After the turbulence of 2010, what can investors expect from 2011?
James Ferguson warns against the comfortable consensus on gold, recovery stocks and emerging markets. Swen Lorenz tips a strong and growing company going cheap. Tim Price tells us about four funds that will deliver returns. Dominic Frisby is sticking to his 'things'. Simon Caufield is buying into Japan. And Hugh Hendry warns that the Chinese tooth fairy is not as benevolent as she seems.
Ignore the comfortable consensus a reversal is on the cards
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When I attended MoneyWeek's end-of-year Roundtable last month, I was struck by just how little had changed during 2010. Despite the huge volatility in news-flow, the same issues seem to be just as prevalent as they were this time last year.
It's not that things haven't moved on at all. But we haven't resolved any of the outstanding issues. The eurozone periphery is still insolvent. The recovery elsewhere still looks sufficiently on track for optimists to believe it's all quite normal, but at the same time weak enough to appear vulnerable to a sharp slowdown for those of us who are post-bank-crisis historians.
Corporate earnings are being driven by improvements in sales and profit margins. But this is happening off a very low 2009 base. Forecasters predict this growth will continue in 2011, yet the year-on-year comparables will get much tougher. Emerging markets and commodities are still top of everyone's buy list. Everyone still hates government bonds with a quite abnormal passion. Generalised currency debauchery remains at the top of most people's worry list, so even more reason to buy gold (although gold was trounced by silver over the last 12 months).
Perhaps the sole shift is that no one now sees deflation as a current risk and inflation a concern for later down the track. Most feel we're now in inflationary territory already (which is a bit bizarre, since house-price inflation is one obvious casualty of 2010).
So, what are we all missing here?
First, banks across the globe are still in trouble. The European stress test passed almost all banks with flying colours. Ever since, major European banks have been dropping like ninepins. Allied Irish Banks has joined Anglo Irish in state hands. Certain Portuguese banks could be next in the nationalisation stakes if the credit default swap market is anything to go by. That's pretty much a decent-sized bank failing every month or two since we were, rather farcically, told that all banks were safe.
Banks across the Western world are still shrinking lending. That's something they only do when they're repairing their balance sheets and hiding losses. So that gives us a strong clue as to why the story looks so similar to last year. Banks with insufficient capital usually take six years or so to get things back under control. During that time, lending shrinks and the economy struggles to grow much above the 1%-1.5% rate.
American growth in the third quarter was a more robust 2.5%. But 1.3% of that production was going straight into inventory. Even after record fiscal and monetary stimulation, real final sales are only growing at 1.2%. Next year, while exports should be up a bit, inventories will be down again. Contrary to what everyone believes, this is bullish for government bonds. Austerity measures are also good for government bonds, as is a barely growing broad money supply. Even Britain's retail price index inflation rate of 4.5% is down almost entirely to low year-on-year comparables and VAT hikes (which are anyway deflationary). This is also good for gilts. The average 30-year gilt yield over the last 12 years has been 4.46%. Today it's 4.40%, yet GDP growth is not expected to return to average levels for some years to come.
I also think that as apparent growth slows down, high and sustainable dividend yields will look more attractive. Avoid the banks, but otherwise, large, defensive UK blue chips with strong dividend track records look well-placed to outperform in 2011 after a disappointing 2010. This year has been all about the FTSE 250, with manufacturers benefiting from both the emerging market theme and the recovery of British exports after sterling lost more than 20% of its value in 2008. This story should continue in 2011, but some of these stocks now look expensive and are vulnerable to a sterling rally.
Gold is still your only real defence against the debauchery of fiat currencies, but silver is already right at the top of its range and looks like a sell now. The big swing factor in 2011, both for sentiment and industrial commodities, will be the rate at which the larger emerging markets deal with their inflationary pressures.
In such markets, with no deflationary shrinkage of bank credit going on, true inflation risks abound. With many countries' currency policies forcing them to run negative real interest rates, medieval suppressions will be required to slow their economies. Some time next year, inflation will either fly or the constraints will work too well. That could potentially trigger an Asian credit crisis to match our own, which would result in a rush for both American dollars and developed world government bonds.
So here's my main advice for 2011: beware the now-comfortable consensus trades of long precious metals, recovery stocks and emerging markets, versus short US dollars and bonds. Some, or indeed all, are vulnerable to a major reversal next year.
Buy into Chinese air travel
Beijing's international airport doesn't suffer from the kind of snow-related chaos that London's Heathrow has just become notorious for. Still, the shareholders of the firm that operates China's largest airport hardly have reason right now to be any happier than a passenger sleeping rough during London's Christmas get-away season. Since its 2007 peak of $2.25, the share price has fallen by nearly 80% and was last trading at around 50 cents. In the US, where Beijing Capital International Airport (HK: 694; US Pink Sheets: BJCHF) was listed as part of an earlier fundraising, that value denotes the share as a penny stock.
This contrasts with the airport's stellar growth. It recently became the world's second-busiest airport ahead of Heathrow. Since 2000, passenger numbers have grown at a double-digit yearly rate and reached 72 million this year, compared to Heathrow's 66 million and outdone only by the 88 million who passed through Atlanta's Hartsfield airport. Its newly built Terminal 3 is 17% bigger than London Heathrow's terminals 1, 2, 3, 4 and 5 combined. In some ways, this airport is one big success story, and with a capacity for 90 million passengers, it has a lot of room for further growth. It could well become the world's largest airport one day.
So what went wrong as far as the investment is concerned? As is so often the case in China, the company has been hurt by politics. The Chinese government plans to build another international airport near Beijing. There are worries that, despite China's ongoing economic growth, the city will eventually suffer a glut of airport capacity. And a lucrative airport fee that had been part of the company's income is potentially going to be scrapped. Throw in rising financing costs due to the huge capacity expansion, and you get a mix that has investors running for the hills. The long-term chart looks like that of a dotcom bubble company (see below).
But where there's adversity, there's opportunity at least, for those who are starting to invest at today's bombed-out price. Right now, investors have to pay little more than the company's book value to get in on the deal. Germany's Fraport AG, which operates Frankfurt airport, trades at nearly double its book value and doesn't have anything like the potential for growth that Beijing Capital International Airport comes with.
Rapid growth in a politicised environment often comes at the expense of short-term problems. Beijing CIA might just be going through the typical cycle that most airport companies undergo. As its peers around the world have shown, these kinds of growing pains are usually overcome in time.
One of the biggest missed opportunities of my investment life was Zurich Airport, which I failed to spot, despite passing through it several times a month. Zurich had just opened a new terminal, when the Swiss national airline, Swissair, collapsed. This, along with the financing costs for the expansion, saw the share price of the company that operated Zurich Airport plunge by 95%. Yet in the ensuing years, all these problems evaporated and the share price rose by a factor of 25. Airports are quasi-monopolistic businesses, and the world's addiction to air travelling won't subside. That makes airports the kind of asset that investors should pile into when they're available at a discount.
Beijing CIA's share price is unlikely to rise quite as much as Zurich airport's did. But the company has a lot of potential, stemming from a combination of ever-rising passenger numbers, increasing spending per passenger (on shopping and food), as well as improved efficiencies in the new facilities.
With 4.3 billion shares outstanding, Beijing CIA is now valued at just over $2bn. Gatwick, by comparison, is the world's 28th-largest airport, with 32 million passengers per year. Yet Gatwick was sold for well over $2bn in late 2009. Frankfurt's airport, in comparison, is valued at more than $5bn.
These are back-of-the-envelope figures, but should Gatwick really be worth more than the world's second-largest airport? With the world's major economies and asset prices gradually converging, it seems that the share price of Beijing CIA is set to go up and 2011 should be the year that this stock turns the corner.
Swen Lorenz is a private investor, entrepreneur, and author. He publishes his own blog, Undervalued Shares.
Four funds to buy now
The markets face some huge challenges in 2011. These include an unsustainable mountain of debt in the developed world; ongoing credit deflation; a growing crisis of confidence in fiat currencies; and the early stages of broad commodity inflation. So more than ever before, investors need to be highly selective about where they put their money. I view the investible world in terms of four broad asset types: high-quality bonds; high-quality equities; absolute return funds; and real assets.
In each case, you have to be extremely picky. And given the fragility of the banking sector and the ongoing debt crisis in the eurozone and elsewhere, you need to be particularly careful when it comes to bond investments. Rather than invest in what are seen as conventionally safe bond markets (those of the US and UK, for example, which mysteriously still enjoy 'AAA' ratings from the major agencies), I prefer to lend my money to governments that can actually afford to pay it back.
The best vehicle I know in this regard is the New Capital Wealthy Nations Bond Fund, advised by Stratton Street Capital (call Andrew Clark on 020-7766 0888 for more on how to invest). This invests only in those countries the managers consider the most creditworthy, and which have a high positive ratio of overall assets relative to GDP. These countries are widely overlooked by institutional bond funds, which typically only invest in the largest (and therefore most heavily indebted) government bond markets. Wealthy Nations also yields roughly 7%. Given its high fundamental credit quality, that strikes me as an extraordinary bargain in an environment of 0% interest rates.
In terms of equity investments, my favourite vehicle is RIT Capital (LSE: RCP), an investment trust managed by, and on behalf of, the Rothschild family. It's technically a multi-asset fund, albeit one in which equity plays the largest part. It's also exposed to a range of different currencies, including US dollars, sterling, Singapore dollars and the renminbi. The fund has recently raised its exposure to developing and frontier markets, and also to real assets in the form of gold and gold shares, oil and energy-related investments. As a one-stop-shop investment vehicle, RIT Capital has few peers. Its track record relative to the FTSE is mightily impressive.
Absolute-return funds get a bad press these days. But there are some superb managers out there if you look hard enough. The trick is to avoid the Johnny-come-latelies who are merely hitching a ride on the coat-tails of marketing hype. One of my favourite absolute-return vehicles is CF Miton Special Situations (0845-606 6182), managed by Martin Gray.
It sounds like a small-cap fund, but it's actually a multi-asset vehicle, again with a superb longer-term track record. Like any good absolute-return fund it is unconstrained by any requirement to track a specific index or benchmark, so if Martin wants to maintain a hefty allocation to cash, he can. Indeed, he currently does; over 40% of the portfolio is held on deposit, albeit across multiple currencies as with RIT Capital, this is very actively managed to optimise returns. Since launch at the end of 1997, Miton Special Situations has delivered a return of more than 270%, versus 82% for the IMA Balanced Managed Sector. This is a genuinely high-conviction, flexibly managed fund, which has so far delivered exactly what purchasers of absolute-return funds are looking for.
Last and by no means last, we come to real assets. For me, this consists largely of the monetary metals, gold and silver. Pundits still don't tend to 'get' the gold story. But the reality, I suggest, is fairly simple. Global investors are losing faith in paper money because governments continue to destroy its value by printing so much of it. In the words of Andreas Acavalos, management consultant, trying to assess the value of things under a fiat monetary regime is like trying to measure a length of cloth with an elastic tape measure. The only solution is to throw away the elastic (paper money) and use a yardstick that cannot be stretched at will (gold and silver). My favourite bullion fund is the Central Fund of Canada (TSX: CEF/A), a Toronto-listed closed-end fund holding gold and silver bullion. And it's denominated in Canadian dollars a currency I prefer to sterling.
These are challenging times, and there's every reason to expect further volatility throughout 2011. But I'm convinced that a diversified, though high-conviction approach across multiple asset classes is the best way to protect your wealth through the storms to come.
Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report newsletter .
Stick with things
Historians may well look back at the Noughties as one of the most, if not the most, volatile decade in history. Broadly speaking, from 2000 to 2002, the trade was deflation: be long cash and short assets. From 2003 until 2007, this reversed. You wanted to be long 'things', as virtually every asset going from stocks to metals to corporate bonds to real estate, rose dramatically in value. The last thing you wanted to own was cash. Then from 2007 to 2009 the pendulum swung back. Deflation was the name of the game once again. Forget 'things' cash, ideally the US dollar, was where you wanted to be.
And, of course, since spring 2009 we've been back to inflation. Stocks, commodities and corporate bonds have all roared higher, while cash has been fast losing its purchasing power in this environment of negative real interest rates. Central banks have successfully blown another inflationary bubble, where assets of all kinds are rising and cash is fading. Let's not delude ourselves that this rising market is due to sound economic fundamentals. Enjoy the rise and profit from it. But don't be under any illusions as to what it is. The question now is: how long until this latest bubble pops and we get the next, inevitable bout of deflation?
Sentiment is at extreme levels on the positive side of things, while there are all sorts of nasty threats from still-insolvent banks to a sovereign debt crisis lurking in the shadows. But that doesn't mean markets can't go higher. The more bullish investors become, the more leverage they will take on, which, of course, only makes the liquidity crisis worse when the bubble does pop.
My main mistake of the past year is to have been too bearish too soon. For now, the trend remains up. This may last another month, or even another couple of years. I wish I knew. But I do know that policy-makers in general have been trying to fudge their way around problems, to defer crises rather than tackle them head on, perhaps in the hope that they'll go away. The structural problems at the heart of our economy have not been properly addressed. Sooner or later, we are going to have to face the music and it is not going to be nice.
I can't help thinking that this period of reckoning, which could morph into a whopping great monetary crisis, is coming sometime between now and 2013. But it may well be later, rather than sooner. Bull markets have a habit of going on for longer than anyone expects, just as this rally from 2009 has exceeded all expectations.
I remain bullish on gold. I am bullish on silver too, but with reservations. I also have built up a larger-than-usual US dollar position, as I believe there is another rally left in this tank. And, broadly speaking, I remain very positive about certain commodities for which there should be demand, even in a crisis. As a play on this, for me, you can't beat junior resource stocks. At a fairly early stage in their development, but with quality assets and management, there is so much potential for growth. Of course, there is also huge potential for things to go belly up. I think that's why I find them so exciting. I'll be looking at the most promising candidates in MoneyWeek and the free Money Morning email in the months ahead.
Sell your bonds and buy Japanese stocks
What do Daniel Defoe, Benjamin Franklin and Brad Pitt have in common? Asked to predict the future, all three replied: "nothing is certain except death and taxes" (in Pitt's case, it was in the 1998 film, Meet Joe Black). Normally, I would agree. Most forecasts are invariably wrong including my own. But these are not normal times. And I think that a rise in US government bond yields is another sure thing to add to that list.
The ten-year US Treasury yield peaked at 15.68% on 25 September 1981. After falling for 29 years, it hit 2.50% on 26 August this year. Why anyone would lend to politicians for ten years at 2.5% is beyond me. The very next day, Federal Reserve chairman Ben Bernanke announced the second round of quantitative easing (QE2) at the annual meeting of central bankers at Jackson Hole. Since then, ten-year yields have jumped one percentage point. I suspect they'll keep rising because the US economy is recovering faster than anyone realises as it should be, with all the money being thrown at it. There will be a price to pay for that later, but it could be good for equities in 2011. But even if I'm wrong about the US economy, Bernanke will keep printing money until it recovers. Either that will cause inflation or bond vigilantes will start to worry that America can't repay its debt. Either way, yields rise.
Few of us have any memory of rising rates. All our experience everything we know about investing will be turned on its head. You need to prepare. Sell your bonds now. And consider going short using the Baring Absolute Return Global Bond Trust (0845-082 2479). It's a neat way to short government bonds without losing money while you wait for prices to fall. You could also buy high-quality, large-cap dividend-payers, especially in America. Stick with multinationals then you'll have a hedge if the dollar weakens again. But watch ten-year US Treasury yields like a hawk: 5% is probably all right but much higher could trigger a new bear market.
There's another, perhaps unexpected way to play rising bond yields: buy Japanese equities. They are already cheap. The price-to-book-value ratio is barely more than one. That means you're buying the assets at historic cost. In contrast, the S&P 500's price-to-book is 2.3. And if I'm right, rising US bond yields could be the catalyst that unlocks the value of Japanese stocks. Why?
Let's go back to summer 2007. The US Federal Funds rate is 5.25%. In Japan, official interest rates are 0.5%. Speculators borrow in Japan to buy higher-yielding US assets. This so-called 'carry trade' weakens the yen the exchange rate is 124 to the dollar.
But the financial crisis changes everything. Both US and Japanese interest rates fall to zero. The yen soars to 83 per dollar. Imagine you are chief executive of one of Japan's many world-class exporters. Your profit margins are now 33 percentage points lower than they were three years ago. And you're losing sales to your Korean competitors, because the Korean won has also weakened against the yen. You're still in business only because you've slashed your costs. But your profits have disappeared. If your stock price matches the performance of the Nikkei 225, it's down 61%.
So imagine what happens if US bond yields start to rise. Speculators resume the carry trade and the yen weakens. Your export prices rise off a much lower cost base. So your profit margins explode. Your stock price soars. Already the Nikkei index is up 16.5% since 26 August. I think it can go much higher. Buy Japan.
And, if you can, hedge the currency exposure. If I'm wrong, at least you have downside protection because Japanese stocks are so cheap. And a year from now, I'll be making the same prediction. Death, taxes and rising bond yields.
Simon Caufield writes the True Value newsletter.
China's tooth fairy turns malevolent
I think we are now approaching the end of a chapter that began with much cynicism directed towards China and commodities and is closing with fervent devotion. For example, the gold price has risen more than fourfold since 2002 and has climbed every single calendar year for the past decade; only the 12-year sequence of consecutive 'up' years from 1978 to 1989 in the Nikkei can beat it. I have no beef about gold, but how likely is it to be the next big trade?
In 1929, global economic growth was to be found almost exclusively in the creditor country, America. From 1927 to 1929 the debtor countries of Europe struggled with austerity. And when domestic demand finally faltered stateside, the decline was made more dramatic by this lack of offsetting economic growth elsewhere.
Today, of course, the Asian countries, especially China, are the only story in town. But the comparison breaks down when it comes to how pro-cyclical the Chinese have been in thwarting the steep recession of 2008. If we were still following the 1930s script, then the Chinese should have displayed monetary hawkishness concerning their domestic speculation and soaring asset prices. But this time around, the dominant creditor has shown great monetary extravagance and, as a result, global GDP growth is bounding back.
However, the recent Chinese hysteria concerning the Fed's second round of quantitative easing (QE2) may be a sign that this will change. I find the very vocal Chinese admonishment of the Americans strange. Sure, they own over a trillion dollars of US short-dated Treasuries and the value of this asset is vulnerable to inflation. But so what? I would happily wager that they would accept an almighty paper loss on such securities should it underwrite a robust cyclical economic recovery for their largest customer, the US. Remember, all economic policies in China are predicated on maintaining the Communist Party's hold on power. The true nightmare for the Chinese has to be a prolonged Japanese-style recovery in the West.
Arguably, their misgivings about QE2 bespeak anxiety over food-price inflation taking root and threatening their precious social cohesiveness. China's insistence on undervaluing and managing its currency while capital flight to its shores pushes more freshly printed renminbi back into its expanding banking system is evidence of the international economic order seeking equilibrium if not through the external value of the renminbi, then through higher domestic Chinese prices.
The Chinese have been the global economy's magic tooth fairy these last two years, absolving us from our economic sins and making the fallout from the crisis of 2008 more manageable than bears like myself thought possible. But it is just about conceivable that their benevolence is changing as they seek to rein in their own domestic price inflation.
Charity to strangers has come at a cost and their bureaucrats are frantically twiddling their knobs to cool the monetary system down. The danger is that a credit bubble when starved of its marginal credit soon exhibits a sudden and sharp reversal in asset prices. So the time is nearing when we might experience the world's two most successful creditor nations (Germany and China) seeking, if not a purge of the rottenness, then certainly its moderation.
Hugh Hendry is founding partner and CIO of Eclectica Asset Management ( www.eclectica-am.com).
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