How has the prospect of QE ending affected markets? And where should investors look for profits? Piper Terrett chairs our Roundtable.
Piper Terrett: What are your biggest concerns?
Marcus Ashworth: I'd like to ask Peter if he thinks we can get through the summer without Europe falling apart again? Obviously they are trying to suppress everything ahead of the [German] general election in September. Can they do it?
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Peter Westaway: Yes. Last year policymakers made a commitment that for now markets have taken at face value. The latest turmoil in Portugal and Greece is just as bad, if not worse, than before. But the market's response has been much more measured. The European Central Bank (ECB) has yet to be tested on that commitment, of course. If something went badly wrong in Italy or Spain especially if we had a situation where the Spanish or Italian governments couldn't deliver on austerity policies that were acceptable to the ECB then that would be a big test. Would the ECB still buy the bonds of troubled governments? So far the indications are that they would.
Portugal is a mess. As for Greece, it's likely there will be haircuts even on the debt that other governments in Europe are holding. That's politically very difficult, so until the German election is out of the way, it's not going to happen. But throughout this crisis, the line has been shifted, and it will be shifted again Greece will stay in the monetary union.
Marcus: Not one cent has been written off by any European country yet.
Peter: That's true people talk about bail-outs, but they're actually loans. However, at some point they will have to take a hit. For now, Greece has its work cut out. People sometimes talk as if Greece has done nothing. Yet at the start of all this, Greece had a structural deficit amounting to 12% of GDP [ie, Greece was overspending by 12% of its GDP each year, excluding interest payments]. It's now 0%. So the economy's been clobbered it's not surprising we're getting social unrest. But Greece has further to go. To reduce its national debt, it needs to get to a 5% or a 6% primary surplus [ie, it needs to cut spending, raise taxes, or both].
Marcus: But Greece's debt-to-GDP ratio is now worse than when it started. We're two bail-outs in and heading for a third.
Peter: What really matters is not the debt ratio, but the interest payment on that debt. Compared to two years ago, those payments are lower than they thought they'd be. But it's still crippling, which is why I think more debt will have to be written down.
Marcus: Germany is actually benefiting from this crisis it costs them next to nothing to borrow. Everyone is buying their debt because they think there may be a new reichsmark at some point. Shouldn't the Germans admit that they've had a huge windfall, and put some of that in a pot that they can use to subsidise Portugal and Ireland's borrowing costs?
Peter: Politically that would be very difficult to swallow! The monetary union rules were that there would be no fiscal transfers from rich to poor countries. Anything that goes over that line is incredibly difficult for them to sell. But in the end they'll implicitly be subsidising the rest of Europe in any case.
Hugh Grieves: Will Germany even have the capacity in future to bail everyone out though? If the global economy carries on slowing down, people aren't going to be buying BMWs in China and Brazil.
Marcus: If the yen keeps falling, the Japanese will see them off. But you sound positive, Peter, are you bullish on European equities?
Peter: Equities are clearly underweighted in Europe and eventually they'll come back. But whether this year's the time to pile in
Marcus: Yes sometimes I step back and think that as an equity investor there are huge bargains here is it time to say: it's all priced in'? But even ignoring the politics, as an economy Europe has nothing going for it. What really worries me is when you look at economies such as Denmark's or Holland's, which really shouldn't be in quite as bad a state as they are.
Peter: But the long-run positive is that there's a lot of potential upside. If these countries push through structural reforms that have been postponed for the last 25 to 30 years, they'll start growing again.
Marcus: You believe Greece can reform?
Peter: It's a decade away it won't happen soon. But the counter to the bearish position is that Germany has gone all in'. However costly it is to keep bailing Greece out, the cost of letting it and any others go are even greater the banking system would be devastated.
Hugh: The time to buy these stocks is when things stop getting worse, not when they start getting better. So there comes a time when you shut your eyes and buy.
Peter: Weren't you struck by how much less volatile the market's been this summer compared to last?
Marcus: So far, yes. Although we had the taper tantrum' after Federal Reserve boss Ben Bernanke threatened to ease up on the pace of quantitative easing (QE). That shocked the world. Take the Indonesian rupiah it's become much weaker. That is a potentially huge economy, 180 million people, going into free-fall, all because Bernanke said he might chuck $70bn a month into the US economy, rather than $85bn.
Peter: Yes, but the emerging markets that have benefited' from huge capital inflows were an accident waiting to happen.
Hugh: Yes, when the dollar strengthens you get an emerging-markets crisis. Whether it's the Cuban crisis, the Russian crisis or Asia it happens every time.
Peter: Bernanke's just talking about slowing the rate at which he adds money. Even stopping altogether still leaves the stock of QE in place.
Marcus: But this is why Operation Twist' [where the Federal Reserve used the proceeds from maturing short-dated bonds to buy longer-dated ones] was such a mistake, because you can't get rid of 30-year securities by just waiting for them to mature. The ECB has always kept their buying to three years and under. Their exit plan is do nothing, and hope it quietly goes away. The Fed had a similar arrangement, but now it's got mortgage-backed securities with a much longer duration. This is why rates simply can't go higher certainly not at the front end because it will bankrupt the world's central banks. Rates must stay at next to zero until they've got out of this problem, by waiting for this debt to mature.
Piper: Are there good investment opportunities in America?
Hugh: Huge opportunities. The American consumer is spending again, car sales are reasonable, the housing bubble is way behind it...
Peter: The American housing market is just starting to show signs of life.
Marcus: We've seen a lot of life in the American housing market. The best-performing S&P sector last year was house builders up nearly 100%. But the taper tantrum' clobbered them because mortgage costs suddenly jumped.
Hugh: The great thing about America is that it is a relatively closed economy only 15% of GDP comes from exports. For Britain, it's 30%. A global slowdown will hurt Europe, which is a big exporter. But America will carry on. What matters from a stock-picking perspective is that smaller companies do much better than larger ones in that environment. Over a third of S&P 500 revenues come from overseas, and probably about half of all growth. So if you just buy an S&P 500 tracker fund, you are taking a huge gamble on growth in the rest of the world.
Marcus: What about the shale gas story?
Hugh: Production has gone up by, what, 30% in two years? By 2020, some suggest America will go from being the number-three oil producer to number one, ahead of Saudi Arabia. Let's think about that. Two-thirds of America's trade deficit is energy. If it gets energy independence, that's two-thirds of the trade deficit gone: what does that do for the strength of the US dollar? As for domestic energy prices, America is now the cheapest place in the world to make chemicals, or to refine petroleum products, and one of the cheapest places to produce steel. Gas is so much cheaper in America than elsewhere in the world that from 2015 it will start exporting from liquefied natural gas (LNG) plants that were originally built to import gas. I've heard this described by American managers as a once-in-a-generation event. That is how big it is.
Killian Connolly: But the S&P 500 is trading at, what, at least 17 times?
Hugh: 16.8. The average for the last 60 years is 19.
Killian: When I look at American sovereign and household debt levels, and look at growth over the last few years, I don't see how 16 times is justified.
Marcus: Well, firstly, I think growth is going to go substantially higher from 1% or 2% to 3%-4% in the next two or three years. Secondly, comparing today's price-to-earnings (p/e) ratio with the historical average is meaningless if you don't consider interest rates. We're in a much lower interest-rate environment now. If you can only get 1%-3% on a bond, you're prepared to pay more for a stock. Some of these firms are paying substantially more in dividends than they pay in yield on their corporate bonds. That's why you have to put the p/e ratio into context.
Killian: Sure, but a high p/e ratio is also indicative of expectations for higher earnings growth. And I can't see where that growth is going to come from.
Hugh: Forget p/es for a second. The S&P gives you 2% a year, it's inflation-hedged and it's growing. Would you rather have the S&P at 2%, or a fixed 2.5% from the US Treasury?
Killian: I'd prefer the US Treasury at 2.5%, because I don't like the market valuation. I struggle to be positive about any Western economy. Look at Russia it's trading off 3.5 times or 4.5 times. That I can get excited about.
Marcus: Before I came here I went round my firm and asked if anyone had any hot stock tips. Every single person gave me a commodity or mining tip. If you want to buy a commodity, Russia must, by definition, be the best way of playing it.
Killian: Only 17% of Russian GDP is accounted for by the gas and oil sector. There are plenty of good Russian firms in the retail space. Russia has 130 million people; it's bigger than the German consumer base.
Hugh: If commodity prices collapse, Russia will follow the government will be bankrupt.
Killian: They're in a stronger fiscal position than everybody else in the West. They've got much lower debt.
Hugh: Not if commodities collapse. Talking about commodities now is like pushing tech stocks in 2001. We've had a boom, you get a bust. The time to buy commodities is when everyone thinks you're crazy to. It'll be the same for emerging markets.
Killian: I think you just buy it because it's cheap.
Marcus: I know what you mean. I was looking at African Barrick Gold (LSE: ABG), which has been clobbered. I was in South Africa six months ago and everyone said: whatever you do, don't buy any South African miners, you're absolutely mad'. But prices have since moved down to reflect that. So there's a point where you say: it's a value play'. I'll admit, I don't feel confident buying something purely because it's cheap, but seeing how badly commodities have been clobbered, I can't help thinking is it time to buy?
Hugh: But after the 1970s boom, how long did it take before people were looking at commodities again? A decade.
Marcus: But my analyst reckons Chinese iron-ore inventories are lower than they've been for some time. The over-surplus of steel and so on has corrected too. So there's potential in China to be less bearish than I've been, certainly for the last year and a half or so.
Hugh: If you believe in commodities, do you have to believe in China?
Marcus: Yes, I think you do.
Hugh: Do we hit 7% growth and stay at 7% then?
Marcus: I don't think we're even close to 7%, but that's the number the Chinese want to feed us. They've made it very clear that 7% is the floor.
Hugh: Is there a Minsky moment where everyone suddenly goes, Oh my God', and the whole shebang collapses like a house of cards?
Peter: I do see China as a bigger risk than Europe. There's an inherent unsustainability.
Hugh: Credit is growing at three or four times the rate of GDP. That cannot go on.
Marcus: But the Chinese will bail out their banks like everyone else did.
Hugh: So will they devalue the currency and try to export their way to growth? The only way to do that when everyone else is already devaluing is by themselves devaluing. So do we get a deflationary wave across America and Europe?
Marcus: Very possible.
Piper: Can we move onto your tips now?
Our Roundtable picks
Killian: Russian gas giant Gazprom (LSE: OGZD) trades at less than three times forward earnings. It has the world's largest natural gas reserves. It's 50%-owned by the Russian government, which in mid-2012 passed legislation that state-controlled companies must distribute 25% of net profits. It's a cash-generative company, so you can just pick up your dividend yields.
There's so much wrong with Russian corporate governance, but I think that could improve in the long-term. Meanwhile, the dividend yield is 4.5%. And I don't think the rouble's any worse than the dollar over the medium term.
My second tip is a gold play. It has a market cap of C$6bn but only employs 20 people Franco-Nevada (Toronto: FNV). It's a royalty streaming stock. It lends to a mine operator, in exchange for a cut of the revenues, or the option to buy the gold or silver at a big discount to the spot price. So it doesn't have to bear the risk of rising costs that some of the miners are going through. Its annual compound return, including dividends, is 30%. There's very little operational risk there.
Hugh: My first tip is a US domestic consumption play, Watsco (NYSE: WSO). It's the most boring business imaginable. It sells supplies to air-conditioning contractors. It has 10% of this huge market five times the share of its main rival and it's continuing to grow its market share. The market itself is growing by 5%-6% a year as environmental standards tighten. If your air-conditioning breaks and you live in the sunbelt states of the US, which is where 80% of Watsco's revenue comes from, you need to fix it. The only question is whether you repair or replace it.
We've had three or four years of people just repairing these things, because they don't have the money, but there's a limit to that. So now people are starting to upgrade, and that's more revenues for Watsco. It's a great, boring little business.
My second tip is oil services group Schlumberger (NYSE: SLB). The stock has gone sideways for two years, but the international business is growing very well. We're replacing easy-to-reach oil that cost maybe $3 a barrel to get out of the ground, with oil from west of Shetland, or offshore Brazil, that costs $60 a barrel. That means more revenue for Schlumberger. What's held the stock back is that, in 2010, when shale gas took off, the explorers installed too much capacity, and profit margins were killed. They're just starting to turn now.
With LNG exports starting in 2015, companies will want to start drilling to ensure they have the production capacity to supply those exports. So drilling and pumping demand in onshore US will increase, which will boost Schlumberger's margins.
My third choice, Cognizant (Nasdaq: CTSH), is an Indian IT services business. About 80% of its business comes from the US, mostly in banking and financial services, manufacturing and healthcare. Its shares were hammered recently on fears over an immigration bill that's going through Congress just now. This caps the number of visas that companies can use to bring people into America, which would be bad news for Cognizant.
But while no one is publicly standing up and saying this shouldn't happen because it's political suicide behind the scenes all the firms who use these contractors are complaining like hell because there are no spare people around.
Marcus: A small inside tip from a couple of acquaintances who are in the know: this will get sorted. They have to allow immigration. It's killing economic growth.
Hugh: Absolutely. Among IT workers in the US, unemployment is 3% effectively zero. Will the US shoot itself in the foot, or quietly let firms such as Cognizant carry on bringing people in? This is a high-quality stock, growing at 15% a year, with 20% operating margins, and it should be on a higher earnings multiple.
Marcus: For my tips, the Japanese car industry is on its way back. South Korea and Germany I'm talking Volkswagen here have had it far too good for far too long. I won't bore you with what I think's going on in Japan, but overall, the yen is going to weaken. For me, the best way to play it is through Mazda (JP: 7261). It has penetration into America and other parts of the world, and I think it will do extremely well. On a valuation basis it's extremely cheap and has an ability to outperform. Alternatively, you could play the story via Toyota (NYSE: TM), which has a listing in New York.
I'm also looking at specialist mortgage lender Paragon (LSE: PAG). I'm recommending this one for all the wrong reasons. Our government is making a fundamental mistake. It is goosing the real-estate development and housing market for purely political reasons they want to copy what Labour did to stay in power for 13 years, which was to make sure house prices kept going up. I think they'll succeed, and certain stocks will outperform as a result. Paragon, which is effectively a leveraged play on a rising housing market, is one of them.
In the mining sector I like Glencore Xstrata (LSE: GLEN) or Rio Tinto (LSE: RIO), or maybe even African Barrick. Rio is the logical, easy trade. It's the cheapest of the big miners. But if you really like the mining trade, African Barrick probably has the most upside potential because it's been battered so much. Glencore is the smartest trade, in that if you think things are going to go back in commodities' favour, Glencore probably has more leverage. Also, if you buy its stock, you are actively aligned with management, which is rare.
Peter: At Vanguard we don't believe in stock-picking. So my advice is simple: hold a diversified fund. The evidence shows that active fund managers I'm sure it's not true of you gentlemen, but on average underperform their benchmarks. The fact is, you can't control markets, but you can control costs, and evidence suggests there's a very strong correlation between the cost of a portfolio and its average return. So focus on finding low-cost investments, like index funds. And don't have unrealistic expectations about what can be achieved.
Marcus: Yes, don't chase higher returns. The biggest danger in this market now lies in thinking: Oh God, I need to get a 5% return. It doesn't matter if it has a single B-credit rating or whatever, I'll just go for it.' That's the biggest risk.
Peter: One thing we do fear is that, because of the apparently bleak outlook for bonds, people will pile into equities and abandon bonds altogether. Investors should remember why they hold bonds in the first place. It's partly to dampen volatility to act as a counterweight to equities when the bad times come. Sure, if we knew China wasn't going to have a hard landing and that Europe was going to be fine, then we'd get rid of all of our bonds. But the point is that we don't know.
Piper Terrett is a financial journalist and author. Piper graduated from Newnham College, Cambridge, in 1997 and worked for Germaine Greer and for Adam Faith’s Money Channel before embarking on a career in business journalism.
She has worked for most top financial titles, including Investors Chronicle, Shares magazine, Yahoo! Finance and MSN Money. She lectures part-time at London Metropolitan University and is the author of four books.
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