John Stepek: Markets seem complacent. Is anything going to wake them up?
David von Simson: I don't think people in the City look at macroeconomics, or think much beyond next week. It's all about relative value: "this is cheap compared to that". No one looks at the big picture and says "everything is expensive".
Killian Connolly: The market is by all reckonings overvalued, but that doesn't mean it's going to drop soon. The macroeconomic outlook might be bad, but it's got all this monetary debauchery propping it up. Too many people think that government involvement is the answer. We think the economy would be a lot healthier if we could have a bit of pure capitalism rather than today's crony capitalism but we're not betting on it.
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David: Having said that, we always underestimate how quickly America can turn around compared to the rest of us. We also always forget that there can't be a global recovery without America. So the nascent recovery in the States is definitely one bright spot.
Chris White: Everyone seems to accept that America is going to grow at 2% this year and global growth is going to be possibly 2.5% to 3%. What worries me is what happens after the American election.
David: I would probably have my money on Obama winning at this point.
Chris: Yes, I'm not sure any of the Republican candidates look particularly electable. But regardless of who gets in, there will have to be more of a commitment to austerity and tackling the deficit. That could eventually snuff out any positive news coming out of the US.
James Ferguson: I agree that there isn't much evidence that people understand what's going on. We are benefiting from investors taking the "don't fight the Fed" approach. My guess is that equity markets will be quite good until May. After that, you should probably sell up, spend the rest of the year watching the cricket and playing golf, then come back for some bargain hunting in October/November.
We still have some big issues to deal with. America is clearly the best major economy in the world, but only because it's winning the ugly contest. The banks' prospects are improving they are lending again and there are better employment prospects and a stronger housing market. But it's from a low base and it will probably be an unspectacular rebound.
That's still much better than the outlook for Europe. People don't understand that recent European Central Bank (ECB) schemes such as the Long-Term Refinancing Operation (LTRO) will actually accelerate rather than prevent banks from cutting lending, as they take the chance to de-risk their balance sheets. So Europe will either face a shrinking money supply, or it will have to do quantitative easing (QE). That can be good for markets, but so many people are against QE in Europe that we'll probably have to see the downside before it goes ahead. So I think as we go into the seasonally complacent part of the year with an artificial boost behind us that no one seems to understand the implications of, then really you should be looking for the right time to take some money out of the market.
John: Does Japan's recent rally have legs?
David: Japan's biggest problem is the truly terrible demographics.
James: Worse than Germany, worse than China? I don't think so.
David: Yes, worse than China. It's extremely difficult to pay off high levels of debt if you've got a shrinking working population.
James: Don't forget the debt is all owed to itself. The net debt is not 200% of GDP, it's only 120%. I say only Italy's is 120%, Greece would like theirs to be 120%. But it's not as bad as it first looks.
David: There are worse cases around, I agree.
James: In a banking crisis, it's not the size of the debt that counts, but the value of the assets behind the debt. If the value of those assets goes down, you start to have a really big problem. China had a huge 'banking crisis' during the Asian crisis, but because the value of the collateral never went down, no one gave a monkey's whether anyone defaulted or not, because you just took the collateral back.
The problem with Japan is that land prices now are a quarter of what they were at the peak they are back where they were in 1970. Land prices in Japan could double and they would still be half of what they were in nominal terms 20 years ago. So you've got the prerequisite for a fantastic recovery, which is also a classic value trap. Everyone piles in thinking the market looks cheap, nothing happens, it gets worse, they lose money, give up and leave. So it's vital to look for catalysts.
David: Aren't the Koreans and Taiwanese eating their lunch industrially?
James: In the last 40 years the average per-decade increase in the value of the yen has been 30%. Last decade it was 40%. That's a nightmare for exporters. All they can do is focus on cutting costs. But if these guys were ever put on a level playing field with everyone else, then watch out.
Killian: So a catalyst I guess would be the yen weakening?
James: It doesn't have to weaken, it just has to stop going up. Now that the Bank of Japan has started doing Western-style QE (rather than what they were doing before, which wasn't working), it looks like that is happening. We've already seen the yen break the chart in an emphatic way, and given that it's had four decades of strength and that the dollar looks fantastic value against the yen there is an awful lot of give in the system.
Chris: I'm not an expert on Japan but people seem to have been having this debate for the last ten years, and it hasn't got them very far. I can see there is a value case on price-to-book, but it does seem to depend on catalysts that may or may not be there. So I feel there might be better opportunities elsewhere.
James: It's funny you should say that, because I actually think the opportunity cost of Japan is quite low, given that it's very hard to make a really powerful case for anywhere else.
John: Where would you put your money just now Chris?
Chris: You can find high-quality, blue-chip stocks yielding 4.5% or 5% with well-covered dividends. The firms have good balance sheets and strong cash flow and the ability to grow that cash flow over time. So my big theme is companies with strong free cash-flow yields. I think a lot of those will do quite well over the next 12 to 18 months.
Five years ago, if you did a free cash-flow yield screen, you would be struggling to find large blue-chip companies with free cash-flow yields of 7% plus. Now there are plenty that yield 9% plus. These sorts of stocks did well last year.
They've done very badly in the first two months of this year, but they should come back as we go through 2012. I feel a bit nervous of following the trend and going into the cyclical names such as the miners, banks and industrials that have done very well so far this year.
John: Is anyone at all worried about rising interest rates?
James: Yes. I'm very worried it won't happen for years.
John: Maybe not base rates, but British banks have started nudging up mortgage rates.
Killian: Well, if I'm going to lend my money to somebody I want to have a real return. Central banks can lend at whatever rate they want. But anyone else needs to build in an inflation buffer.
John: What does it mean for British property though? We've seen the government desperately try to prop prices up again with this scheme for first-time buyers.
David: You might think the first thing the government wouldn't do is make every graduate leave university with £40,000 worth of debt. That's not the way to kick start the first-time buyers' market.
James: The government has no interest in making house prices affordable. Sure, it wants to look as though it is, but in fact it has a huge vested interest in keeping middle-class voters voting for it. You do that by not bankrupting them and by keeping mortgage rates as low as possible. We estimate that something like £270bn to £300bn of UK interest-only mortgages are not backed by parallel savings products, so they are 100% exposed to rising rates. The average interest-only rate is 2.77%. So if the base rate went back to 5% the long-term average many people's mortgage payments would nearly triple.
John: What if the banks get sick of forbearance and start calling in bad loans?
James: Arguably that's what you are seeing with banks raising interest rates. They are trying to price their risk appropriately. They are starting to say to people: "base rates will go up one day; I've got you on interest-only with no parallel savings programme. I think you are toast. I've got to start getting some repossessions and nudging this along. Are you going to pay me back or are you going to default? I need to know I need to manage my position."
John: What about China? It's obviously slowing down. Is that a major worry?
David: All the things that have been said about China seem to me to be broadly true: it is a very unbalanced economy, with a multiplicity of problems. There are rising social tensions; an unhappy banking system; and a lack of any kind of domestic consumption-led growth.
Chris: Growth is still 7.5% of GDP. It's the shape of that growth that's going to be interesting over the next few years. You might have less government stimulus-led, infrastructure-type programmes instead they are trying to make it more consumer-led. This could have ramifications for miners and metal prices.
James: The implications are huge. If China is moving from a capital spending cycle to a consumption cycle, the whole metal story is gone. My concern about trying to boost consumption is that 40 years ago consumption in China was, pretty much, almost as high as it is in the US. But now it's one-third.
Between times, you've taught two generations of Chinese that the state is too busy building infrastructure through the state-owned enterprises to help them, so they'll have to look after themselves in terms of medical treatment, retirement and all the rest of it. And suddenly the state turns around and says, "our new thing is going to be consumption".
That's going to be a tough transition to manage, especially as consumption is a much smaller proportion of the economy than infrastructure. I'm not saying it can't be done, but if you're running it from head office with the sort of poor information the Chinese have, it's not going to be easy. I'd be very impressed if it turns out that capitalism was a 100-year mistake and that we should actually have been doing this with a Politburo telling us how to run the economy all along.
Killian: It's not that much different from what happens in capitalism.
James: It's not that much different from what happens in capitalism now, but I'm talking about the last hundred years.
Killian: The thing is, whatever happens, we won't see any banks go bust in China. You didn't see that over here either of course, but you're not going to see people wake up and say "the banks are in trouble, let's pull our money out". Any troubles will manifest themselves in social upheaval. Because the banking system is in a mess, you'll see manipulation there, and that will probably lead to high levels of inflation, which will anger the population when they find they can't buy a loaf of bread.
James: It is totally feasible that China could go wrong. Where did it come from? Nowhere. What has it actually done? Name a single Chinese product that you buy.
Killian: Is that not normalcy bias? Back in the days of the dynasties, China was the leading light it created paper money not necessarily a good thing.
David: Portugal was pretty good too around that time.
James: What you have to ask is, if China has become the latest Asian tiger just like Singapore, Taiwan, Japan, and Korea well, what had it achieved by the end of its surge in infrastructure investment? Had it achieved any brand recognition? Any corporate governance? Had it established any quality control? Were people actually buying its products because they were cheap but starting to appreciate the fact that they were high quality as well? The answer to all these things is no'. China has done none of this. I think history may well look back on China and say "what a waste".
Killian: But they've got human resources, and a relatively good infrastructure set up.
James: China may have got a really good set of infrastructure out of this, but there is a great risk for China that the world has moved on. Because it's not run by entrepreneurs, China has found itself able to earn a cheap buck by underbidding other manufacturers, but that's not necessarily a sign of strength. The fact that it can't turn any of its dollars back into renminbi is not a sign of strength.
One interesting thing that will happen quite soon is that if the dollar starts to recover, then in order to manipulate their currency, the Chinese will have to start selling their US Treasuries to buy back their own currency, because suddenly the renminbi will be a weakening currency, not a strengthening one. If that's the case, then America may well be back into a normal situation much more rapidly than people would imagine.
David: Never underestimate the capacity of bad government to mess up good economies. India underperforms grossly compared to its potential because of poor government. It's a very sad thing to observe. The country has perfect demographics and huge potential and it's just not getting its act together.
John: So where would you put your money just now?
Our Roundtable tips
David: I do believe in an American recovery, so I'd buy Cisco (US: CSCO). During the recession, a lot of spending on information technology naturally gets pushed back, so it tends to see a strong hockey stick' effect when it takes off, it takes off fast.
Also, Cisco has a huge installed base and high market share. It has been managed quite badly in recent years, but has begun to get it right again, in terms of restoring margins and moving back onto the offensive. Because it has underperformed, it has had a lot of analysts on its case. That means it's been forced to do things like start paying dividends. So it's a stock I think could perform very well.
The other is a North Sea oil stock, Valiant Petroleum (Aim: VPP). With oil at present levels and likely to stay there, a small explorer with good management strikes me as a great play. There are a number of exploration properties that should come on stream and I think the downside is quite limited, even though it has risen quite steeply in recent months.
Killian: AstraZeneca (LSE: AZN) is on a forward price/earnings ratio (p/e) of 7.3 and yields nearly 7%. It has dropped on the back of some of its patents falling away, but you can't go much wrong with a company with Astra's history and its strong management base. On that p/e it's worth more than a punt. People have been predicting the end of big pharma for a long time, but they have as big a stranglehold as any other lobby group on political interests.
James: Unlike 20 years ago they are not trading on 30 times multiples, it's sub ten.
Killian: I also like AMEC (LSE: AMEC), another energy play. It's on 14 times earnings, so it's not as cheap as we would like. But if you consider which sectors will get a bigger piece of the economic pie in the future, you've got to think there will be less going to finance, and more to energy. There is less easily accessible oil and gas out there, and then you've got the renewables play as well. AMEC has, if not consultancy, then engineering business along the whole value chain. It's not cheap, but it's a good quality stock and it makes products that will benefit society.
On gold there's a Channel Islands-based investment company called Altus Resource Capital (Aim: ARCL). It's a junior resource mining investment company. The management team are geologists so people from the mining industry are choosing the underlying investments. If you believe in the high gold price, as we do, then this is a way to get an extra kicker, by investing in some of the smaller miners. The likes of Barrick and other majors are generating a lot of cash and need to build up their resources too, so we could see some merger activity. A lot of juniors have good potential based on the fact that they might be bought.
Chris: Daily Mail (LSE: DMGT) has a free cash-flow yield of 12.5% before the dividend. It's on a p/e of nine, and a yield of 4.5%. People think of it as a newspaper company not surprising, given the name but 65% of its profits come from its business to business (B2B) units, such as Euromoney.
The B2B businesses are growing underlying earnings at about 6% a year. I think it will do something with its regional newspaper business, which is the problem area, and only represents 5% of profits. I think it will be merged with something else, which will take an awful lot of cost out. I think the group will also buy out the minority of Euromoney, which it doesn't own and will probably sell the events business during the next 12 to 18 months. The free cash-flow yield should be pretty stable.
Close Brothers (LSE: CBG) is my second pick. I don't necessarily like banks per se, but I would pay up for a bit of quality in the sector. The bank has grown at double-digit rates for the last five years or so, and it is very good at what it does. A lot of people think that the current market cap of Close Brothers is covered by the banking business, but it also owns a securities business, Winterflood, which is starting to improve after a bad year last year. On a yield of 5.5% and a p/e of about 11, with a price-to-book of about 1.4 times, it is very attractive.
As for my last stock William Morrison (LSE: MRW) it's a very cash-generative business. People are worried about a price war among the supermarkets, but I don't think it's going to happen. I think Tesco will just invest in more staff to improve its customer service.
Morrison is interesting because it's just a food retailer. It's got everything to go for in online, non-food and metro-type stores, so that's all growth ahead of it. If it gets that right, the shares will do very well and the current market cap is just about covered by the freehold property anyway, so I would be pretty confident in that as a store of value.
James: I agree with Chris that you can't go far wrong with a good quality, high-yield portfolio. There are two things that might be interesting on top of that. One is US bank Citigroup (US: C). Citigroup's loan-loss rate now is 15%; the Japanese banking system's loan-loss rate was 20% when it was all done and dusted; and the average in a banking crisis is 10%.
Citigroup has done a huge amount and, of course, that gives it a reputation as being a rubbish bank because it has generated a lot of losses. But if you are looking at this from a balance sheet point of view, it means that Citigroup is a long way through the cleaning-up process. Yet it's still trading at a substantial discount to book value of 0.6 times. In the old days, it traded at a premium of 2.0 times book. So I think you are covered a long way in terms of downside and it's all gravy on the upside.
Then there's Japan. You can buy exposure to Japan via investment trusts on deep discounts for example, the JP Morgan Japanese Large Cap Trust (LSE: JFJ) and Schroeder Japan Growth (LSE: SJG). You can also go for the Morant Wright Nippon Yield Fund, which is run by some very good guys. A market that can double and still look cheap could really be a proper bull market, and Japanese property and Japanese exporters, in an environment of a weak yen, are two such markets. You would be mad not to have some.
This article was originally published in MoneyWeek magazine issue number 581 on 23 March 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
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