Last year was a tough one for investors. ill 2012 be any different? And what should we be buying now? Six of our experts give their views.
Watch out for the coming bull market in stocks
By James Ferguson
As a result of Europe's failure to deal with its debt crisis, the second big credit crunch in four years has begun. This will be the theme that dominates 2012. It's bad news for the real economy. But it does mean that we're almost certain to see quantitative easing (QE money printing) in Europe this year. And that will be good news for European stocks, many of which already look cheap.
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But first, there has to be some pain. The problem is that the European authorities have become obsessed with imposing fiscal constraints on member countries so that Germany can bring itself to commit to fiscal transfers. However, as a result, they have inadvertently introduced a banking crisis by the back door. The European Banking Authority (EBA) has demanded that European banks recapitalise themselves. It wants them to raise an extra €115bn by June. That may sound like a good idea, but the EBA is getting the whole process the wrong way round.
Banks are supposed to start a downturn with lots of capital. Regulators should then let them run that capital down, as they absorb the losses they will inevitably suffer in a downturn. But this time, regulators allowed the banks to enter the downturn without sufficient capital to back the loans they have made (from a bank's point of view, the loans it writes are assets). Now the regulators feel they need to force banks to raise more capital, so as to maintain confidence in the system by improving banks' capital-to-assets ratios.
Unfortunately, banks can't raise new capital when the market is spooked. So they are doing two things. Firstly, several European banks have put their best non-core businesses up for sale. In other words, they are flogging the family silver, even though this could damage profitability in the long run. Secondly, they are reining in lending. If you can't easily raise more capital to back the loans you've made, then the only other way to improve the capital/assets ratio is to reduce the assets side of the equation. Roughly translated, this means shedding loans.
But there are two catches with this. The first is that €115bn in capital doesn't equate to the same sum in loans. Banks all have at least ten times gearing of loans to capital (in other words, they write ten times as many loans as they have capital). So the equivalent of raising €115bn in capital would be to shrink lending by at least ten times that sum. So you are talking about well over €1trn. That would be a bigger lending contraction than we've seen in the American banking system since their crisis started.
The second catch is that banks can't get rid of their worst loans. Why? Because for now they can pretend these loans are still going to be repaid in full. But if they get rid of them, they would have to write them down to their market value. That's a lot lower than the value at which they are carrying these loans on their books. Such write-downs would hurt their capital even more, making things worse, not better.
So instead the banks will ditch healthy loans. First to go are the short-maturity rollover loans (short-term loans that are normally just renewed). Interbank lending has already seized up. Next to go will be trade finance, commodity trading credit, working capital and credit lines. The hard work tidying up commercial real estate-backed lending and consumer credit will have to wait until significant retained earnings have been built up in a year or two's time. In other words, they can't start writing down the really bad stuff until they have earned enough profits to cushion against the losses.
We've seen this already in the first credit crunch from late 2008. But that only involved the banks of the US, UK, Switzerland, Ireland and Iceland. Now it's the turn of continental European banks. The bad news is that the banks aren't just super geared: they are also very large. Total European bank assets are estimated to be €32trn. So the impact of a dramatic pull-back in lending will be felt everywhere. European banks fund almost all international trade, credit provision in eastern Europe, 21% of Asian credit and much in Latin and South America. So the global economic outlook is pretty dire.
Yet the same is not necessarily the case for financial markets. In the first part of the year, the risks to news flow, sentiment and profit forecasts are to the downside, so expect gilts to continue their amazing run and stocks to stumble.
But just as the Anglo-Saxon economies did in 2009, the Europeans will eventually realise that there's only one obvious strategy to head off a deflationary depression once the European Central Bank has cut rates to as close to zero as it can: QE. In Britain, printing money to replace the money supply destroyed as our banks slashed lending was the only thing that prevented outright deflation and the sort of 28% drop in nominal GNP that Ireland has had to endure. Once the Germans see the light, they'll do QE too. That will be the market's signal to launch a bull-market rally in stocks, probably in the second half of the year.
James Ferguson is the head of strategy at Arbuthnot Securities.
Four bright lights in an increasingly dark world
By By Tim Price
These are dark days for investors. Interest rates on cash savings are set to remain at ultra-low levels for the foreseeable future. Bond yields remain eye-wateringly thin. The eurozone remains a basket case. There are debt bombs everywhere just waiting to explode. Did we mention the universal drive to depreciate currencies? A desperate macro-environment strongly suggests steering close to shore. In an unsafe world, here are my favourite assets:
High-quality debt issued by objectively wealthy countries and companies. If you're going to lend money to somebody (which is what buying bonds amounts to), lend it to somebody who can afford to pay you back.
This is exactly what the managers of the New Capital Wealthy Nations Bond Fund do (tel: 020-7766 0820). The fund consists of sovereign, quasi-sovereign and corporate debt issued by the wealthiest borrowers in the world. The fund currently yields more than 7%, which in my opinion is a bargain in the middle of a global debt crisis.
High-quality equity issued by objectively sound companies. You may be detecting a theme here. We know, more or less, what the most defensive stockmarket sectors are: pharmaceuticals; utilities; tobacco; consumer staples. To then get a handle on individual company prospects within these sectors you can do worse than use the Altman Z Score. This is a quick way of establishing balance-sheet strength and vulnerability to recession. High-scoring companies, particularly those indefensive sectors, are the best investments in the equity market.
Absolute return' or uncorrelated funds. The absolute return' fund sector gets a poor press, but there are managers within it who are capable of protecting their investors' capital in poor markets while growing it during good ones. CF Miton Special Situations' Martin Gray is one of them. Successful absolute return funds are best suited to wealthy investors more concerned with wealth preservation than unconstrained capital growth which is a risky proposition in the current climate.
Real assets, notably precious metals. In an environment of debt deflation, currency depreciation and unrestrained money printing, the risks of inflation rising to uncomfortably high levels are much more acute than normal. So it makes sense to hedge against those risks by holding the likes of gold and silver. It doesn't matter that gold has been in an uptrend for the last decade. What matters is that central banks are doing their damnedest to destroy their own currencies. They may well succeed. And in any case, real assets in all forms make sense as part of a broader portfolio and risk diversification.
This is a difficult market for all investors. But don't blame capital managers blame the bankers and politicians whose uncontrolled debt binge brought us here. I sincerely believe that a judicious spread of these investments will help to see us through until something closer to normality prevails.
Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report newsletter. Visit www.moneyweek.com/TPR for more.
A start up worth shouting about
By By Swen Lorenz
Bankers have become Britain's most-hated professionals. Few would trust their advice now, especially on life-altering decisions such as pension planning. This is unlikely to change soon. Yet people will still need to get financial advice, wealth management, and retirement planning services from somewhere. This is where a group of hedge-fund managers, family offices and entrepreneurs has spotted an opportunity to create Britain's next fast-growing financial services company.
So far, only a handful of investors have wind of this new venture. If you want to evaluate the investment opportunity, you need to dig through piles of reports and regulatory papers dealing with a company that has recently changed its name. But if you do make the effort, you'll discover some noteworthy facts. For example, the new chief executive who the Financial Times has described as a "hyperactive whippet of a man... who is fired up about the growth opportunities starting to emerge from the scorched earth of the fund industry" has agreed to run the company based on a very simple pay package: if he triples his shareholders' money, he'll be rewarded handsomely. If he achieves anything less, he will have wasted his time.
The man in question is Jonathan Polin. The company he has taken on is Aim-listed Ashcourt Rowan (Aim: ARP), an independent wealth management firm previously known as Syndicate Asset Management. It's had a tumultuous past. It was created during the boom years, but ran into some Iceland-related financing problems and underwent various restructuring measures refinancings, senior executive changes, the sale of unwanted assets. An earlier generation of shareholders was heavily diluted, losing almost its entire investment.
Yet despite this, Ashcourt Rowan has always had a relatively constant customer base. Throughout the financial crisis it retained about £5bn in client assets, proving it had a stable, attractive core operation. This in turn attracted a number of professional, forward-looking investors who felt the company was an ideal platform for initiating some sweeping changes both for the company, and for the British finance industry.
In theory, independent asset managers should have been among the biggest winners of the financial crisis. They tend not to have risky assets on their balance sheets, and they provide clients with unbiased advice about the best available financial products. Clients disillusioned with their banks should have been banging on their doors. Yet the independents failed to turn the crisis into an opportunity. Why? They lack profile in the market and the financial resources needed to invest for growth. Moreover, the public's wariness of smaller financial services firms hasn't helped.
Polin aims to change all that. He has spotted the need to consolidate a number of smaller British players into a bigger, more visible, stronger unit, and he has the backing of investors who can provide sufficient capital for an ambitious growth strategy. Polin honed his acquisition skills while working at asset manager Ignis, where he was responsible for buying out smaller asset management firms. A similar player in the US has been very successful. Affiliated Managers Group (NYSE: AMG) identified the need to consolidate independent wealth managers as far back as 1997. Since then, its share price has risen more than 500% and earnings are up sixfold over the past 12 years.
Many smaller players in the British wealth management sector are under huge pressure. Their regulatory burden only ever increases. So Britain urgently needs an equivalent to AMG. Polin's ambition is to turn Ashcourt Rowan into a "multi-manager platform", where smaller firms can latch onto a mother ship that takes care of back-office needs such as IT, compliance and distribution, while giving the asset managers and client advisers of the acquired firms the freedom to run their businesses. He believes that "wealth management will be the most interesting and vibrant sub-sectors of financial services over the next three to five years".
Investors recently snapped up an £8.5m placement of shares at 100p. But even at the current price of 115p, the market cap is less than £30m. With the CEO's pay package only kicking in once the market cap has hit £100m, he has every incentive to drive it higher. This is a small company where you can get into the slipstream of a number of experienced players. It won't be long before others start to take notice.
Swen Lorenz is a private investor, entrepreneur, and author. He publishes his own blog, www.undervalued-shares.com.
Sell aggressively in spring
By By Dominic Frisby
Over the last four or five years we have seen two huge financial forces clashing. On the one hand, we have colossal debt deflation. On the other, we have the attempted remedy of managed currency devaluation. There has been no real winner just phases when one force dominates. This clash has manifested itself as the risk-on, risk-off' trade.
In 2010, investors were happy to take risks as money-printing by governments seemed to be beating deflation. You could bet on anything, from emerging markets to commodities to precious metals. In spring 2011 the tide turned. Deflation became the big worry again, and suddenly you wanted to be in cash ideally the US dollar. I expect more swings between risk-on and risk-off mode in 2012. After all, policymakers are still caught between a rock and a hard place. The global financial crisis is unresolved.
But I also suspect the reservoirs of panic and fear are, for now, exhausted, and that investors will rediscover their risk appetite at least until the spring. In other words, we'll see a rally in stockmarkets, gold, gold miners and commodities, and a small slide in the US dollar. Take copper. Inventory levels in Asia (according to the London Metal Exchange) are at a five-year low. That leaves plenty of scope for buying.
The FTSE 100, meanwhile, has come up against resistance in the 5,600 area and the S&P 500 at 1,260. If we can get through these levels and stay above them, we may even get back to the highs of spring 2011. Mining stocks also look likely to rally. Most particularly the juniors came under a lot of selling pressure in the final months of 2011, due largely to tax-loss selling'. This is when the Americans and Canadians sell their losers to declare a loss that they can then offset against the winners elsewhere and minimise tax. That selling pressure has now abated, so there is a good chance of a nice bounce.
Precious metals should also rally. But I'm not expecting new highs. We might see $1,800 or even $1,900 an ounce for gold, but I believe that gold is still in consolidation mode after the dramatic moves it made earlier this year. Gold made similar moves in early 2006 and in 2008. On both occasions, gold went into consolidation mode for a year or more, settling at these higher levels, before going off on another of its runs. To be clear, I don't think the bull market is over. I've got a feeling it will end at about the time the victor of the debt deflation/currency devaluation war is declared.
However, even if I'm right about markets rebounding in the first quarter of the year, I shall be selling quite aggressively come the spring. There are too many tripwires out there, from civil unrest to the potential break-up of the eurozone; so I suspect it won't be too long before investors are fleeing for safety again. And if I'm wrong, and we are headed lower from here, without any rebound? Well, thank goodness for stop-losses.
Dominic writes for Money Morning, MoneyWeek's free daily email. You can sign up for it here .
Stocks and commodities to buy now
By Bengt Saelensminde
My portfolio is currently split into four parts, with 25% each in cash, bonds, equities and commodities. I'll focus on equities and commodities here. I have a much lower allocation to equities than perhaps most mainstream analysts. That's because I think we'll get better opportunities to buy stocks further down the line (that's why I have such a large cash holding). Investors have short memories. Less than three years ago, we were in the midst of a global equity rout. The bull market that came out of quantitative easing silenced the sceptics. But it seems to have run out of juice.
With the government now squeezing spending, rather than throwing more petrol on the economic fire, the economy looks fragile. And a soggy economy isn't good for stocks. Lower earnings lead to lower valuations it's as simple as that. I suspect that one reason why the FTSE is trading at just ten-times earnings is that investors expect earnings to fall. And I can't see anything happening to change that in the short term.
So which equities am I buying just now? One sector I like is pharmaceutical companies.
Worldwide Healthcare Trust (LSE: WWH) is an investment trust that gives broad, global exposure to the sector. It currently trades at a 7.8% discount to its net asset value, which looks attractive.
As for commodities, I think you need to hold these as the best way to protect your wealth against a financial system reboot'. We've built up too much debt in the West. It needs to disappear so that our economies can start to grow again. In biblical times this was called a debt jubilee' debt forgiveness. You can get there by decree, where the authorities re-set the monetary system, or it can come from hyperinflation, where the debt's real value gets inflated away. A deflationary depression could do it too: basically, businesses and individuals go bankrupt and debt disappears in a painful and protracted mess.
But however you get there, it's painful. So how would you protect your wealth amid this carnage? For me, the answer is physical assets, especially precious metals. Gold could be your best bet, whether we get the seemingly opposite outcomes of hyper-inflation or depressionary deflation. It is undoubtedly the king of the commodities. It's been used for thousands of years for both transactions and for storing wealth. Gold has historically been the ultimate security for the wealthy. Physical gold and silver coins safely tucked away are the ultimate insurance. But I can't put those in my pension or my individual savings account (Isa), so exchange-traded funds (ETFs) are a way to play financial gold'.
But it's not just gold. You can include industrial metals, agricultural staples and other foodstuffs you can even stretch it to other tangible assets, such as fine wines and art. I have around 8% in physical precious metals, 7% in gold and silver exchange-traded funds, 5% in mining stocks, 2% in agriculture stocks, and 3% in a commodities fund I'm particularly keen on the Close Brothers Enhanced Commodities II Trust (LSE: CED2). It was launched in 2007 at £1 a share and will be redeemed in June 2013. At redemption, investors get their £1 back, plus twice the growth in the value of a basket of commodities that includes crude oil, aluminium, copper, zinc, nickel, wheat, corn and sugar. If the basket hasn't grown, investors just get their £1 back. There is counterparty risk if any of the five banks backing the bonds behind the trust go bust, you'll lose some of your money but I think concerns about this are overdone.
Bengt Saelensminde writes The Right Side free email.
How to hedge against trouble in the Middle East
By Julian Redmayne
In 2011, the markets came through the upheaval of the Arab Spring virtually unscathed. That may well change in 2012. The struggle to halt Iran's nuclear programme is reaching its final stages. In the face of growing belligerence from Iran's leadership, Israel's political and defence establishment is giving every sign it's preparing for a military strike against the programme. Iran's recent threat to close the Straits of Hormuz could also lead to direct confrontation with America.
The key event leading to this increased rhetoric and military activity was the release in November of the International Atomic Energy Agency (IAEA) report on Iran's nuclear programme. This made clear that Iran's nuclear enrichment programme was now close to producing sufficient material to reach the threshold needed to build bombs. Adding to the urgency is the fact that Iran plans to transfer its centrifuge activity from the Natanz facility (always given as a top five target for either a US or Israeli strike) to the fortified mountain site at Fordow. The Fordow facility is built deep into a mountain range in the geographic centre of Iran near Qom. It is close to major military bases and is considered essentially immune to conventional attack. So once the centrifuges are moved and functioning, Iran's production of ever-growing amounts of weapons-grade uranium is, in practice, unstoppable. This gives America or Israel a period of only six to 12 months to launch an attack that would produce any effective delay in Iran's weapons programme.
Why not use sanctions? Because there seems little chance that they will succeed. Sanctions against Iran's nuclear programme have been in place since December 2006 to little effect. For knock-out sanctions to work against Iran's central bank or its oil industry, both China and Russia would need to agree to comply. Neither looks likely to do so.
What does all of this mean for investors? Even if an attack is avoided, tensions in the region are likely to remain high. This should support the oil price despite the frail economic backdrop. In all scenarios in which Israel or the US launches an attack on Iran, there is likely to be an immediate, significant rise in the price of oil, and the gold price. The extent and duration of the increase depends primarily on the Iranian response. Iran may opt to react indirectly, attacking Israel via terrorist groups such as Hamas and Hezbollah, and avoiding a direct confrontation.
However, Iran could take a more aggressive route attacking Israel, or US interests in Afghanistan and Iraq. Or it could aim to shut down the Straits of Hormuz, disrupting the global oil supply. These extreme scenarios could pull the US and others into a wider conflict, hammering oil production and exports across the Middle East. That could see the oil price hit $250 a barrel, reckons Israeli brokerage Clal. Currencies seen as risk' trades (ie, Australian and New Zealand dollars), would be likely to slide, along with the euro and pound, but those considered safer (ie, the US dollar, yen, and Swiss franc), would benefit.
It would also be bad news for most stocks. The Gulf War of 1991 saw falls of some 50% in major indices, and an Israeli-Iranian or US-Iranian conflict could well see similar losses. Particularly hard hit would be airlines, shipping, insurance, and eventually retail and manufacturing, as the knock-on impact of a higher oil price squeezed the global economy. However, there would be some beneficiaries, such as non-Middle-Eastern oil producers, which would rise in value as the world came to depend on them more for energy imports. Similarly, gold producers would likewise benefit from the gold price rise.
So it makes sense for investors to hedge against this risk. It's another reason to hang on to gold this year, and it's also worth getting exposure to the US dollar. As for UK oil producers, BG (LSE: BG) is a non-Middle Eastern dependent oil producer, while BP (LSE: BP) only draws a small proportion of its production from the Middle East. For the more adventurous, Brazil's Petrobas (NYSE: PBR), with output of two million barrels a day mostly sourced in South America, would potentially be a huge beneficiary of an oil price spike.
Julian Redmayne formerly specialised in Asian investment banking for SBCI & Barings. He currently works as an Asia-based consultant and analyst.
Ten outrageous predictions for 2012
Every year, financial group Saxo Bank publishes ten "outrageous predictions" events that it believes are "unlikely to happen, but far more likely than the market appreciates". Here are three of the predictions that we think could be among the most likely surprises of the year ahead.
Australia goes into recession
As Saxo Bank puts it, "if ever there was a country dependent on the well-being of China, it is Australia". As Chinese demand for natural resources weakens, Australia could be pushed into a recession, which would be made worse "as the housing sector finally experiences its long overdue crash a half decade after the rest of the developed world".
Sweden and Norway replace Switzerland as safe havens
With Switzerland still trying to prevent the Swiss franc from appreciating, "money managers are looking for new safe havens for capital". Saxo Bank suggests that ten-year rates on the two countries could end up falling to "more than 100 basis points below the classic safe haven, German bunds".
The US dollar rises 10% against the Chinese yuan (CNY)
The extent of the move might look extreme, but it's already becoming clear that the yuan is not a one-way bet against the US dollar. If China gets to the brink of a recession (meaning 5% -6% GDP growth), says Saxo Bank, then Chinese policymakers might decide "to allow the CNY to decline against the US dollar". Meanwhile, the dollar would be buoyed by the ongoing sovereign-debt crisis potentially sending "the pair up to 7.00, for a 10% increase".
Other outrageous' predictions include wheat prices doubling (amid more money-printing and a poor 2011 crop); 50 banks being nationalised across Europe as regulators force them to deleverage too rapidly (see James Ferguson's piece for more on this); and technology darling Apple's share price plunging by 50% from its 2011 high as rapidly increasing competition in its key markets leaves it unable to maintain its market share.
This article was originally published in MoneyWeek magazine issue number 570 on 6 January 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
