard to believe.
Jan: Yes, it has what seems to be an amazing situation: minimum wages are rocketing, yet producer price inflation isn’t rising, exports are soaring, and industrial profits aren’t suffering. Perhaps we’re seeing huge improvements in manufacturing efficiency, infrastructure efficiency, and what you might call back-office efficiency. If that’s so, China has got long legs on it. But if it’s a fabrication, then in the short term it would be worrying.
That said, if you also believe that austerity in America is causing a back log of infrastructure maintenance and replacement and renewal to build up, then you want to be in resources. If you are a safety-first player, GlaxoSmithKline (LSE: GSK) is a great option.
The world population is expanding and everyone on the planet is going to get old, get sick and die. None of us wants to do that, so buy a pharmaceutical firm. It’s that basic.
But GSK is also broadening its footprint: it’s not just about Western primary care, it is emerging markets, it’s branded generics, it’s over-the-counter, it’s lifestyle. That’s not reflected in the price yet.
Ana: Also, if you’re a bond holder and you’re looking to rotate into equities, are you really going to rush into tech stocks? No, you’re going to buy defensives.
Killian: Norwegian oil firm Statoil (Oslo: STL) is on eight times earnings. It’s cash-flow positive and pays a 4.5% dividend. It’s a way to play shale gas: the firm is in three of the biggest operations in the US and it is an operator in the fourth biggest.
The Norwegian government owns 67% and, as a libertarian, I’d rather not be in bed with it, but you’ve got some high impact wells being dug in Angola and Mozambique, so it’s a bit of an Africa play too – around 10% worth.
Sanofi (Paris: SAN) is on 11 times earnings and pays a 3.6% dividend. With Obamacare there are now 30 million to 40 million more Americans who will have to have medical coverage, so Big Pharma will have to give away some cheaper drugs as part of the new legislation, but Sanofi is another very cash-generative company, and it doesn’t have a lot of debt.
It’s also a play on emerging-market growth – $1,000 is paid per person per year in America for healthcare costs, whereas in the likes of China and India it’s in the $200 range, so that’s likely to grow. Emerging markets are also an outlet for drugs that havegone off-patent – customers in emerging markets are more likely to buy a branded drug they feel they can trust.
Marcus: I’ll stick on mining. One firm I think is super-cheap is Petropavlovsk (LSE: POG). It owns an iron-ore mine on the Russian/Chinese border. It’s on the Russian side, but it’s got Chinese backing: two big Chinese firms have put $250m into it. As you say, Jan, it’s all about the security of supply. So POG will get its production bought regardless, and it’s not going to need any funding. So if you believe in the China story, this is a much more geared way to play it. But it’s not for widows and orphans.
Next is a Japanese tech company called Digital Garage (JP: 4819). It’s an IT super-lab-type thing: all about creative ideas, games, start-ups, whatever – and it owns 3% of Twitter. So it’s the only way for small investors to play Twitter’s possible initial public offering later this year.
Finally, I like Premier Farnell (LSE: PFL). It’s a distribution company with a lot of American and Latin American exposure and, if you believe in this recovery (or you think everyone else does), then in a dash for trash these are the stocks you’re after – you want something that’s got some juice.
Just don’t stake too much on them, because 2013 is going to be a racy year. You’re going to get some very big gains and some very big swings afterwards. There is a chance to make decent trading profits for a two-to three-month horizon. Just don’t get wedded to anything.