It’s been a tough year for investors – but 2009 could be even tougher. As James Ferguson and Hugh Hendry point out, deflation will be the enemy (for now at least) – their views on how to protect yourself are below. Tim Price and Dominic Frisby like the look of gold, but careful stockpickers can still find opportunities: Sven Lorenz has a play on a despised sector, while Paul Hill shows you how to profit from pension-fund woes.
Buy Treasuries and blue-chips
My view on 2009 is not hugely different to what I predicted for 2008. I warned then that it was the end of cheap credit, which would hammer asset classes that relied on the credit bubble for their returns. Next year will bring more of the same. Illiquid assets take a long time to unwind. History shows that bank deleveraging (or more accurately, asset book de-risking) takes four to five years on average; that’s how long we should expect the credit crunch to hang around for. So illiquid assets, financed by cheap credit, like property, hedge funds and private equity, will all continue to suffer.
I can’t see things improving much for hedge funds, although most of the damage may have already been done. The private-equity outlook is far worse. The model always seemed to rely almost entirely on the mis-match between very low financing costs and very cheap equity. Already commitments are changing hands at 50% below face value. Private equity also bought very badly; I expect some of the biggest bankruptcies to come in this space. As for property – I’ve been very bearish on property for several years and I expect to remain so for a good few to come. All my sums suggest prices will fall by more than 50% from the peak (at least in real terms). With inflation so low, nominal price falls will also have to be very large – larger than anything seen since World War II, since all prior house-price corrections were partly obscured by inflationary environments.
Also, I’ve never been a fan of emerging markets or commodities. I could never subscribe to the de-coupling myth when 46% of Asia’s GDP (excluding Japan) was accounted for by exports (a 1% drop, for example, in US GDP leads to a 22% drop in Chinese exports). Likewise, industrial metal prices actually stopped rising a year ago. Once oil and food peaked earlier this year, the scene was set for the end of the commodity bubble (chased up in large but unquantifiable part by financial funds and leverage) and of product-price inflation pressures.
For many, gold is the obvious beneficiary of the huge need for government debt, but I don’t really buy this either. Gold seems to have been in a downtrend since the March peak, although it’s falling at a slower rate than other assets. Ultimately, it’s a hedge against a total breakdown in fiat currency confidence (don’t get me wrong – this could still happen) and is a great inflation hedge, which is what has been driving its run since 2001.
But ten-year Treasuries, which were very worried about inflation as recently as mid-November, have suddenly got the deflationary story. And that’s the story I believe will dominate over the next couple of years. Deflation will drive a multi-year bull market in government bonds as all the record-breaking supply gets scooped up by banks (government bonds are very low-risk assets, guaranteed not to default). This is the one area where I’m confident you can make money, especially in long-dated bonds, as long as you avoid inflation-protected (index-linked) issues. You can get broad exposure to gilts via the iShares UK All Stocks Gilt ETF (LSE:IGLT).
What about stocks? I expect big, boring, liquid, lowly geared, defensive blue-chips (the FTSE 100 basically) to keep outperforming smaller stocks (which were driven up by private-equity bid hopes over the last six to seven years). Between 1999 and 2007, the FTSE 100 fell from more than 1.2 times the FTSE 250, to below 0.54 times, a relative drop of 55%. Since 2007, the FTSE 100 has so far gained 30% relative to the smaller index – but assuming a return to 1999’s levels, there’s another 70% or more relative outperformance to go. But what will stock prices do compared to cash? In the run-up to May (usually seasonally strong), a bear-market rally is more than possible. Banks should start making profits again (although only because the accounting rules have been fiddled), and while whole economy earnings will drop across the board, they may not fall by quite as much as markets expect. But any rally should be used as a good time to sell, rather than an indication that the worst is over. The only stocks that can make actual gains through such a period will be very defensive blue-chips. Super-safe FTSE 100 stocks (in that they have high Altman Z-scores – see Tim Price’s note on page 28) include software group Autonomy (LSE:AU); drug giant GlaxoSmithKline (LSE:GSK); engineer Amec (LSE:AMEC); food and retail group Associated British Foods (LSE:ABF); and defence group Cobham (LSE:COB).
Go for the least-worst options
Back in 1980, President Jimmy Carter, chastened by the economic turmoil of the time, called upon American ‘patriots’ to cut up their credit cards. In the words of Paul Volker, then-Fed Reserve chairman, “the bottom just fell out”. The US economy nosedived. Having grown 1.3% in the first quarter, real GDP contracted 7.8% in the second. Many feared the Great Depression Part II. They were wrong. Unlike today, America wasn’t leveraged, asset prices were modest (the Dow sold for just 192 in real terms, 49% below its 1929 high) and already wary consumers had a cushion of high savings. The recovery was swift.
Fast forward almost 30 years. Spending is again shrinking in real terms. But the recovery is unlikely to be as rapid as in 1980. This time, the economy is leveraged, the savings rate is just 0.5%, the rate of inflation might turn negative next year and asset prices are still high (the Dow is trading four times higher in real terms than in the 1980s; house prices have only fallen back to 2006 levels). As falling asset prices lead to unprecedented wealth destruction, households will aim to rebuild their extremely low savings. Should the savings rate return to some kind of average, then the US economy could see the equivalent of two years’ worth of Wal-Mart sales – $800bn – permanently removed from the economy.
Deflation and high-debt levels are a toxic mix. Businesses cut prices, jobs, and investment to try to stay afloat. The entrepreneur cuts costs by firing his ultimate consumers, who are forced to cut spending further and are unable to pay interest on their loans; bad news begets more bad news. But Fed chairman Ben Bernanke isn’t just aware of the dangers of debt deflation – he wrote the book on the subject. He believes the Great Depression was caused by a lack of money creation by his own organisation. So the Fed has slashed interest rates to zero – or as close as it can get – and has already announced it will buy bonds issued by mortgage groups Fannie Mae and Freddie Mac. The printing presses have begun to speed up. President-elect Barack Obama has also promised a huge fiscal stimulus package for early next year of at least $500bn.
So will the deflation bogeyman be crushed in 2009? We think not. It’s far from certain that quantitative easing (printing money) will work when the world is stuck with too much debt and spare capacity. There are no successful precedents: it works in theory, but this recession isn’t just a ‘credit crisis’. It is no longer possible for the global economy to grow through expanding debt burdens faster than incomes. Total US debt has risen from 165% of GDP in 1982 to more than 350% today. This process is over and the outcome is far from certain.
Meanwhile, countries such as China and the Middle East in particular have over-leveraged their economies to the whims of US consumers. They have been on a huge building spree, which could come to an abrupt end over the next year, exposing mal-investment in too many new factories, five-star hotels, apartment towers, and office blocks. In fact, with the recent bounce in global markets, we have opened a modest short on China’s stockmarket using the Ultrashort FTSE/Xinhua 25 Proshares (US:FXP), an exchange-traded fund that matches 200% of the inverse movement in the Chinese market.
So if global deflation is the future, what should we buy? In November, the long end of the government bond market grabbed everyone’s attention. Ten and 30-year government bonds across the US, UK and Europe saw some of their strongest monthly rallies in history. But with an almost parabolic rise in bond prices in recent weeks, we have sharply cut back our commitment to this asset class as the risks start to outweigh likely returns. Instead, we believe we’ve found an investment in which the possibility of losing money is unthinkable. I’ll explain. Two-year inflation-linked US Treasury bonds currently price in deflation greater than 4% in each of the next two years. So a real return of 4%, backed by the US Treasury, is sitting on the table. The only missing variable is the nominal return.
As long as you are not leveraged, there are worse things to do with your money. If you lose money on these bonds in nominal terms (remember you are guaranteed a real positive return), then other asset prices will lose far, far, greater amounts. An 8-10% fall in consumer price inflation over the next two years would bring about a debt-deflation spiral that would challenge the Great Depression in severity. Other asset prices would fall much further; certainly we would make a considerable return from our inverse Chinese bet.
In fact, you don’t want to think of the consequences of losing money on these bonds – equity and property markets would almost certainly halve again. So a nominal loss on these inflation-linked Treasuries would translate into a big leap forward relative to the price of everything else, except regular long-dated Treasuries and cash. It’s a strange world when one is choosing asset classes based on what offers the least unpalatable return. With global stockmarkets down 40% this year, some might mock our lack of valour. But how many of them will succeed?
Hugh Hendry is founder and CIO of Eclectica Asset Management
Why everyone must hang on to gold
I reserve the right to change my mind as events unfold – but for now this is what I see. We are in the early stages of a bear-market rally, which could go on until spring, with most stocks and commodities rising. But it will be no more than a bear-market bounce, retracing about 50% of the falls from last August. Using methods I won’t go into here, I predict a peak on 20 April 2009. Then the bear will tighten its grip. We’ll fall through the November 2008 lows before year end, reaching an eventual bottom around summer 2011. Intraday volatility is so extreme that I would not use any leverage at all, unless you really know what you are doing. These are traders’ markets, not investors’ markets.
The fundamentals for gold are becoming more and more bullish. But measured in US dollars, although a retest of $1,000 is likely, I do not see a significant break to new highs in the first half of the year. Perhaps we will see a decline from late April into July or August, which is when I expect to see the next six- to nine-month move in gold beginning. The price will break above $1,000 towards the end of the year, or by early 2010, and by spring 2010 we will have made the $1,400 to $1,500 range.
But these predictions are based on crude technical analysis. The bigger picture is that this banking crisis could easily morph into a global currency crisis. Iceland will not be the only country to go bankrupt. There is no predicting when this might happen, so you must keep a core holding in physical gold at all times, particularly if you are a British resident. Exchange-traded funds are a useful trading vehicle, but until you can take delivery of the metal, they are not the same as owning physical gold. Talk of deflation is irrelevant if your currency collapses, and the sheer scale of Britain’s debts means that sterling is vulnerable. Although it’s due a bounce, in the longer-term the pound will hit new lows in 2009. I am less bearish on the dollar. It’s flawed, but it is benefiting hugely from its status as the senior global currency. However, I do expect a short-term pullback into the spring as other markets rise.
The good news is that there will be a big party in 2009, and that will be in gold stocks. I think we are in the early stages of a new bull market for gold stocks that could last for another two to three years. Gold stocks do well in a post-bubble contraction as, even without much higher gold prices, their operating margins rise dramatically as production costs fall. In 2007-2008, gold outperformed gold stocks. Recent price action suggests this is now reversing and gold stocks are now detaching themselves from the rest of the market. Gold stocks made a low in October. Everything else hit rock bottom in late November. They were the first to rise from the ashes and have since been one of the best-performing asset classes out there.
As for other sectors that should do well, I would suggest infrastructure stocks and clean tech, both of which should be among the main beneficiaries of government spending programmes worldwide. Look at China Energy Recovery (US:CGYV) as one small-cap route to play this. They use heat and other waste energy from Chinese industry to generate electricity and have an order book almost as big as our glorious government’s portfolio of banking stocks. I would also consider positions in oil. The oil price may be falling now, but I believe in Peak Oil theory, and one day this chicken will come home to roost. But for now, I would avoid most Canadian Royalty Trusts. Instead, take a look at Gulfsands Petroleum (Aim:GPX). With producing fields in Syria and the Gulf of Mexico, nice numbers and some exploration upside, it’s a nice little junior play on oil.
One last prediction – David Hayes will become boxing’s heavyweight world champion by spring 2010 at the latest.
Pensions adviser well placed to cash in on market woes
One side effect of this year’s collapse in global stockmarkets is that pension plans are at risk of not being able to pay out. According to the Pensions Protection Fund, at the end of November, the UK’s defined benefit pension schemes had a combined deficit of £155bn, with £47bn wiped off their value in October and November alone. Pension assets around the world have plunged by around $4,000bn in 2008.
This is, of course, a major concern to trustees, whose powers have recently been beefed up on both sides of the Atlantic. For instance, in America new laws force sponsors to revalue under-funded schemes and make extra contributions over a seven-year period. With the major markets not expected to recover anytime soon, it’s likely that demand for related pension advice will grow in 2009. One stock well placed to benefit from this counter-cyclical trend is Watson Wyatt Worldwide (NYSE:WW). Watson Wyatt is a leading human resources consultant. Its largest division provides pensions and benefits advice to firms, actuaries and trustees around the world. As many businesses cut jobs, there is also the need for expert advice on redundancies, lay-offs and corporate restructuring, again boosting Watson Wyatt’s near-term prospects. Turnover is split roughly 43% in America, 32% in Britain, 15% in continental Europe, and the remainder in the rest of the world.
Chief executive John Haley said in November that all the group’s “operations grew on a constant currency basis, and we expect to continue to see a lot of work for the remainder of the year”. The firm expects revenues and underlying earnings per share for the period ending June 2009, to be $1.75bn and $3.50 respectively. The big unknown is the strength of the dollar. Due to its heavy international exposure, a 10% drop in the pound or euro against the dollar, translates into about a 5% hit to earnings. But organic growth remains solid, and the stock trades on an attractive forward p/e ratio of 11.8, along with having minimal net debt (of $40m). Cautious investors hunting for recession-resilient stocks should definitely take a closer look.
A safe bet for 2009: a bank in a former war zone
Banks are widely seen as a toxic asset class right now. So buying a bank in the middle of a former war zone probably doesn’t sound like a great tip for 2009. Yet this particular bank might actually be one of the safest bets in the sector.
This year was grim for many, but few more so than the people of the former Soviet Republic of Georgia. In August, Russia moved its troops into the country to gain control of the breakaway regions South Ossetia and Abkhazia. Before the brief war, Georgia had made a name for itself as a small, yet highly desirable investment location. In 2006, the World Bank named it the most reform-friendly economy in the world. By 2007, cumulative foreign direct investment over the previous five years amounted to a staggering 51% of GDP.
From this country of just 4.4 million people came an investment that just a few short years ago got London’s institutional investors very excited indeed. As recently as 2004, Bank of Georgia (LSE:BGEO) had been a $25m niche bank from a country that most people couldn’t even find on a map. In December 2006, the same bank listed on the main board of the London Stock Exchange and reached a market cap of more than $1bn.
American-educated CEO Lado Gurgenidze had brought far-reaching changes to the bank. Once a loss-making commercial bank with a narrow business model, Bank of Georgia became the undisputed domestic universal bank. Its activities included corporate banking, retail finance, asset management, private banking, insurance, and securities trading. Net income in 2007 rose to $47m, twice its market cap of just four years earlier. With 150 branches and more than a million clients, Bank of Georgia is now the country’s leading bank with a market share of more than 30%. Gurgenidze’s management skills were widely noticed and he became prime minister.
The combination of the global banking crisis and the war brought a halt to the success story. Investors had driven the share price from $18 at the time of the initial public offering to $44 by the summer of 2007. It has since fallen back to around $4.25. But with the war over, is Bank of Georgia set for a comeback? Trying to predict the next quarterly figures of just about any bank right now is difficult and pointless. But investors should primarily look at the big picture. The share price has fallen 90% from the peak. Does the bank deserve to be valued at less than one tenth of the value the market assigned to it just 18 months ago?
Political reverberations will persist, but Georgia has essentially lost these two breakaway regions. Does it matter? Economically speaking, the two regions had a combined population of less than 250,000 and made up just 5% of the entire populace. The rest of the country has received a $4.5bn assistance package from the international community, a huge stimulus, amounting to $1,000 for every person living in Georgia, compared to a yearly GDP per capita of $2,500. There are bound to be losses in the local loan portfolio. Some customers may choose to keep their money under the mattress and economic activity in the country will be dampened during 2009 (GDP growth is projected to slow from a run rate of 10% a year to around 3% in 2009). But the bank has relatively low leverage, a conservative liquidity position, and a disciplined management team that immediately took steps to deal with the crisis. And it has no subprime exposure.
The latest figures on the Georgian economy also give some hope. The bank had made provisions to deal with a 5% fall in GDP and a 10% devaluation of the local currency. The currency was devalued by just under 10%, but the latest GDP figures are more upbeat than the bank’s internal guidelines. In other words, the Bank of Georgia could soon be upwardly revising its projections. All that is needed now is for the market to realise that in the long-run, Georgia can pull itself out of this situation – just as it did around the millennium, when it went from agrarian poor-house to super-charged emerging market by introducing very low flat taxes, for example. American Express just issued a vote of confidence in the country (and the bank) by choosing Bank of Georgia as exclusive partner for issuing its credit cards in Georgia. Clearly, the US card giant believes that Georgians will still be able to pay their shopping bills.
What London’s institutions were chasing back in July 2007 at $44 is now available at around $4. At this level, the share price seems to have bottomed. It is trading at less than 0.3 times book value, extremely low given the conservative balance sheet. Even if two subsidiaries in Belarus and Ukraine were written off entirely, the share would only trade at 0.4 times to 0.5 times book value. At the end of this very difficult year, believing there is light at the end of the tunnel is hard. But given how oversold the markets are, 2009 should bring a quick rebound once confirmation comes that the world isn’t ending after all. Think 2010 and 2011, and both the war as well as the sell-off of shares might have grown to be a distant memory. Getting in now could then look like an incredibly smart decision.
Sven Lorenz writes at www.undervalued-shares.com and is CEO of Swiss fund-management firm ARBB.
The future looks very much like the past
The most interesting sector to watch in 2009 is likely to be hedge funds – in many respects the ‘ground zero’ of the financial markets as 2008 staggered to a close. It was the forced selling of assets by hedge funds, in order to return money to spooked clients, that contributed to the wholesale sell-off in financial markets over the last 12 months. The scale and ubiquity of the sell-off has left all sorts of mispriced assets amid the rubble. Some will prove to be great opportunities for the brave. As Warren Buffett once said, “cash combined with courage in a crisis is priceless”. Hedge funds that survive the fall-out will be in clover.
But in the meantime, what should investors who have managed to shelter their hard-earned cash from the storms of the past year do to preserve their wealth – and create more – in 2009? Cash alone is unlikely to do the job. Interest rates will fall further to multi-decade lows. Sterling base rates are already at levels last seen in 1951, while recessionary forces and deflationary pressures are gathering strength. And while the pound is currently the whipping boy of the financial markets, I fear that 2009 will see more widespread suspicion of all fiat currencies, particularly those of unbalanced and heavily-indebted economies. That means we could see significant returns from the monetary metals, gold and silver.
Equity markets will continue to be volatile. Hedge fund deleveraging may be largely over by the second quarter, but global asset prices will keep falling. We already know which sectors will be broadly defensive if the bear market continues: they include food, brewing (particularly spirits), tobacco, utilities and pharmaceuticals/healthcare. At a stock-specific level, investors should focus on businesses with little or no debt that have monopolistic characteristics and robust balance sheets capable of weathering an intense downturn.
One measure above all will be relevant for equity investors in 2009: the Altman Z-Score, which takes into account working capital, earnings and equity relative to debt and assets, and which indicates the probability of a company going bankrupt within the next two years. Companies with high Z-Scores, and ideally with high, well-covered dividend yields, will be the ideal Christmas gift – I personally like BP and Royal Dutch Shell, which both pay dividend yields in excess of 5%. As for bonds, 2009 is likely to be the year for high-quality corporate bonds, already trading at their cheapest levels relative to government debt since the 1930s. While default rates will inevitably rise, again a focus on robust businesses with sound credit ratings will reward the patient investor. You can buy broad exposure to corporate bonds cheaply using the iShares £ Corporate Bond ETF (LSE:SLXX).
So the future looks, for once, quite old-fashioned: there will be merit in high-quality stocks and high-quality bonds – and probably not much else.