John Stepek: The Bank of England and Bank of Japan are doing more quantitative easing (QE); in the US, the Federal Reserve may print more money too; and China is cutting reserve requirements and rolling over bank loans. What can possibly go wrong?
Mouhammed Choukeir: The point of printing money is to create inflation. For now, it's under control. But ultimately, this money has to make its way into the economy. So the danger is we get a big spike in inflation.
Killian Connolly: Although central banks are probably more worried that it won't work at all the Japanese have been printing for years and they still can't trigger inflation.
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Edward Allen: Yes, the problem is if banks fail to pass on the benefit money supply growth from the European Central Bank (ECB), for example, has been entirely swallowed up by the banks.
Marcus Ashworth: Yes, but meanwhile, Europe has narrowly avoided a massive credit crunch. Whatever you think of what Mario Draghi (the head of the ECB) is doing with the the Long-Term Refinancing Operation (LTRO Europe's version of QE), he has saved Europe in the short term at least. Also, just in the last week or two, central banks in the US and Japan the two biggest bond markets in the world have both set inflation targets. They've clearly decided that the way to deal with this crisis is to pump everything up until you can get out of it.
Mouhammed: Yes, at first QE was meant to avert Japan-style deflation, rather than create inflation. But what it has done now is fuel another bubble. We have been moving from one bubble to the next first it was the tech bubble, then the housing bubble, and now it's the government bond bubble.
Killian: But where will the next bubble come from? In the 1990s, the internet was going to create so much growth that price/earnings (p/e) ratios of 200 actually made sense to some people. Then you had people believing that house prices could only ever go up. Now bonds are a bubble much more of a bubble than people think gold is. But I'm not too sure what the hot new story is that will attract all the money out of bonds. Maybe there doesn't need to be one. I do think that people should be scared of the bond market as a place to leave their capital.
Marcus: Fed chief Ben Bernanke is trying to do two things: weaken the dollar and prop up the stockmarket. The Labour party kept power in Britain by making sure house prices kept rising. People were happy to borrow and consume because they had so much money in the house'. Bernanke no longer has the luxury of this property wealth effect because the American housing market has collapsed.
So all he can do is to try to prop up stocks instead, which account for a higher proportion of US household wealth than in most countries. We've heard it from Bill Gross, we've heard it from Warren Buffett everyone's expecting a wall of money to shift out of bonds and into stocks. Central banks want us are begging us to buy stocks, because they hope the trickle-down effect will then push everything else higher, and the housing market will turn up, which will refloat the whole economy and keep the banks alive that's the whole big con trick.
David Pinniger: Yes, but it's a strategy that accentuates social inequality people are rightly getting very agitated about the widening gap between the haves and the have-nots. People with huge properties and huge debts are sitting pretty, because debt is cheap, and everything is going to be massively inflated. But people who don't own property or expensive assets are getting absolutely nailed, and watching their cost of living rise as food and fuel prices go up. I don't think politicians are at all ready to tackle this problem.
Marcus: Did you see that great Jeremy Grantham quote? He was pointing out that the assets of the top 400 people in the States are equal to those of the lowest 140 million. "If that doesn't disturb you, you have a wallet for a heart."
Mouhammed: Central banks want to keep the party going. They want wealthy consumers to feel rich and keep spending. But the Fed has a duel mandate: price stability and full employment. They've managed to stave off deflation so far. So the way we should measure the Fed's success isn't by looking at the stockmarket, but at unemployment figures, which, to be fair, have been improving.
Killian: But you have to question some of the reporting of unemployment. It's all smoke and mirrors. The participation rate is at its lowest in years. Barack Obama's approval rating has gone up, so he'll probably secure a new term. But in reality, we have high unemployment and a level of debt that's reached the stage where it needs to be repaid or defaulted on, which will hurt GDP growth.
With a backdrop like that, I don't see who is going to move from bonds into stocks. Look what happened to Tesco it reported a small drop in its long-term growth outlook and the stock fell by around 20% in a couple of days. That's not a risk you want to take if you just care about securing an income for the foreseeable future. The idea that this is a problem central banks or politicians can solve simply by coming up with the right plan is a fallacy. This can't be solved: there will be defaults at some point. Trying to delay it is making things worse.
Mouhammed: QE is just delaying the inevitable. All these countries are running deficits, so the debt is in fact increasing. The more debt you have, the bigger the eventual restructuring or write-down you have to do. It's happening in Greece now, and others will follow. The trouble is that debt hurts growth. Japan may be surviving with a huge debt pile, but it's had sluggish growth about 0.7% a year since the mid-1990s. America in the 1990s was growing at 5% a year that's not going to be the case anymore.
John: So where are you investing now?
Mouhammed: In this environment, investors are looking for yield. And there are good high-yielding stocks around.
John: The defensive story is very well-known by now. Is it overdone yet?
Mouhammed: Certainly cyclicals have rebounded in the last six weeks, as investors got bored of being bearish. But fundamentally, nothing has changed. So we are still looking for value. And there are pockets of value within equity markets. The UK equity market, for example, offers a dividend yield of around 3.5%, against a long-term average of 3%. In America, yields are around 2%. The same goes for the likes of price/earnings (p/e) ratios you get better value out of British stocks than you do out of America right now.
Marcus: What about currencies?
Mouhammed: We are long dollars. That's simply an anti-euro view. One thing that led to the euro rally last year was the European Central Bank (ECB) hiking interest rates. That tailwind has been removed rates are going to be cut. The euro's value does not reflect the challenges Europe faces it should be closer to $1.10, not $1.30.
Killian: But the dollar is still a basket case. In two years' time, the US is going to be printing as much money as Europe. There are better currencies even fiat ones in which to put your money. The Canadian dollar, for example.
Marcus: I would certainly rather buy the Canadian dollar than the Singapore dollar or Swiss franc, but it's still very reliant on China, and on China, I think a hard landing is due. We already know these stories. What we want to know is, which currency is going to see the big, surprise shift? What if the yen weakens? Could Japanese stocks just go to the moon?
Mouhammed: Not with a 220% debt-to-GDP ratio.
Marcus: But if the yen falls, the exporters will fly and the stockmarket will fly.
Mouhammed: It's delaying the inevitable.
Marcus: Yes, but it means they'll go bang a few years later than they would have, and in the meantime, stocks will rocket.
Killian: Isn't the real problem fiat currencies? Maybe you just need to get out of them.
John: Who else is keen on gold?
Mouhammed: You wouldn't put all your money in gold, but you should have some. You don't buy it for yield or because it's attractively valued it's had a big run and who knows what its real value is? You buy it because in times of crisis it behaves very well, and it's also a store of value in case there is that big inflation spike.
Marcus: I suspect we might see it back over $2,000 an ounce.
Mouhammed: There are also rumours the Chinese are buying gold on the dips.
Marcus: That's a huge trend. The average factory owner in China is moving his money out of the yuan and into gold. Meanwhile, central banks in the likes of Thailand and Korea are adding to gold on any dips.
John: What else is everyone buying?
Edward: We are still holders of emerging markets. It wasn't much fun last year, but it has been good so far this year.
Marcus: If you believe in the rally, then that's where you have got to put your money. The better the US does, the better it'll be for emerging markets.
John: David, what about biotech? That's an exciting place to be at the moment.
David: It's been in the shadows for a long time, what with all the big-picture economic problems around, but now it's off to the races. The technology cycle is delivering fantastic new drugs, and we are seeing a huge wave of mergers and acquisitions (M&A). Big drug companies are in all sorts of trouble and need to outsource innovation to the smaller, nimbler companies. So you are getting this M&A feeding frenzy for drugs that really do change medicine. For example, a hepatitis C treatment is coming through that acts on the virus itself and actually cures the disease it's not often you get to talk about cures in medicine.
Marcus: Who are the big buyers?
David: The Japanese are hungry for US assets, and big US pharmaceutical firms are also desperate for assets. In Britain GlaxoSmithKline has shut down all sorts of research divisions neuroscience, for example. AstraZeneca has just restructured. They are all shutting cost bases that aren't delivering, and shifting their focus to areas where they can sell drugs at high prices for high margins, then going out and buying the assets they want. And they are writing really big cheques, which is why the sector has shot higher over the past two or three months.
Marcus: Are there any particularly exciting sectors right now?
David: Prostate cancer is a really hot therapeutic area because of the number of new drugs that are radically improving the survival prospects of men with late-stage prostate cancer. The same is true of multiple sclerosis (MS) and hepatitis C. HIV has turned from being a death sentence into a disease that you can now live with for decades that sort of change is starting to happen in these other very serious diseases, such as MS. Advances in genome technology have helped. Ten years ago, sequencing the genome was incredibly expensive and took forever. But now you can sequence a genome for $1,000 and it takes less than a day.
Marcus: So where should we be?
David: The sector is quite concentrated in the US. The Nasdaq Biotech Index consists of 160-odd companies, but in terms of investable companies for a generalist who is just chasing the theme, there are probably only about 12. The money is flowing into these and the multiples are crazy. I wouldn't pile in with all your chips right now, because it has had such a good run. But if we get a big pull back, get stuck in.
John: Marcus, what are your share tips?
Marcus: Qinetiq (LSE: QQ) is unique in the British defence sector. Leo Quinn, the new chief executive, has turned the company around and made it more professional, which should help it ride out the downturn in US defence spending better than its peers. It has a double-digit free cash-flow yield and looks set to be virtually debt-free by next year.
The CEO also has a history of delivering shareholder value via disposals, and management has confirmed that all three divisions of Qinetiq could be run as separate businesses. The Ministry of Defence is also increasing its focus on technology, which can only be good news for the company. The p/e of around 7.7 is lower than the sector average.
I also like civil engineering consultancy WS Atkins (LSE: ATK). It provides various infrastructure services for the big growth areas, like oil and nuclear. It trades on a p/e of less than ten and yields around 4.5%. Then there's pubs group Enterprise Inns (LSE: ETI). It's a pure and simple punt on the dash for trash rally. It's recovered quite a bit already, but there's room for more.
For a little pairs trade, you could go short Rio Tinto (LSE: RIO) and long Xstrata (LSE: XTA). Long Xstrata because I think Glencore is going to have to pay up a bit more for the merger deal. And short Rio because Rio is more dependent on China's iron-ore demand than the other miners, and so is more vulnerable to a hard landing there.
Killian: We're concerned about valuations across the board. There's little value in developed country sovereign bonds. Cash is safer, but offering return-free risk. While there are successful companies around, we think equity valuations simply have to fall in this deleveraging cycle we're in. But there is so much more out there that retail investors don't normally touch.
John: Such as?
Killian: If we could only allocate money to one strategy over the next five years, we'd invest in trend-following funds. Long-term trend following has been through world wars and new currency regimes and yet it's always delivered good, real (inflation-adjusted) returns over a three-to-five-year cycle.
So why doesn't everyone do it? Because it's had a poor last 12 months; it's not discretionary; and you are not making the choices yourself, you are outsourcing decisions to a quant or an algorithm. But that's exactly what we want. We don't want the last year to impact on our decision making. We want it to be very mechanical.
John: This is basically technical analysis, isn't it spotting trends and riding them?
Mouhammed: It has elements of that. I think its real power lies not so much in participating in the up trends, as in getting out in the down trends.
John: What's the best product to buy as an individual investor?
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Killian: Hedge fund group BlueCrest is launching an investment trust that will feed into its BlueTrend systematic trend-following fund. Since launch in 2005, this fund has returned 16% a year, annualised. In 2008, when everything else went wrong, it returned 14%. In 2009, it was up just 3%. But as a diversifier and a risk-reward play, it's something we believe should be in people's portfolios. It should be tradeable on the London Stock Exchange by the end of March.
John: Mouhammed, what about you?
Mouhammed: I think investors are concerned about two things. One is the return of their money, rather than the return on their money. The second is retaining their purchasing power. With regard to the return of money, gilts still have a role in portfolios because the UK government doesn't have the same issues as some of its European counterparts. Refinancing is only at 9% of outstanding debt versus continental Europe at 20%, and Britain is refinancing at around 2% versus parts of Europe at 5% or 6%. Gold is worth having too we like the Source Physical Gold ETC (LSE: SGLD), which is physically backed and also insured.
On the equity side, we like cash-rich companies offering good dividend yields. Within the telecoms sector, we like Vodafone (LSE: VOD). We also like caterer Compass (LSE: CPG), which is benefiting from outsourcing in the corporate world, and also from growth in emerging markets. It offers a yield of around 3.5% and it's likely todo a share buyback in the next two to three years.
Edward: We continue to buy Giles Hargreaves's Marlborough Special Situations Fund. The fund owns and trades UK small cap and Aim stocks, and Giles believes there could be further opportunities for M&A in the next 12 months. We also continue to buy the M&G Strategic Bond Fund, which has done very well over the last couple of years. Lastly, there's the iShares Dow Jones Emerging Markets Select Dividend exchange-traded fund (LSE: SEDY), which tracks a selection of high-yielding stocks from the MSCI Emerging Market index. ThisETF (exchange-traded fund)offers exposure to emerging market currencies and equity markets and throws off an income yield of around 7.5%, which provides investors with some protection against the volatility of emerging market equities.
John: David what's the best way into biotech?
David: I wouldn't advise anyone to buy just one stock in this sector, particularly not a small cap. If you are going to invest in biotech, use an investment vehicle: you could look at the iShares Nasdaq Biotech index tracker (US: IBB), which tracks the Nasdaq Biotech Index.
But if you don't want to do that, you could buy Shire (LSE: SHP). The company is diversifying into finding drugs that treat rare genetic diseases. They typically sell for high prices, but because they are treating tiny patient populations, the overall burden on the healthcare system is very low. So it's an area that we think is well insulated from healthcare reform issues.
The company is growing very strongly on the top line; and on the bottom line, the earnings-per-share growth rate for the next five years could be as high as 20%. Dividends are also being raised, and it's a perennial subject of M&A rumours: it's of a sufficient scale and in the right strategic areas to make it a very good fit for any big pharma company that needs a boost.
Futura Medical (LSE: FUM) makes nitroglycerin-coated condoms for enhanced sexual performance. They've sold the technology to Reckitt Benckiser who now own the Durex brand it's going to be launched this year.
John: If you had to buy one big pharma company, would you have a preference?
David: They've got into this huge patent-expiry cycle, which is chipping away at their cash-flow generation, so that's a big problem. Look for a company that's buying biotech assets that will give them long-term growth. Biotech drugs are quite well protected they are hard to make (and therefore copy), address serious life-threatening diseases in specialist markets, are highly profitable and insulated from healthcare reform and austerity, and have the right sorts of markets all the things that big pharma needs to do to bolster their long-term growth. Glaxo (LSE: GSK) is not a bad one it is good at deal making.
This article was originally published in MoneyWeek magazine issue number 577 on 24 February 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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