Will bonds crash? And should investors be wary of China? John Stepek chairs our Roundtable discussion.
John Stepek:Let's start with next week'sBudget speech what do you think will happen?
Ashok Shah: Cutting tax relief onpensions is probably on the cards. But it's austerity I'm interested in. If we're really going to have a balanced budget in five years' time, then the impact of the cuts needed means you can kiss goodbye to 2.5%-3% annual growth. It'll be below 1.5%.
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Max King: I think tax revenues will be up.
Ashok: Maybe, but a lot of the jobs created have been poor quality low wages, part-time and this has meant little in the way of productivity gains. The feel-good factor is going to dissipate.
Tim Price: The greatest trick the previous coalition goverment ever played was to persuade people they were tackling the debt, when in fact it grew faster than under the previous Labour administration. I think the Budget is going to be horrible I just hope it's not as horrible as it could be.
Max: I don't think they need do anything more than they did in the March Budget. But for political reasons they want to come up with new initiatives. I worry they'll do something they will regret.
Marcus Ashworth: Because it'll hit the economy, or because there will be riots?
Max: Not riots more just getting off on the wrong foot with the electorate.
Marcus: I think they feel they have topush ahead. It's about reshaping the economy away from government dependency, towards a more Conservative-style vision. I agree with that vision, although it makes no sense to me to ring-fence the NHS and the international aid budget and the rest. You have to expect a government with a very small majority to move quickly.
Ashok: That's true. But the other stuff being ring-fenced matters it means that cuts to the unprotected areas are going to be really deep: 20%-40%. People don't understand what that means the private sector will be forced to take on a lot of services further down the road.
Max: Yes and that may well be too controversial and end up being reversed.
John: What do you think will happen with UK interest rates this year?
Marcus: Who cares? They might go up, they might not. I don't think it makes much difference. The Federal Reserve in the US is going to make all the mistakes and do all the running on it in any case.
Max: I agree, the UK will follow America, but I would like to see the Fed raise American rates by September. I think it would be seen as normalisation, and the market would respond positively. If the Fed keeps delaying, people might start to fret about inflation creeping higher and demand higher bond yields to compensate.
Tim: Why do you think European bond yields have spiked?
Max: I think they just fell too far, too fast. One per cent on a German ten-year bond is pretty attractive, whereas nine basis points (0.09%) clearly wasn't.
Tim: I find the volatility at the long end of the German market striking.
Max: We may well have to revise our attitudes about the riskiness of asset classes. The volatility and price moves in bonds suggest that the risk relationship of bonds versus equities may have changed.
John: Do you expect a bond crash?
Max: No, because inflation will remain very low. The US ten-year Treasury at about 2.5% is reasonably attractive andI expect it to stay in a range of 2% to 3%.If credit growth remains constrained,we are looking at a steady-growth, low-inflation environment secular moderation rather than stagnation.
Tim: My problem with the bond market is agency risk. The big funds are basically sovereign-wealth players managing pension money nobody invests their own cash, it's all other people's. So you've got a market that (a) is manipulated beyond all reasonable bounds by central banks and (b) run by people who have no skin in the game. If that isn't a recipe for problems, I don't know what is. On the equity side, there are at least a few managers who do have some skin in the game.
Marcus: Exactly equities should outperform bonds. And we may be seeing the first signs that they will do. That's healthy. Bond yields need to rise and normalise in other words, bonds should sell off otherwise what central banks are doing isn't working. As Max said, that's why they need to get the first hike out there.
Ashok: The key thing with bonds islack of liquidity. So there will be much bigger moves up and down, whicheverway it goes. But another key point is that this year overall supply of government bonds can't keep up with central-bank buying. So there's an artificial shortage. And while these huge liquidity injections continue, markets cannot fall.
Yes, bonds will be more volatile, because market-making capacity has been eroded, butthey are fundamentally being supported. And as far as turning all this central-bank cash into loans from commercial banks goes, that's not going to happen until2019, when the Basel III rules kick in until then banks' total leverage has to keep coming down.
John: Basically, banks are still shoring up their capital due to Basel III, so they can't go on an inflationary lending spree?
Ashok: Yes the tier-one requirement just keeps rising again and again.
Max: So it's bond volatility, yes; crash, no. That's the key to secular moderation and low inflation constraint of bank credit.
John: Let's talk more about equities.Is America overvalued?
Max: I don't really think so. America has great, exciting growth companies it deserves to trade at a premium.
Tim: But they might have said that in 1929. They definitely said it in 2000.
Marcus: The dollar is likely to keep rising, so why wouldn't you have more US exposure? And if rates are really, really low, then you have to factor that in. A p/e of 16 when rates are at 8% is very different to when rates are at 0%.
Tim: I accept that US firms are in many cases better quality, but at the top of every cycle there's always a rationale to explain away scepticism, and I don't think this time is any different. So I'd look at Japan. Around 40% of the Japanese market trades at a price-to-book ratio of less than one; more than 70% of the US market is on a price-to-book of more than two. So if you're interested in value, there isn't a whole lot on offer in America, whereas it's in abundance in Japan.
Marcus: I'm a big fanof Japan too but why now specifically?
Max: Because now companies get it. They're raising returns on equity and creating value for shareholders.
Tim: Japanese companies are among the most profitable in the world. Other markets look pricey. You've got the most accommodating central bank in the world and you've had 20-odd years of extraordinary underperformance.
Max: And you've got a cheap currency.
Ashok: Moving back to America, the stronger dollar has hit earnings momentum about 60% of S&P 500 profits are not US dollars. However, consumers haven't yet spent the savings from the falling oil price, so there are good things to come you just need to focus on the domestic economy. But I think we should be talking about European equities.
The cost of capital is now collapsing, and lending to the private sector, which was contracting, is stabilising. So there's a lot of good news in the pipeline with ongoing quantitative easing (QE), the cost of capital for households, and for small to medium enterprises (SMEs), will fall quite a bit more.
Marcus: Do you think Europe has beaten deflation? I'm not convinced.
Ashok: Yes, because QE will just keep going until inflation gets to 2%. September 2016 is the earliest end date for QE but it'll probably last for at least three years. Housing markets have stabilised, so the bad debt cycle will turn around, which means banks will be more willing to lend. There's a lot of good news in store for Europe after Greece whatever happens.
John: How about China?
Max: I'm looking to buy, particularly if it weakens further. The slowdown in Chinese growth is good for profitability. Historically, China overinvested and overproduced, so profit margins were rock bottom, returns on equity were poor and you didn't make any money. Now the economy is slowing down and people are focusing on boosting margins. The market in certain areas has got overextended.But the question is at what price and when you buy, not whether you buy.
Marcus: The percentage of Chinese citizens who invest in stocks is something like 14% compared with 50% in the US. So this isn't a bubble it's just growing pains. The real story is that, for seven years after the financial crisis, the Chinese market went straight down, because everyone took their money out of equities and put it into housing. Then the authorities said to stop doing that. So they went back into equities.
Ashok: You have to be careful. I ran a fund in China and know from experience that Chinese firms are hard to analyse at the best of times. That said, China has a lot of room to loosen monetary policy and reflate the economy if needs be, and it's trying its best to clean up the system politically. So I wouldn't be negative in the medium term.
John: So what tips do you have for us?
Our Roundtable picks
Tim: Being mindful of volatility, I want to be as defensive as possible. For Japan, I'll go for the Neptune Japan Opportunities Fund, which hedges the yen. My second defensive investment is a trend-following fund. These have historically been good at protecting capital during market shocks. In 2008, trend followers were among the few who made money. So I'd buy Bluecrest Bluetrend (LSE: BBTS).
John: The point is that trend followers can go short as well as long?
Tim: Exactly. My third choice is a bullion play: Central Fund of Canada (Toronto: CEF/A), which is 50% physical silver, 50% gold bullion. Precious metals offer a hedge against inflation and systemic instability.
Ashok: If we are set for sustained low interest rates, low growth and low inflation, then income-generating assets will continue to do well. You want stocks with low debt to equity ratios, high free cash flow generation and revenue stability global multinationals, such as consumer goods groups Unilever (LSE: ULVR), Pepsico (NYSE: PEP) and publisher Reed Elsevier (LSE: REL). I also like cyber security total spending on the sector is set to rise at around 15% a year for a few years to come.
There are three sub-sectors: firms that deal with governments; those that deal with the financial sector banking details and authentication, etc; and those that guard the data of large corporations. In this area we like Symantec Corp (Nasdaq: SYMC). Finally, there's the obesity epidemic. It's not just developed markets eating terrible food, but China and others too as a result, diabetes and other lifestyle diseases are exploding. So you want to buy the companies that help to tackle that, such as Baxter International (NYSE: BAX).
Max: I'll focus on listed private-equity vehicles. The underlying companies are doing pretty well, so you have a combination of operational and financial leverage, companies trading on attractive discounts to asset value, and conservative valuations. Electra (LSE: ELTA) is still on a discount of more than 10%, as is HGT (LSE: HGT), where momentum in the invested businesses is strong. And I think that Simon Borrows at 3i (LSE: III) knows what he's doing, so although the share price looks quite expensive, I'm happy to hold as well.
Pantheon (LSE: PIN) a fund of funds on a double-digit discount also looks very attractive. I even like the two Better Capital funds, whose fortunes are improving after a rocky ride. Overall, there's very good quality with great momentum available at a reasonable price. I think any investor should have around 10% of their equity exposure in this sector.
Marcus: I'm a large bull on Japan and, to a lesser degree, China China is not to be ignored, but the upside potential in Japan is just so much larger. And I would say that you can now invest without the currency hedge. I think the domestic inflation trade is now the most important aspect.
We have the 2020 Olympic Games coming up, which is a big deal for logistic companies, such as Kintetsu World Express (JP: 9375). Dentsu (JP: 4324), one of the largest advertising agencies in the world, is another beneficiary. These "enabling" companies will become so much more important in the run-up to 2020. The Nikkei is sitting at around 20,000 can it get to 25,000 in the 18 months? It absolutely can.
And if you're a fixed income investor, I'd tip the Church House Investment Grade bond fund. The manager, Jeremy Wharton, has moved ahead of impending volatility and got his portfolio onto safe ground. About a third of the fund is in good-quality floating-rate debt (which means yields should rise with rates) and the fund looks well placed to weather forthcoming events, while still paying a fair yield of around 3.4%.
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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