What will happen as the Fed turns off the money taps? John Stepek asks our Roundtable of experts for their views.
John Stepek: Let's start with the US. It's had a very good year, but it's probably the most expensive market in the world now.
Steve Russell: We think the US is moving towards a gentle recovery not enough to sort out its debt issues, but sufficient to encourage Janet Yellen to taper or stop quantitative easing (QE). We think the Federal Reserve will replace QE with aggressive forward guidance, and make it clear that rates will stay nailed to the floor for a long time.
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But how will the market cope without all the extra liquidity? And what is the back-stop? For years, you've had the Bernanke put' if anything went wrong, the Fed would step in with more liquidity immediately. But in future that might not happen as quickly.
John: Because it's tricky politically to start printing money again once you've stopped?
Steve: Yes. But if growth doesn't come through as strongly as they hope, they may move towards what Larry Summers has talked about coordinated fiscal and monetary policy. We can see a scenario where money is printed and the government spends it directly.
John: Monetising the deficit?
Steve: They won't call it that, but yes.
Jim Mellon: I agree. US earnings growth isn't real it's manipulated by buybacks and financial engineering. And while price/earnings (p/e) ratios aren't at dangerous levels, they're pretty high. While the Fed will keep rates low, longer term US bond yields will rise I'm certain the ten-year bond yield will hit 3% soon.The housing market, which has been one of the pillars of growth, is immediately sensitive to that. But what worries me more is inequality.
Banks, central bankers and elites have benefited enormously from money printing, but in the US, inequality has grown to such an extent that for the first time in my lifetime you are seeing I wouldn't say a revolution, but discontent. The aspirational society is being broken. This demand for fast food workers to get $15 per hour, double the minimum wage, is something we should watch, because it could sweep America in the next few years.
One of the pillars of the stock market is that corporate profits are exceptionally high as a percentage of the economy. If you start getting serious wage demands and government intervention, those profits will be eroded.
John: Big wage demands would also be inflationary.
Jim: We've already got inflation in all the developed countries. They've been manipulating the indices, but there's a real squeeze on people's living standards.
Steve: Yes, there clearly is a mismatch between what is effectively a deflationary print across official numbers globally, and what's happening on the ground in terms of cost of living. I don't know how that'll resolve itself, but increased government intervention can only be inflationary, and that's how I think all this will end because any hint of deflation or slowdown will only drive policymakers to target higher inflation.
In the US they're already discussing optimal guidance', saying: "inflation's been beneath target on official measures, so why not have a period of above-target inflation"?
Tim Price: The Fed turned 100 this year. It took 100 years for it to amass a balance sheet of $800bn. It's now printing $1trn a year. So if you're not already concerned about inflation, just wait a bit. The difficulty, particularly for a value investor, is that QE distorts relative prices it's just impossible to know where prices should' be. But we think the best opportunities lie outside the US.
Take Japan. QE has only just begun there. The last five years have taught us that, if you print money, stockmarkets go up. So owning Japan while hedging the currency seems one of the best bets for next year.
John: Steve, you've been in Japan for a long time is this about more than QE?
Steve: The turning point was summer 2012, when the major banks began paying tax. They can only do that because (a) they're making profits and (b) they've used up all the tax losses from the past decade or two. So Japan was improving already. You then throw in massive QE $70bn a month, compared with $85bn a month in the US, for an economy half to a third its size. So I think the market's got legs.
I love the operational gearing on Japanese companies. Margins have been so slim that a small rise in turnover can generate huge growth in profits. Plus if something goes wrong, there's nothing to stop the Japanese doing more QE.
Jim: Euro strength is also helping Japan, because its export markets overlap heavily with Germany's. It's getting a serious currency advantage. But I don't think euro strength can last. The euro might be about right for Germany at this level, but it's way too high for everyone else. Any nascent recovery in Spain, Portugal or Greece cannot be sustained. So I think the Germans will have to live with the idea of QE in Europe that's why the euro is a wonderful short.
John: But what triggers that?
Jim: Well, Greece can't possibly repay its €360bn in debt, quite a lot of which comes due next year. So either it will have to do a major debt restructuring, which means another bail-out, or accept a bad debt impairment, or Greece will have to leave the euro which is unlikely. So the Greek refinancing will be yet another focal point for the bureaucrats. And the unemployment rate in Spain, for example, is just so high that I can't see any recovery.
I live in Ibiza for half of the year. Ibiza Magazine which has been around for 40 years has shut down just this week. Although Ibiza is a little bubble in the middle of Spain with very high GDP, they can't get any advertising. You're getting more and more of that in Spain, and until the euro's at a competitive level, it's not going to change.
Steve: We reach the same conclusion via a slightly different route. People have been shorting the euro for the last two or three years on the basis it would break up but it hasn't and probably won't. But now that there's a sheen of normality, it may give the European Central Bank (ECB) the confidence to push for a weaker euro.
Two years ago, it couldn't, because a falling euro would have been taken as a sign of imminent collapse. But now, a weaker euro policy would come from a position of strength and a desire to boost growth.
Jim: But why is the euro strong? It's because the Japanese are buying French government bonds, because current-account deficits have shrunk in Europe, and because of the collapse in internal demand. It's not because the euro represents a fundamentally strong area.
Tim: Isn't it just that the Europeans are printing money less aggressively than the US, the UK and the Japanese? Somebody's currency has to rise.
James Ferguson: Yes, it's not that the euro's strong, it's that the other guys are weak. But I think that will unravel in 2014. I was a tad early on this last year I forgot about the politics. The Europeans had to get through the German elections before they were in a position to tackle the state of their banks. But now that can start to happen and it will involve some sort of QE eventually.
QE is the process of replacing the money that gets pulled out of the system when banks contract their assets (reduce lending, in other words). In October last year, eurozone money supply growth was running at about 3.5% a year. This year it's sub-1%.
Now usually, money supply growth runs about 1%-2% stronger than nominal (unadjusted for inflation) GDP. So if you've got money supply growth at 1%, you'll struggle to have any nominal GDP growth at all. In other words, we're looking at deflation. So the ECB will have to do something about that.
On top of that, banks also have major solvency problems. There are differences in the way US and European banks account for their assets. But they've just agreed to make them comparable across the board. On that basis, Japanese and US banks look strong and they're the ones who have actually taken their losses, which makes them doubly strong because they've done the hard work.
But European banks not only look the weakest, but also they haven't yet recognised their losses, which makes them doubly weak. So there is still a crisis to come in Europe. They've known about it for years, but they need QE to counteract the deflationary force of banks shrinking their balance sheets, and they couldn't contemplate that until the German election was in the bag. They also have to sort out a banking union. So all these things have to be put in place.
John: So we still expect QE in the eurozone. What about gold? It's had its worst year in a long, long time.
Tim: At the end of 2007 pre-Bear Stearns, Lehman and everything that's followed gold was trading about $840 an ounce. It's comfortably above that now. So the death of gold is overstated it's allowed a breather. If you look at the fundamentals, in what way has the global debt situation improved? I'd argue that it's deteriorated. Money printing has simply papered over the gaps. I don't see how this mess ends in any other way than in a disorderly currency revaluation' and an inflationary mess.
There are only three ways to deal with debt. You have sufficient growth to service it; or you default, which is Armageddon in a debt-based monetary system; or you end up with what we have today and will have for years to come explicit, state-sanctioned inflationism, or financial repression. So we're holding gold because we're looking at what happens at the end of this process, rather than just as things stand today.
Steve: Gold is an unstable asset, because it has no associated cash flows. But it is also very valuable in periods of currency depreciation and inflation, and it can even be useful in deflation because it is a form of money. The key for us is simply not to have too much of it about 5% is the right level. We prefer pure inflation protection index-linked bonds where at least you have some cash flow, so the price is more anchored.
John: Why do you like index-linkers?
Steve: We love the way they price in basically no inflation, especially in the US. They've had a tough year they were always likely to suffer from concerns about tapering or rising rates. They've done fantastically in deflationary scares since the crash as pseudo-conventional bonds, so they always had the potential to give some of that back, especially as there's likely to be a hiatus between bond markets selling off and inflation being seen. That's a risk, but it's one we're willing to bear.
Jim: Most government bonds are still shorts, but the one that really interests me is the original widow maker the Japanese long bond. Everything in Japan militates for rising long bond yields.
Mr and Mrs Mikimoto have 800trn of savings earning nothing, and they can now put around $10,000 or the equivalent into a tax-free Isa-style account. You could get a melt-up in Japanese stocks, and the corollary is that long bond prices fall. I can easily see the yield going to 1%, from around 0.6% now, a fantastic return if you're sufficiently leveraged. So I'd be short the Japanese long bond.
John: Is anyone less bearish on bonds?
James: I'm now a medium-to-long-term seller of government bonds. But I think US Treasuries and gilts will rally short-term. While you wouldn't know it to look at the papers, during periods of QE, US Treasury yields have actually risen (prices have dropped). Take away QE and yields fall. So it's bizarre that the press perpetuates this idea that the bond market's terrified of tapering it's the stock markets that should be terrified.
Over the last six years US stock markets have doubled. But during periods without QE, they gained nothing. Stocks are rising because QE floods the system with liquidity and pushes people into risky assets and out of risk-free ones. Take away QE and the money goes back into the risk-free assets Treasuries.
Tim: I don't disagree with the logic, but do you have a strong conviction about what the Fed's going to do next year?
James: No, I don't. We are completely beholden to them and their nutty ideas. But they should not do QE, unless it's to neutralise a contraction of the broad money supply caused by balance-sheet repair it's an emergency policy. If you do it when the banks are okay, let alone growing, then it should be inflationary.
And I think inflation is higher than many realise in many cases we're mistaking inflation for real growth. The three places that have delivered surprisingly' good growth this year are those that have done, or been doing, QE Britain, the US, and Japan. It's not rocket science.
We've got a bleed-over from nominal into real GDP because they don't know how to measure it. If you use the Retail Price Index (RPI) to deflate UK nominal GDP, rather than the official deflator, you get a very different picture. Having tracked each other for 50 years almost perfectly, a gap of about 2% has appeared between real GDP deflated by the National Statistics Office, compared to real GDP deflated by RPI (see chart on the right). This means we don't have 2% growth, we have 0% growth and more inflation than we realised. So if you stop QE, it's a big risk for the S&P, but it should mean a technical rally for Treasuries, which will drag gilts straight up on their coat-tails.
Tim: But it still feels as though the tide is going out for credit markets generally. We're at the end of a 30-year bull market in Anglo-Saxon interest rates.
James: Well, if the system's not fixed, as Japan proved, we can go down to 1% yields, then 0.5%, then 0.4%. There is no number that cannot be halved. But in America even if the politicians and the Fed don't get it they have fixed it, which means QE now carries a lot of risks.
The first is from inflation which is why Treasury yields are double what they were in December 2011. That was coming off a huge spike, so it's not that relevant. But if you add 1.5 percentage points to Treasury yields from here, that's a disaster. You'd have the worst bear market seen for two generations in terms of the pain suffered by bond-holders.
In the past bear market investors lost about 20% of their capital value if yields rose by three percentage points. But they were getting 8%-10% coupons, so adjusting for that, they were flat or down 2%. But now, you'd lose 20% on your capital value and get a coupon of just 3% a 17% loss. And bonds are where most people stash what they think is their totally safe' money! So the Fed is in a very tight spot.
The economy is still saying: Hey what's the risk? Buy more growth, stay popular.' But the Treasury market is saying: What will it take to convince you this has to stop: 3%, 3.5%, 4%?' But when it does stop, Treasuries will rally, and stocks will go down.
John: I suppose most people assume that because QE involves a big buyer like the Fed buying Treasuries, then if it stops, prices will fall.
James: Barings collapsed because it was buying huge amounts of Japanese Nikkei futures. But because of that, everyone else was selling furiously. It doesn't matter how big the biggest buyer is if they're going the opposite way to everyone else, it can't last.
John: What about the story of the moment, bitcoin?
Jim: It's a complete and utter fraud, isn't it? It's where the speculative excess has shifted to. It's like the dotcom bubble everyone knew it was rubbish but thought: While it's going up, I can make more money in a week being long, than in any other investment over a whole year.' Everyone's an optimist, everyone believes they're lucky and that they'll get out before the crash.
Tim: Bitcoin mining is now even more expensive than the real thing.
Steve: But it's interesting that a ridiculous bubble should develop in a trade that is basically about revulsion of fiat currency. It shows the underlying fear people have that money is being damaged.
John: Let's talk stock tips. Last year, Steve, you tipped Secure Trust, Travis Perkins, Cranswick and Sumitomo. Secure Trust is up by nearly 80%, and even Cranswick, your worst performer, is up 33%. What now?
Our Roundtable tips
|Manx Financ.||LSE: MFX|
|Royal Mail||LSE: RMG|
|B. of America||US: BAC|
|Blue Trend||LSE: BBTS|
|Russian Prosperity Fund|
|Newscape Strategic Bond Fund|
|Reed Elsevier||LSE: REL|
|BG Japan||LSE: BGFD|
Steve: I'll stick with Japan. I'm happy with Sumitomo (JP: 8316), but Hitachi (JP: 6501) is interesting too. There's a restructuring story and it's benefiting from the weak yen/euro story it competes with Siemens. If people want to invest in Japan as a whole, funds are fine, but hedge the currency. Outside Japan, Secure Trust Bank (LSE: STB) is benefiting from the fact that big banks are still shedding customers and assets, so it remains a good long-term holding, but I can't see it doing 80% again. I like VW (DAX: VOW), which would benefit from any euro weakness and is very undervalued on a sum-of-its-parts basis. I'll also go for Headlam (LSE: HEAD), the UK floor-covering distributor. So far the new UK housing bubble has been great for house builders, and for builders' merchants. This is the third sector that should do well if the bubble continues, but it hasn't started moving yet.
John: So sell Travis Perkins and buy that?
Steve: Yes. As for Cranswick (LSE: CWK), I think it'll produce a decent return, but not 30%-40%.
John: James, you tipped Citigroup and Bank of America, which delivered 23% and 27%, roughly in line with the index. What are you thinking this year?
James: I think they should dramatically outperform this year. That's partly because I'm quite negative on US stocks generally, because I think QE will be scaled back. But US banks are also going through a structural rather than cyclical recovery, and they're about the same price as European banks on many measures, even though they are in a much better condition. So I would stick with Citigroup (NYSE: C) and Bank of America (NYSE: BAC) they will either be pedestrian or exciting. But when people finally get it, they will be rerated 100% that year. Meanwhile, I'm almost tempted although I think I'm a year early to look at Italian banks.
James: They've done a lot of work. And the whole point of this balance-sheet process is to buy when they're finally bust, because that means they've processed their losses and taken the hits. But there will probably still be more problems, so it's too brave for me right now but I'll be doing some serious number crunching over Christmas.
John: Okay, so keep an eye on that.
James: Otherwise, I think Japan is definitely the sweet spot. It's doing QE, share prices are historically low, and the fundamentals are improving massively. Profit margins are higher than at any time since World War II. The only people who don't get Japan are the Japanese, which is why they keep buying Japanese Government Bonds (JGBs). Eventually it'll go nuts.
Steve: The silly indicator I'm waiting for is when they stop publishing Asia ex-Japan unit trust data.
James: But won't they do that when it's too late?
Steve: Yes, that'll be the end.
James: I would also counsel people to look at their US stocks (other than the banks) and consider where they think they'll get further growth from here. I think they're quite vulnerable. Profit margins are super wide so they can only come down, and QE will be removed, which is the only thing that pushed them up. So I would be cautious about a US-equity-centric portfolio. Unless Janet Yellen, the incoming head of the Fed, is a complete nut which she might be, based on the evidence.
Tim: She's taken the job, which qualifies her as a real nut as far as I'm concerned. What did I tip last time?
John: Trend-following fund Bluecrest BlueTrend (LSE: BBTS), which has fallen 10%. You also tipped Russian Prosperity and Newscape Strategic bond funds.
Tim: I would be happy to reiterate any of those. These sharp risk-on/risk- off QE-related rallies don't help long-term trend followers. But if we get a repeat of conditions like those in 2008, God forbid, then trend-followers can make an awful lot of money, because they're the only active investors who are just as happy to be short as long in the market.
As a new tip, if you liked gold 18 months ago, you'd still have to like it now, and the same goes for silver. So I would go for Fresnillo (LSE: FRES), which is primarily a silver miner but also does gold. It has an unchallenging multiple, a yield of nearly 5% what's not to like? At some point this market will turn, and when it does, it will turn very sharply, very quickly.
Steve: That's a brave call. I think it's the right one in any case, you're almost guaranteed top or bottom slot next year.
John: Jim Webis doubled, Pacira nearly tripled and Synergy fell a third. What now?
Jim: Pacira's doing incredibly well, but the price is too high so we're out of that. Webis is building its operations in the US. It's one of the British gambling firms with a US licence, which looks promising, but I'm not going to recommend it again.
Synergy has a drug for chronic constipation that is still in trials, but I may have overestimated the size of the market for that there's a competitor drug out there, and it's not selling as well as people thought, so I wouldn't re-recommend that.
So I've got three new tips. My first is Arrowhead (Nasdaq: ARWR), which we have a reasonable-sized position in. Its market cap is around $300m. In 2011, it bought all of Roche's siRNA assets treatments which alter gene expression. The firm now has a hepatitis B drug in Phase II [mid-stage] trials.
Hepatitis C has been a big theme in pharma over the last two years. For example, Gilead is bringing a drug to market that it expects to hit peak sales of $7bn. Hepatitis B is just as big a problem, particularly in Asia. I'm sure Arrowhead will either partner that product, which looks incredibly good on the trial data I've seen, or the firm will be bought Roche is the obvious buyer, though that's just speculation.
The second tip is a bank that I have an interest in, called Manx Financial Group (LSE: MFX). The underlying bank is called Conister. It's selling at about book value and growing quickly. I really like the business, I think it's cheap and the balance sheet looks excellent. Then there's another US drug company, Repros (Nasdaq: RPRX).
It's got a Phase III [late stage] drug called Androxal, which is likely to be approved for testosterone replacement, and doesn't have the side effects of existing drugs. It's also got a drug for endometriosis, which looks promising. The firm's market cap is about $500m, which is relatively cheap, so I think it will be bought this year.
One pharma stock to avoid is Alexion (Nasdaq: ALXN). It's successful, but it's a single-product firm with a market cap of $30bn. It's a bit like Tesla or LinkedIn speculative with very high expectations priced in. It's an outright short.
John: Biotech has had a great run how much further do you think it can go?
Jim: In the US, companies once deemed medium-sized are enormous now. Alexion's a good example, but there are others, such as Onyx, which was recently bought for $11bn. These were small-to-medium-sized companies three years ago. So there's over-speculation, particularly around acquisitions.
But the big pharma companies still don't have the research pipelines, so they need to buy in innovation. In Britain we have an arbitrage opportunity, because compared to the US, UK small pharma is still very cheap and the science is very good. So we're trying to buy into British small- and medium-sized pharma companies simply on an arbitrage basis.
John: Thanks everyone.
Investec's Max King updates on his tips for 2013
Max King from Investec couldn't make it this year, but he updated us on his 2013 tips, and what he'd buy now. He'd hold fund managers Schroders (LSE: SDR) and Prudential (LSE: PRU), and publisher Reed Elsevier (LSE: REL).
He still rates airline IAG (LSE: IAG) as buy' "my target is £10, but it will take a few years to get there". And he thinks Baillie Gifford Japan (LSE: BGFD) is "still the best way to access the long-term potential of Japan".
For 2014, "look for low-risk stocks with visible long-term growth stocks that might be a bit expensive in the short term, but which have a high probability of making good returns over three years". One is Rolls-Royce (LSE: RR) "the completion of the plant in Singapore will enable a significant increase in capacity to meet its ever-growing aerospace order book".
He also likes Royal Mail (LSE: RMG) "the share price is ahead of events but everyone wants to buy it on weakness for the long-term growth driven by internet shopping, its potential for market share gains and the prospect of a significant rise in margins".
Eurotunnel (PARIS: GET) is a buy, as "an unregulated monopoly that combines operational gearing, financial gearing and growth".
Finally, Imagination (LSE: IMG) is worth a punt. It's suffered as a step-up in research and development spending has hit profits. "There is considerable risk in its plans but also a potentially big pay-off the current share price takes a very pessimistic view."
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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