Tim Price: what the bond market and the Berlin Wall have in common

Merryn Somerset Webb talks to Tim Price about the 'dysfunctional' financial environment, and when the world's culture of debt will finally collapse.

If you missed any of Merryn's past interviews, you can seethem allhere.


Merryn: I'm here today with Tim Price, investment manager and editor of The Price Report, which some of our readers will know. We're going talk generally about the market and about Tim's investment philosophy, but I want to start, Tim, by asking you about the financial world in general. There's a view that since the crisis things have begun to normalise and we're getting to a more regular environment, but I suspect you're not really of that view.

Tim: No, I'm afraid I don't really buy that. McKinsey the McKinsey Global Institute recently pointed out that far from this being an environment where you've had a slow, gradual and easy deleveraging, actually there's just more debt being added. So I think, by their figures, 57 trillion more has been issued since 2007/2008. We're living in a completely dysfunctional market environment. The metaphor that everybody has used is that of cans being kicked down a road. Extend, pretend, nothing has been fixed.

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Merryn: So, as far as you're concerned, the debt problem with had in 2007 is entirely with us, and it's just got slightly worse.

Tim: Not worse to the extent that people now look at bond yields being abnormally low all time low historic yields, or in many cases, I think there at least five countries in Europe now that have negative, in the eurozone, that have negative bond yields. Who in their wildest dreams would have thought you could have negative yields, full-stop? But we got that. I think every bund yield in Germany is now negative out to seven years.

Merryn: Well, can you explain for readers who don't necessarily work in this world what it means to have a negative bond yield?

Tim: It means you're paying money to lend money to the government. It's worse than having a bank account that you're being charged half a percent or one percent on. Buying a bond is simply lending money to someone. It's just an IOU. If you're buying a bond with a negative yield, you are guaranteeing that if you hold that loan to maturity, you're going to end up losing money. It makes no economic sense whatsoever.

Merryn: So why on Earth would somebody do this? Why would an investor go out and buy a bond with a negative yield when they could just keep the money?

Tim: Well, that's a perfectly legitimate question. One answer is you've got the biggest buyer in the world who has already pre-announced he's going to be buying €60bn a month of this trash, and that's Mario Draghi at the ECB. So, effectively the institutions in Europe are, you could argue, being sensible in that they're simply front-running the European Central Bank. Because they're going to be out in the market buying this rubbish.

Merryn: Your point being that that will make the yield even more

Tim: They'll be buying it an even higher price, and even lower negative yield. Correct.

Merryn: So a greater fool' environment with the greater fool already preannounced.

Tim: Being Mario Draghi. Another possible answer is that you've got a lot institutional investors, pension funds specifically they've got no real choice but to buy this stuff. A typical pension fund, its liabilities paying out future pensioners, the only thing that the authorities deem an appropriate asset to match those liabilities is the so called "risk free" asset known as government bonds. So there are a number of reasons why this is market is dysfunctional, but clearly for those investors who have a choice, it doesn't make any sense to be buying this rubbish.

Merryn: So, what, does it make sense for people who don't have to buy bonds to buy in an environment like that?

"Every part of the bond landscape is completely over-valued. It doesn't make any sense"

Tim: That's a very good question, and it's a very tricky question to answer. Quite reasonably, people are looking for a decent return with low or no risk, and the problem that we all have is that there's no such thing as a no-risk investment. There's no such thing as a risk-less investment any more, and there hasn't really been since the crisis started.

So you've got his artificial suppression of interest rates. So interest rates throughout the world are at all-time low yield, not just in the context of a lifetime, but in the context of the last 5,000 years. So effectively, in all recorded history, rates have never been this low. The Bank of England said as much quite recently in a report by Andy Holdane. So if you accept that the risk free is effectively giving you nothing, it's giving you no yield whatsoever, then you should, I think, have a nuanced view of where opportunities are. If everything is priced off the risk-free rate, and the risk-free is effectively zero or negative, don't expect huge future returns from anything.

But, what I do think makes sense in this really abnormal environment is to go for, for want of a better phrase, is to go value. So, I'd argue pretty much every part of the bond landscape is completely over-valued. It doesn't make any sense, completely over-valued. By definition, therefore, you're looking at equity risk; you're looking at listed businesses. But, in the words of Ben Graham, who is the acknowledged master of value investing, it really comes down to two things. Firstly, don't buy poor quality assets. Don't buy rubbishy businesses. That may appear as a subjective call, but I think we can all agree, to a great or a lesser extent, what rubbishy business is.

And secondly, when you've identified quality businesses, just don't overpay for them. So, only buy quality businesses, quality listed franchises of good or exceptional management ability, but just don't pay too much for them. And again, we can agree what that is, it's just not paying a premium price for these.

Merryn: It sounds like an almost impossible suggestion in a market like this, in that we know that almost everything is over-priced. We know the entire US market is over-priced, we know a lot of the European market is now, you know, not nearly as cheap as it was. How on Earth do we go out there and find this kind of value, good quality companies trading a reasonable prices?

Tim: I think the answer is you have to go slightly further afield. You have to go the extra mile. I'd absolutely agree that there doesn't seem to be any kind of compelling value in the US. On the, you know, Shiller PE ratio basis, the US is something like 60% over-valued compared to its long-run average. So the US is clearly not a cheap market by anyone's means.

The UK and Europe, probably not so bad, but they are probably only pockets of value. As far we're concerned compelling value opportunities right now are opportunities in Asia and Japan. Japan is the one market that leaps out. There are other markets that are cheap, Russia for example, but I don't think anybody would describe Russia as being a sort of a safe type haven. But Japan is an example where you've got this sort of strange convergence of factors. It's still, the third largest economy in the world, but there are probably more Ben Graham style value opportunities in Japan than there are in any single other market today.

So they do exist, but you have to look somewhat further afield for them.

Merryn: And Japan also has its own QE programme on the go.

Tim: And it doesn't hurt, exactly, it doesn't hurt that under Abe you've now got one of the most aggressive monetary stimulus plans in the world occurring right now.

Merryn: And a shift into equities by various institutions in Japan.

Tim: Including the government pension fund, correct. So it's kind of like "What's not to like about this?"

Merryn: It's an unusual situation. As you said earlier, across the world, most pension funds are obliged to buy bonds, bonds, bonds and more bonds.

Tim: Japan may be the only market here the government is actually trying to turn the super tank around and say, "Guys: buy more stocks".

"The only compelling value opportunities right now are in Asia and Japan"

Merryn: And this makes sense, really. I mean, if over the long term we know that the return from equities are pretty much, well always, higher than the returns from bonds.

Tim: And also the Japanese, you know, debt to GDP ratio is just off the charts. There's a text and hedge fund manager that I'm sure many of your readers will know called Carl Bass, and he's described the Japanese government bond market as "A bug in search of a windshield".

Merryn: But if you look at traditional evaluation methods in Japan, for example if you look at PE etc, it doesn't look that cheap.

Tim: Japan has always had a problem with shareholder value. There are a lot of businesses in Japan that I think culturally they've been run for some time, and I'm sure you've seen this personally from your time over there, they're run for the benefit of employees, for stakeholders if you like, but not for shareholders. Our sense is that that's slowly changing, but again if you go, even in the context of the Japanese market, somewhat further afield, if you go more into kind of small and mid-cap territory, you'll find We're finding managers who are investing into that area. There are plenty of opportunities where these companies are run more like a classic Western model. They're run for the benefit of shareholders, for shareholder returns, and it's not just, you know, playing lip service to that, they're genuinely delivering the goods. They're delivering in some cases record revenues. And the beauty of that market is if you can find the right, either the right business or the right asset manager who is investing into those businesses, if you can strike it lucky you can buy businesses, you can buy shares of businesses that are trading, generating all time record profits, and you can buy them at a low PE single digit price/earnings ratios at one times book or less.

And these companies are not covered, in some cases, by a single analyst. This is what happens when you've got a stock market that's been in a bear market for 25 years. There's no research coverage of a lot of these businesses. It's a fabulous opportunity.

Merryn: Let's go back a bit to interest rates and the bond market. What changes this bizarre situation of historically low interest rates, of negative yields, etc? What is that that might turn things around and have us see interest rate rises?

Tim: That's a good question and I'd love to have the answer.

Merryn: I'd love you have the answer too.

Tim: OK, I'll defer to somebody else. I'll kick into somebody else's back garden. Dylan Grice, the analyst Dylan Grice, I remember we were talking about how long does this dysfunction market last, and the reality as he described it, he made a very fair point I think, he said, "You have to appreciate that when you had the Soviet Union, you had a clearly dysfunctional non-market economy, a central planned economy, born in the chaos of 1917, and pretty much every year objective international observers would have said you know, "This cannot last, it's going to fall apart, it's going to break apart." So apparently the CIA every year was issuing research saying," Any time now, it's going to break." And the reality is the Berlin Wall didn't fall until 1989."" So the bottom line is, if that metaphor is valid, and I'm sure it is, then this dysfunctional environment can outlive us. It can outlive all of us. However, I don't think it's a straight forward as just saying, "Look, this really bad thing can be a bad thing for longer than we think." Because it's not just one country, it's most of the Western world. So I just simply cannot see how it doesn't get ultimately addressed by the market.

We don't have a free market in anything at the moment. We have a centrally planned financial market system. So interest rates aren't set by a market, they're set by a handful of central bankers at artificially low levels. That means bond yields are artificially low, that in turn means that stockmarket investments are also artificially high. Because everything is relative. What happens to break this? You have maybe bond market vigilantes, or stock market vigilantes come back onto the scene. Maybe some form of market dislocation. Some kind of crash. There's a perception that central banks have got everyone's backs. And I just think that's a very dangerous delusion. I think this comes down to a battle royale between governments, because that's who central banks are working for, and the market. And I happen to think that over time the market will prevail, but it may take some time.

"This dysfunctional environment can outlive all of us"

Merryn: And what about the debt situation? It's very hard to see how governments, even in this incredibly low interest rate environment, and even if it does go on for a long time, how they will resolve their public debt.

Tim: I'm not sure they can. As a former bonds sales man, the way I see this is you've only got three outcomes. One outcome is that you have enough economic growth to service a clearly unsustainable debt burden. I think in the eurozone, that's just not going to happen. We're too far gone for that in Europe. So let's discount that.

Merryn: So we have to expect default.

Tim: Well, then you've got option two or option three. Option two is default. Option two is default or repudiation or, if you want to be polite, restructuring. Maybe we get some form of that. The third outcome though, and this is the one I think is most likely to happen, is the one that also governments throughout history have resorted to, and it's inflation. Now, clearly we don't have that yet. Everyone is talking about deflation.

Merryn: But the governments have been attempting to create

Tim: But the governments have been attempting to trigger inflation, so I'm just minded to think given enough time, and given enough, well, lack of political will to impose the economic restructuring that's desperately required, in the absence of that, to fill that political vacuum, central banks will step in. And if you thought QE thus far was aggressive, well get a load of what may be to come. Deflation effectively is game over for indebted governments. So, on that basis, I think at some point this thing does turn around, and in response to perhaps quite alarming levels of deflation, the central banks go all in and then some, and then wait to see what the inflation outlook suddenly looks like.

Merryn: OK, so the more deflation we get now, the more inflation we're likely have later.

Tim: That strikes me as a very fair conclusion.

Merryn: There is a view that QE is actually deflationary, not inflationary. In that by keeping interest rates very low, by bailing out zombie companies etc, etc, it keeps supply much higher than it would be in an ordinary market or a free market. So the more QE you have, to a degree, the more deflationary it is rather than inflationary.

Tim: There may be something to that. I mean, I'm not an economist, and I'm glad that I'm not an economist, but I remember meeting a Japanese firm manager back in 2000 or 2001, and I'll never forget what he said. He said, "Up until now, Japan has been the dress rehearsal, the rest of the world will be the main event." Now that's fifteen years ago, and at the time that seemed an absurd thing to say. With the benefit of fourteen years hindsight, it doesn't look so absurd anymore. The Japanese have clearly been trying and doing everything in their power to try and get their economy back on its legs. They've been in the wilderness for well over 20 years, and they are where they are now. It does feel like pretty much all of the West has sort of tripped gaily along behind them, going, "Let's try to make our economies a little bit more like Japan". And so far they seem to be succeeding.

"If you thought QE was aggressive so far, well get a load of what may be to come"

Merryn: So, as far you're concerned, the only answer in this environment is to look a value, a value you see as in Japan. What about holding cash? In a deflating environment, cash seems like the obvious place to go.

Tim: Cash, I think, has a role. There's still clearly problems over the solvency or the credit-worthiness of the banking system, so, for my money, if you incorporate gold as part of that cash then I'd absolutely concur. And the problem with gold is that it's a very misunderstood asset. I mean, I've made no secret of the fact that I think gold has a lot of value. There's portfolio insurance, portfolio defence, inflation hedge, catastrophe hedge if you like. But I think gold is a misunderstood asset.

And the best way I've heard gold described by people far more intelligent than me is gold isn't even an investment, it is, quote, "A conscious decision to refrain from investing until you have an honest monetary system." And I think there's a lot of wisdom and truth to that.

Merryn: That could be a long, long wait.

Tim: It could be a long, long time, but ideally we get that system reset quite soon. And it feels to me that we are going to get it quite soon. The idea that you've got all these bonds, government bond markets, trading with negative yields this feels to me like we are much closer to the end of a 30 year-plus bull run in interest rates and in credit. And ideally we get some form of let's not scare the horses, we get some of correction to that credit bubble. I don't think it's going to be pretty, so clearly chose your credit exposure with care, chose your bonds with care, but ideally that situation does get resolved somehow. Possibly by a combination of economic growth and restructuring and inflation. Ideally, all three, because any one in isolation is problematic if it's not growth. But this feels to me like we must be surely closer to the end game now, and that's good news.

Merryn: Are you still holding a lot of gold in your own portfolio?

Tim: Yes.

Merryn: How much?

Tim: It's a lot. I mean it's a lot. It's more than I would advocate any other person or entity held. But, no, I'm perfectly relaxed, because I'm playing a long game.

Merryn: So, the average person how much gold do you think they should be holding in their portfolio?

Tim: I think, for any asset, in the interest of true diversification you need to be at least, let's say, 10% committed otherwise it's meaningless, it's completely marginal. So depending on people's appetite, risk tolerance, requirement for income, I'd say anything from 10 to maybe 25-30% is prudent. It'll look more prudent if the price clearly starts to recover, and I sense that we may be close to some kind of a low. Everybody hates this thing! So, you know, just from a contrarian perspective now is probably not a bad time to be buying either gold or gold miners.

Merryn: Brilliant. Tim, thank you very much.

Tim: Thank you.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.