John Stepek: Given that the Federal Reserve is still withdrawing quantitative easing (QE), why is the US dollar so weak?
Marcus Ashworth: You mean, why is the euro so strong?
Sandra Crowl: Quite. There are some pretty good reasons for the euro’s strength. First, the whopping eurozone current account surplus – 3% of GDP and getting bigger. Second, lots of offshore investors have been moving out of the US and back into Europe – that’s been going on for at least six months, though it’s unlikely to be repeated. Third, we saw disappointing first-quarter growth in the US.
In the longer run, it boils down to rate differentials – there isn’t a big enough gap in rates between the US and Europe yet. We think that will change over the next two years.
Mouhammed Choukeir: You also have to remember that the euro and sterling started from a low base. The euro recovery hasn’t happened because everything is now perfect – it just started from a very weak state. So while the recent move has been quite big, both the euro and sterling are around fair value against the dollar right now, rather than being especially strong.
The other point, as Sandra says, is that there have been significant flows into European assets after the big rally in European stocks. But while Europe was undervalued, it’s not as cheap as it was.
Marcus: Yes, a lot of American money coming out of the yen has been going into Europe. But I think the biggest story is that European banks – particularly French and German – have been repatriating assets from the US in order to stay alive. That’s been going on and on.
John: Everyone talks about the European Central Bank (ECB) doing QE. But with things calming down, do you think they might just try to bluff their way out?
Killian Connolly: They can’t bluff this amount of debt away. To do that, nominal GDP (GDP including inflation) would have to grow much faster than the debt. But they didn’t manage it under the gold standard in the 1930s – eventually they had to come off gold and default.
In fact – as economists Rogoff and Reinhart found – no nation has ever managed to simply grow out of the debt levels we see in the peripheral countries today.
John: So you need a devaluation or a bail-out?
Killian: Yes – and I think that’s what will happen. Greece will have to leave the eurozone – or the eurozone will have to have a fiscal and banking union. But I don’t think that will happen.
The upcoming European elections will likely demonstrate that there’s no appetite for further powers to be devolved to Brussels.
Sandra: But do they need to be? In 2015, Portugal’s budget deficit will fall to 2.5% of GDP. Even Greece is set for growth of 0.5% or 0.6% – so I’m surprised to hear investors still saying it will have to leave. 2015 will be a strong year for Europe.
In Spain, growth is getting up to 2%, export volumes are great – I’ve been very bearish on the euro, but I just can’t be as bearish on the eurozone as a whole as you!
Marcus: But it’s too little too late. Spain’s numbers look good, but the debt hasn’t budged – so how long can they last?
Mouhammed: Getting back to the QE question – the risks to Europe’s recovery are threefold. First, the threat of deflation, which would make debt burdens worse. There’s the threat of higher interest rates, which would increase the cost of servicing all that debt.
Finally, there’s the stronger euro, which could hurt the recovery too (by driving up export prices). So if you’re a central banker facing deflation, higher interest rates and a strong currency – well, you’re kind of forced to do QE, like it or not.
Sandra: But isn’t this a Goldilocks scenario we have just now? A nice level of recovery, but not rampant.
Marcus: This is a recovery?
Sandra: Compared to where we came from it is! There is still more room for the spreads between German bond yields and peripheral bond yields to close.
Marcus: But look at Portuguese ten-year yields. They were around 4% going into the crisis. They got as high as 18%. They’re now sub-4%. What’s happened to support that type of move? We’ve had all the good news – everything is priced into equities, everything is priced into bonds.
Yes, I get the idea that you buy before things improve, but the market is pricing in off-to-the-races growth, and I don’t think we’re going to get that. If we do get a correction in European bond yields, and all of a sudden Greece and Portugal again can’t fund themselves, then we’re in trouble.
Killian: Valuations in European peripheral debt are ludicrous – Irish govies yield even less than US Treasuries! Some institutional investors seem very sanguine on all this, but if these countries are going to escape their debt burdens, they’ll need lots of fiscal austerity and financial repression. People aren’t going to vote for those sorts of policies – especially with unemployment as high as it is. Political risk is severely underpriced.
Mouhammed: But all of these economic fundamentals are known. If you want to worry about unknowns, there are two big ones: there’s the asset quality review of eurozone banks, which could throw up some skeletons on the balance sheets.
The ECB has been smart – it warned that this was coming – but no doubt some will not be ready. The other big unknown is what’s happening with Russia and Ukraine, and the risks for energy prices.
Killian: It’s a good point – just because we haven’t had a supply-side shock for decades, doesn’t mean we can’t. We have a real economy that faces real constraints.
John: Moving on to Russia – would anyone buy it?
Marcus: 100% yes. The market trades on a p/e (price/earnings ratio) of five, has an average dividend yield of about 5%, and oil and gas are easy to sell.
Sandra: We’re not buying the index, but there are two stocks we like. Globaltrans (LSE: GLTR), a rail freight stock, is on a 6%-7% yield. The other is Yandex (Nasdaq: YNDX), the Google of Russia. It’s enjoying earnings growth of 20%-22%.
John: But is anyone worried that Ukraine could boil over into something worse?
Mouhammed: You just have to look at the incentives of the leaders involved to see that ultimately it’s in no one’s interests for this to escalate.
Marcus: You have to ask why the International Monetary Fund is even thinking about handing out money to a Ukrainian government that wasn’t democratically elected and shows no signs of being able to repay.
You can see why the Russians are annoyed about this, and they’re not going to back down. They have far more capacity for pain than anyone in the West can understand.
John: What about Japan, last year’s favourite market?
Marcus: I think Japan is poised to take off again. The sales tax has not been as bad as people expected. I still think the Nikkei could get to 20,000 by the end of 2014. The correlation between the Nikkei and the yen is almost 1:1 – if the Bank of Japan continues to print money, the yen’s going to fall and the Nikkei will rise.
Sandra: Prime minister Shinzo Abe has been lucky with his timing to an extent. Japan needs more structural reform, but the economy was already improving. On the sales tax, things do look better – car sales fell by 19% after the 1997 tax hike; it’s just 9% this time around.
Mouhammed: But the reason Japan had a big year last year is because it was cheap, very unloved and had a catalyst. Today? It’s not as cheap as it was. It’s certainly not unloved. And as for the catalyst, the Abenomics honeymoon period is now over. To get the market moving again, the Bank of Japan has to double up on QE or quit. It may well do that, but it’s not as clear a bet as last year.
Sandra: Yes, but it’s not just about QE – inflation is rising behind the scenes. For example, the labour shortage means that temporary workers are being paid more.
Marcus: This is what it boils down to – the most important ‘arrow’ – people need to be paid more. And it’s happening.
Killian: From a big picture perspective, Japan offers the best opportunities right now. Japanese stocks have got cheaper and cheaper over the past two decades – we reckon more than 40% of Japanese companies trade below book value, compared to around 20% in the UK and US. And while Japan has huge debts, the Bank of Japan isn’t going to let Japanese government bond yields rise by much.
John: Let’s turn to your tips.
Marcus: I think annuities provider Just Retirement (LSE: JRG) is worth a look. The shares are priced as if no one will ever buy an annuity again.
That’s too pessimistic – the market might shrink by 50% but annuities will remain an option for retirees, and the company can morph into other areas.
Another is engineer IMI (LSE: IMI). The new chief executive used to be the boss at Weir Group, where he had a good track record, and the overall sector is doing well right now.
Finally there’s microchip producer ARM (LSE: ARM). Management expects a strong second half and solid growth in its royalty revenues, which should help it to break out of its recent trading range. We think this one could have 30% upside.
Sandra: We like companies with quality managements and strong free cash flow. One is Glencore Xstrata (LSE: GLEN). Commodities have been hit by concerns over weak Chinese growth, rising costs, and over-supply in specific markets, such as iron ore and aluminium.
But Glencore is very well run, and has little exposure to ferrous metals (which are the most exposed to China). Also, weaker demand now looks to be priced in. It trades on a p/e of 9.5, a yield of 3.2%, and has a free cash flow yield of more than 9%.
Novo Nordisk (Copenhagen: NOVOB) is a global leader in the treatment of diabetes. It’s a huge, growing market, so Novo doesn’t have to join the recent Big Pharma scramble for growth businesses – it’s already firmly established in the field, and has the most cost-competitive insulin treatment on the market. It may also have an obesity treatment approved later this year.
Finally, there’s internet giant Google (Nasdaq: GOOG). Mobile advertising is growing fast, and Google is a lower-octane way of playing that market rather than a smaller internet stock. The 2015 p/e of 18 offers a reasonable entry point.
Mouhammed: We like plumbing supplies group Wolseley (LSE: WOS). It’s a play on the UK recovery, and also has some exposure to the US. It’s got a strong balance sheet and healthy free cash flow. Another is fund management group Jupiter (LSE: JUP).
It focuses on developed-market equities, but is diversifying into bond funds, and has a good track record. It trades at a discount to its peers, which we think offers a good opportunity to buy, particularly as management plans to share the proceeds of growth with shareholders – suggesting good potential for dividend growth.
We also like plant hire group Ashtead (LSE: AHT). It makes more than 80% of its money from the US construction equipment rental market, which makes it one of our favourite plays on the US housebuilding recovery. Even though it’s the second-biggest player, it only has 6% of this highly-fragmented market, meaning plenty of scope for growth.
Killian: On Russia, we like oil producer Lukoil (LSE: LKOD). It’s the second-largest non-state oil producer in the world by proven reserves. The book value is below 1, it’s on a p/e of below 4, and it offers a dividend yield of around 3%. And to play Japan, we like the hedged version of the iShares MSCI Japan (LSE: IJPH).
A weaker yen tends to go hand in hand with higher Japanese markets, so if you hedge your yen exposure, you get the full benefit of rising prices (rather than losing out when you translate back to sterling). Of course, it also means that if the yen strengthens and the stockmarket falls, there’s nothing to offset that.
Finally, there’s the Bluecrest Bluetrend (LSE: BBTS) ‘trend-following’ fund. This allows private investors to access strategies used by hedge funds to profit from falling or trending markets. It could be useful as a hedge against rising interest rates – higher rates would hit the price of most other assets, and this fund could potentially profit from that. John: And any thoughts on the most important price of all – UK house prices?
Killian: Valuations of houses, like every asset, are a function of ratios. According to Nationwide, UK house-price-to-income ratios are slightly lower than in 2007, but still well above the long-run average of 4.1.
Sure, we’ve got the lowest base rate in history to support that right now. But higher rates, or slower economic growth, would hurt property – along with equities and bonds. So it is hard to see how property, at these sorts of levels, provides adequate diversification in a portfolio.
Mouhammed: The pace of growth in London is starting to slow, but the recovery is becoming more broad-based and feeding into the rest of the UK. That’s healthy. Rental yields in London look fully priced at around 2-3%. But in some smaller towns, you can still get close to double-digit yields. So there’s plenty of opportunity. Commercial real estate also looks attractive, with potential yields of close to 6%, compared to less than half that for government bonds.
Sandra: Government schemes to help first-time buyers have definitely helped revive the market. The risk is that these schemes are unwound, or that new measures are introduced to prick any potential bubble. But rising prices also reflect a lack of supply, along with demand from foreign investors. As long as those forces are still around – the last is more vulnerable to changes in the strength of the pound – pressurewill continue on UK house prices to rise.