What will happen as quantitative easing in America is tapered off? And where should investors put their money? John Stepek talks to our panel of experts to find out their views on the best shares to buy now.
Jan Luthman: I think we are seeing a transition from valuations being driven by QE to being driven more by economic reality. I don't think that's a bad thing.
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Max King: We thought markets were getting towards fair value after a good run this year, so we took some risk off the table before the recent sell-off. I don't think the Fed's comments about QE are significant. What's significant is the pick up in growth the tapering off of QE is an inevitable and healthy part of that. The market's recent slip was to do with the fact that it had enjoyed a good run and just needed a bit of correction.
Paul Marson: I don't think QE does a great deal for economic activity. If you look at the relationship between interest rates and the velocity of circulation of money, it is pretty much linear. Effectively, for every 1% of growth in the monetary base you get an offsetting 1% decline in the velocity of circulation. In other words, as you increase the monetary base, money circulates more slowly, offsetting any inflationary impact. It's a way of creating investor discomfort, by reducing the yield on cash to zero and forcing people to take more risk. So while QE drives up asset prices, it doesn't have much effect on consumer prices.
However, while getting into QE is quite easy, it's much harder to reverse it. That's because if you start raising interest rates, money starts to circulate more quickly it starts to work harder. So a small rise in circulation combined with a much larger monetary base than normal would give you a sharp rise in inflation. If you don't want that to happen, you have to cut the size of the monetary base very quickly.
For example, if the Fed wanted to raise interest rates back to more normal' levels, it would have to cut the size of its balance sheet in half in one go, or inflation could surge. But that would decimate bond markets. So they'd probably rather taper it off gradually reduce the QE then keep hanging on to what they've bought, and let their balance sheets mature over the long term, rather than reversing it.
Max: Perhaps they won't need to reverse it. Increased capital requirements mean the lending capacity of the banks is much reduced. So banks are unlikely to be a major source of money creation via new lending in the near future.
John: What about the UK economy?
Jan: The housing market is definitely picking up. The government's new mortgage guarantee scheme may prove more powerful than many expect. You can actually re-mortgage under it, just not with your existing lender. One clear objective of George Osborne, the chancellor, is to help the new challenger' retail banks, which are small enough to be guaranteed by the government, to grow and undermine the existing, overly large banks.
We think this scheme will help with that, as consumers switch banks to re-mortgage at lower rates. It would also stimulate consumer spending, as they extract equity from their houses all of which would help the government win the next election.
Max: I do think people underestimate the strength of Britain. There's been a boom in London and thereabouts for the last three years, and it's spreading. But this new scheme is deeply suspicious. It might be justified if it resulted in more houses being built. But simply encouraging extra indebtedness to boost house prices would be a stupid thing to do.
Paul: Yes, the ratio of the average house pric to income in Britain is about 4.6 times and rising. In the late 1980s, in the previous boom, house prices peaked at roughly five times income. At the peak in 2006/2007 they were 5.7 times. Are we really saying that we are going to start the next housing market cycle in the UK from a valuation level that is only marginally below the peak of one of the biggest bubbles in British house-price history? This has more to do with political populism than economic policy. If you want to help young people to buy, then house prices need to come down.
Jan: Absolutely. America has had a massive house-price correction, but we haven't here. But the clearing mechanisms have been blocked for understandable social reasons. Do we really want to dispossess hundreds of thousands of people and repossess their homes? Since the major lending banks are owned primarily by the taxpayer, does it matter whether the strain is taken by bank balance sheets or by social security? It's still coming out of the central coffers.
John: And what about QE in Britain?
Jan: For us, the Bank of England's unwritten aim with QE was to weaken sterling in order to become competitive with emerging markets again.
Paul: I used to be an economist at the Bank of England. The idea that Britain can use sterling to dig itself out of a hole has recurred throughout the post-war period. But it never works terribly well. The trouble is, imports are such a large part of our economy that any benefit from currency depreciation is offset by higher cost inflation. The rise in prices since the financial crisis began is almost fully explained by the drop in sterling.
Max: Yes, the contrast with Japan is interesting. The Japanese have devalued the yen, so Japanese firms are cutting the dollar prices of their cars in America by 20%. They do that because they know there's not going to be rampant inflation in Japan. But even with the British currency devalued by 25%, no UK manufacturer is going to cut prices by 20%, because they know their profits will be eroded by rising costs at home.
Paul: Where your sterling effect probably works better is in the property market. From the 2006/2007 peak to early 2009, prime property prices fell by about a quarter. Since then, if you look at central London prime property, prices are up by about 55% to new record levels, while wider British prices are up maybe 5%. That's because so many of those prime buyers are foreigners. If sterling loses a quarter of its value, then from an overseas buyer's point of view, prime property looks horrendously cheap.
Jan: Yes, by British standards the price of London property is rising rapidly, but by international standards it isn't. That's exactly what went on in the Weimar Republic. The international community swept in like locusts and bought up property in Germany. If we don't stop QE fairly quickly, we have a difficult future.
Max: I'm more relaxed. The US and UK economies are picking up and QE will drop off hopefully without having to reverse it. The biggest time bomb if there is one is still the eurozone. The economy will go on shrinking. It's in a far worse state than Japan, and I think that will cause problems for a long time.
Jan: I agree on Europe I think the only reason that bonds haven't collapsed and yields haven't soared is that all the hedgies are terrified of Mario Draghi [the head of the European Central Bank].
Paul: There is a similarity with Japan in that you've now got a current account surplus in the eurozone as a whole. Spain, Portugal and Greece are all now in current account balance, or close to it. So you've got a surplus of domestic savings governments are in deficit, but the private sector is in surplus. Those savings will tend to recycle through the banking system and end up buying domestic government debt. So the situation is a bit more stable, but that doesn't really make it durable as such.
Max: Yes, they're in balance because they're not importing because nobody's got any money.
Paul: Domestic demand has collapsed, but you're seeing a degree of export recovery. Spanish exports are up 6% on last year. But ultimately it's a banking issue. Banks are shrinking their balance sheets because they have no choice they have a huge shortage of capital and they are over-leveraged. That squeeze from the banking side is likely to be prolonged.
John: Will we ever see full-blown QE in the eurozone?
Max: I think it's a step too far politically.
Jan: We might see some sort of targeted response what's good for Germany is plainly very different from what's good for Spain, Portugal, Greece and Italy.
Paul: Well, there's more than one way to exercise QE and they've effectively done it Draghi's threat to do what it takes' has had an equal effect to the action. But now eurozone QE' has been effectively unwound to a degree the European Central Bank's balance sheet is down 17% from its peak. So it's been shrinking its balance sheet when everyone else's is expanding. They've probably been able to do that because they've got a current account surplus, unlike Britain or the US.
Jan: I suppose the eurozone as a whole doesn't have a problem. It has lots of internal dislocations that could be solved by transfers of wealth within the union, as happens within Britain.
Paul: The problem is that monetary policy is like using a tin of paint when you've got a damp patch on your wall. You can paint over a damp patch, but at some point down the road that damp is going to come through again. Monetary policy is painting over damp patches, but the underlying solvency of many of these governments is no better now than it was last week, last year, or the year before.
Max: The important thing for investors is that if you look at European equity markets, more than half of their earnings come from outside the eurozone. So whatever's going on in the eurozone, it's not a problem for European stocks. In fact the small and mid-caps in particular look rather good value.
John: Where are the best opportunities right now?
Max: Well, we don't like government bonds. We're not going to see a bond-market collapse we're going to see a slow puncture. A diversified bond portfolio ought to make you a modest rate of return in the medium term. But if you want to make real money, you're going to have to take on some sort of risk and buy equities.
Jan: We've got this extraordinary situation whereby major companies in the pharmaceuticals business and mining business offer yields on their equity that are substantially higher than the yields on their sterling corporate bonds. That's bizarre it suggests investors believe there will be no growth at all. Yet just look at the pharmaceuticals sector. We're in a world where the population's expanding remorselessly, and everyone is going to get old, sick and die. None of us want that. So right away we are in a growth environment.
It's the same for big miners like BHP Billiton or Rio Tinto. Valuations suggest we'll never see any earnings growth. Yet the one thing the world needs more than anything else is resources.
Max: We like the energy sector, but we're still a little bit wary of mining. In energy, you have innovative technology such as horizontal drilling, and offshore deep water drilling. For mining, it's still a case of shovelling it and grinding it, so the productivity gains are not there.
Paul: I like the idea of owning real assets, things like cheap commercial property, for example, as a hedge against a more inflationary environment. On the equity side, there's a real difference between what's going on in Europe, Japan and the US. I think the US is heavily overvalued.
Max: There's better value elsewhere. But I don't think America is significantly overvalued.
Paul: Well, if you look at ten-year adjusted earnings, the market trades on a multiple of about 25. That's significantly overvalued. If you compare the market cap to US GDP, it's 133%. In 2007 it was 145%, and 185% in 2000. But going back for a century before that, there's only one quarter where the ratio got above 100%. And margin debt [investors borrowing money to invest] is close to record levels, at 2.5% of GDP and rising.
Max: I'm not saying it's particularly cheap. But there are plenty of people around who were bearish on US equities at half the current levels who have been carried out senseless.
Jan: Has anyone else been reading Gavyn Davies in the Financial Times? He was looking at the increasing share of GDP accruing to shareholders, versus the decreasing share of GDP going to workers. This has been going on for decades. It hasn't reverted to the mean yet, and I don't really see why that's going to change in the next five or ten years. The labour pool is expanding more and more people are being born so there are more workers to choose from. And as high-cost economies price themselves back into competitiveness within the global economy, we will see a significant oversupply situation. There will be lots of companies competing to produce more goods than can be absorbed by demand. What's going to give? Among other things, it'll be labour rates.
Paul: You've just described the last ten years. That's not the future. The global economy saw 25 million Chinese people move from the country to the cities, to work in factories. That depressed global wages as a share of global GDP. But the working population in China is starting to fall. So that supply shock' has worked through. Wage levels are rising in China. It is no longer a low-cost producer.
Jan: I agree with all of that. But now that we in the West have priced ourselves back into competitiveness, there is a hugely increased pool of potential supply. And in the short term, I don't see where the demand's going to come from to soak up that supply. Sure, 20 or 30 years from now we will see a global economy that's bigger, richer, better fed, better housed, better educated and all the rest of it
Max: and profit margins might well be lower...
Jan: ... it's just getting from here to there that's quite difficult.
Jan: My first is a repeat from last time, GlaxoSmithKline (LSE: GSK). It's done tremendously well this year, like most of the pharmaceutical sector, but it's still cheap. Demand for medical supplies is growing. People are getting wealthier, so can pay for medical attention themselves or through government health programmes. Glaxo is also expanding into emerging markets and over-the-counter medicines. Governments are also working with drug companies to take some of the risk of drug development out of the equation. The whole sector is becoming less risky and more attractive. We believe investors will slowly move from seeing pharma shares as risky income stocks, to seeing them as long-term growth stocks with a damn good yield attached.
My second tip is bombed-out mining stock BHP Billiton (LSE: BLT). The reasons are obvious.
Max: It's the best stock in the sector.
Jan: Yes. Compare its valuation to its importance to the global economy there's no connection. Sure, China is slowing, but there is a huge growth in consumer demand for cars, white goods, and other durables for which the manufacturing process requires the raw materials and energy that Billiton supplies. China and other emerging markets are still in a build out' phase where they are increasing ownership of goods and assets, whereas everyone here in the West basically has what they need we're now a replacement' market.
And there are still strong drivers for resource demand elsewhere. Look at America's backlog in infrastructure maintenance and repair. Same story in Europe. It just says to us that the outlook for mining is less gloomy than BHP's market valuation is implying.
My third tip is comparison website Moneysupermarket (LSE: MONY). This goes straight back to our view that the mortgage guarantee scheme will inspire a raft of refinancing from January 2014. Where do you go if you want to compare mortgage rates? Moneysupermarket.com is one of the main options. It's the old story in a gold rush, the guy who makes the fortune is the one selling the shovels. Moneysupermarket is the shovel seller par excellence for this refinancing boom.
Max: My favourite sector for this year remains the airlines. One obvious play is International Consolidated Airlines Group (LSE: IAG). The Spanish airline is still a bit of a mess but it's improving, and I think British Airways is going well.
John: Why the airlines?
Max: I think the oil price rise is over and so fuel cost pressures are abating. The engines are getting much more fuel-efficient. And traffic growth continues. But most importantly, more and more airlines are run by business people rather than governments, in what are basically oligopolies. For example, British Airways has the complete monopoly on the London to Cape Town route.
I continue to like financial stocks such as Schroders (LSE: SDR), Prudential (LSE: PRU), and London Stock Exchange (LSE: LSE). Those are simply plays on a rising market. On funds, I still like the Baillie Gifford Japan Investment Trust (LSE: BGFD). It's done really well in the last six months, and has further to go.
And one slightly off-piste idea for the longer term. This is a utility/growth' stock with significant financial and operational gearing a few percent rise in sales means a 10% rise in operating profits, and a 30% rise in free cash flow. It yields around 2%. It's Channel Tunnel operator Eurotunnel (Paris: GET). Stick it away, forget about it and in two years' time and thereafter it should turn out to be a very good investment.
Paul: Sticking with Japan, I think that QE is likely to be highly ineffective at driving inflation higher, because as we've already mentioned, the inflation pass-through from the exchange rate is so slim. Prices have actually fallen further since they announced the shift in policy late last year. So I think they will make their policy much more aggressive. And that means the yen will weaken further. There are a great many Japanese companies that I think will benefit significantly from this.
One is gear manufacturer Shimano (JP: 7309), which is strongly generative of free cash flow, and doesn't use a great deal of leverage. Many of your readers probably own a bike it almost certainly has Shimano gears. Or the fishing enthusiasts out there, they will know of them from fishing reels. If and when the yen slides, Shimano will effectively be a global monopoly, the sole supplier of fishing reels and bicycle gears.
Jan: But why aren't we seeing Japanese corporate bond yields go through the roof if everyone thinks the yen will tank?
Max: I don't think the yen's going to tank. It's had a significant devaluation. But that's not the be all and end all. It's a good start, but the long-term success of Japan will depend on a revival of the entrepreneurial spirit in Japanese companies, and a raising of extra investment, returns on capital, and returns for shareholders. That's going to be the real key to the Japanese market.
John: Any thoughts on gold?
Max: We've got a bit. But we prefer palladium and platinum, where mining capacity is falling in both South Africa and Zimbabwe. There's every chance that every platinum mine in South Africa will close. So you're playing diminishing supply, rather than rising demand.
Paul: You have to ask yourself why you own gold. Despite popular perception, gold has been a very poor inflation hedge. Instead it does best in a credit event' environment it's a good hedge against the financial system being threatened. So it's probably no coincidence that gold prices peaked in the third quarter of 2011 and have been falling since. By the middle of 2011, concerns about a systemic failure had basically dissipated because of QE. Gold then faded away. Of course, systemic risk could re-emerge perhaps through a financial crisis in Japan, or a resumption of the crisis in the eurozone.
Max: Of course, if you're a MoneyWeek reader in southern Europe, then I think we can agree that holding the hard stuff rather than having a bank deposit would be a very good idea.
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He 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.
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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