Is it time to buy VW?

Investors in Volkswagen were only too glad to see the back of CEO Martin Winterkorn. So is the worst behind VW, or is there more punishment lined up for the shares?


Martin Winterkorn says he had nothing to do with it

Ah, that famous German efficiency.

Your cars are too polluting to pass emissions tests? No bother.

We'll just design a car that actually knows when it's being tested, so that it can adjust its figures accordingly I'm no engineer, but I imagine it's a bit like holding in wind in polite company.

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Then, when it's back out on the streets, it can relax and let it all out.

Such a clever solution. If only Volkswagen's engineers had applied that ingenuity to solving the actual problem, rather than masking it, then maybe VW chief executive Martin Winterkorn would still be in a job.

Anyway the shares in the car giant bounced yesterday as he stepped down. Given the scandal gripping the group, it was the only option. Investors were no doubt relieved to see that recognised.

But is now the time to buy? Or is there worse to come?

VW's been selling lemons but is it the only one?

I'm not a mechanic and I don't get excited about cars, so forgive me if my summing up of the main points here is too simplistic. But basically, VW has been caught red-handed trying to con regulators and its customers into thinking that diesel emissions were lower than they really were.

This has hit 11 million cars worldwide. That's more than VW sells in a year, according to Bloomberg's Chad Thomas.

This is bad. When these sorts of scandals hit companies, it's usually down to negligence or bad luck or a combination of both. This time, it's because the company has deliberately and systematically set out to stick two fingers up at the law and its own customers.

Winterkorn says he had nothing to do with it. Maybe that's true. But someone at a pretty senior level surely must have sanctioned this. So expect more heads to roll.

On the other hand, this sort of stuff happens in the car industry all the time. Product recalls are hardly unheard of. Potentially and in some cases, actually lethal flaws have made their way into models on more than one occasion. It can be a dirty business.

And you have to wonder. If VW was doing this systematically, then how have other vehicle manufacturers been passing the same emissions tests?

(I know a fair few of you out there are engineering sorts, by the way be interested to hear your take on it. Is this sort of thing widespread in your experience? Where else should we be looking for the next mechanical scandal to crop up?)

So this probably isn't a scandal that will destroy the business. That means that at some point, VW is worth buying.

Should you buy VW?

But have the shares been punished enough yet?

Lex in the FT notes that the company's market capitalisation has dropped by around €22bn since the scandal broke. That's enough to account for the potential maximum $18bn US fine, plus another few billion in "fines, lawsuits and recall costs".

But it also assumes that profits will be otherwise unaffected. That seems unlikely. There'll be costs associated with rehabilitating the brand and building a car that actually does what they say it does. And who knows? Under scrutiny, VW shareholders might find other little nasties under the bonnet.

As Eoin Treacy points out on, "the bearish case is that VW is but the tip of the iceberg, that clean diesel' was nothing more than a clever marketing campaign predicated on fraud and that irreparable damage has been done to the outlook for diesel passenger vehicles".

Also, this is a foreign company that's messed with American consumers. I seem to remember that the moment of maximum pain for BP shareholders was when Barack Obama was taking the opportunity in every other speech to condemn "British Petroleum".

In all, I'd rather have a better idea of how this is all going to unfurl over the coming weeks before I put any of my own money into VW.

This could be good news for electric cars

I'm more interested in what this might mean for next-generation cars. There's going to be a lot of political pressure arising from this. Particularly at a time when governing politicians are feeling the squeeze from populist rivals who like nothing more than to paint the government as being in bed with big business (and who can blame them?).

This is also a massive embarrassment for the German government. There are questions being raised about how much they knew about this. For example, we already know that they knew of the existence of this software before now, although they're saying that they didn't realise anyone was using it.

One way for both VW and the German government to demonstrate a culture change and to rebolster its green' credentials, would be for the company to make a commitment to expanding the market for electric cars.

My colleague Bengt Saelensminde wrote about the best ways to invest in electric cars in the most recent issue of MoneyWeek magazine, and it's a topic we'll be returning to over and over again. Keep an eye out for his next piece on it.

A seismic scream' in the interest rate market


By Dan Denning

Vulcanologists call it the seismic scream'. It's the sound you hear when thousands of tiny faults in the rock of a volcano begin to crack and split at once. The force of molten rock underneath becomes irresistible. The sound rises to a climax. Then all kinds of fiery hell breaks loose.


Is this akin to how deflation ends and inflation begins? That's my contention in today's Money Morning. I'll keep it brief because Tim Price has much more to say on it below. But for years now, the argument of the inflationists' is that you can't see a huge expansion in central bank balance sheets and 3,000-year low interest rates all around the world without creating the conditions for a massive spike in prices.

Yet, deflation has prevailed. Investors in Ireland and the Netherlands are chasing negative yields on short-term government debt. Dutch two-year yields were as low as -0.25% earlier this week. Irish two-year government yields were at -0.189%. German bond yields have been negative for some time now. Check out the table below from Bloomberg.


If you buy a bond with a negative yield and hold it to maturity, you'll get back less than you paid for it. Why would you accept or even prefer negative yields on short-term bonds? Because in the short term, you view everything else stocks, commodities, and property as highly dangerous or insufficiently liquid.

The seismic scream' in the bond market is telling you that financial markets are under massive duress. But is something really about to give? Or will central bankers succeed in suppressing the natural forces of capitalism (and interest rates) for a bit longer? Let's ask European Central Bank (ECB) president Mario Draghi.

"Should some of the downward risks weaken the inflation outlook over the medium term more fundamentally than we project at present", said Draghi at the European Parliament yesterday, "we would not hesitate to act". But not quite yet. "More time is needed to determine in particular whether the loss of growth momentum in emerging markets is of a temporary or permanent nature."

What does Draghi mean by "act"? More quantitative easing, negative interest rates on excess reserves held on the ECB (which could be passed on as negative interest rates to savers), helicopter money, currency wars. That's the playbook.

The trouble is especially for stockmarket investors central bank interference in the economy is having diminishing marginal returns, for stocks in particular. Take Shinzo Abe in Japan. He begins his second three-year term as his party's leader in Japan. What does his signature reform programme, Abenomics, have to show for itself?

A public debt-to-GDP ratio of 230%, for one thing. Japan has opened the fiscal and monetary taps. It hasn't done much for GDP growth. And it's doing less and less for stock prices. In 2013, Japan's Topix rose 50% with the first rush of liquidity from quantitative easing (QE). In 2014, it rose only 9%. In 2015, it's up only 5% year-to-date.

Can you hear the seismic screaming? Up until recently, traders could count on low rates and central bank QE to boost stocks prices. Those policies weren't boosting growth. But at least owners of stocks and bonds did well. That's not happening anymore.

And that's what concerns me today. Inflation can be quiescent for a long time. And then it can explode. Earlier this week I picked up John Stepek's copy of When Money Dies: The Nightmare of the Weimar Inflation by Adam Fergusson. It's not about monetary policy. It's about how inflation destroys lives and civilised society and leads to war.

It's not easy reading. But it's timely. The failure of QE to boost asset prices any longer could signal a tipping point in the public's faith in central banking itself. If it does, fears of deflation could turn into gales of inflation. Here's Ambrose Evans Pritchard in today's Telegraph:"The powerful social forces that have flooded the global economy with abundant labour for the past four decades years are reversing suddenly, spelling the end of the deflationary super-cycle and the era of zero interest rates. As cheap labour dries up and savings fall, real interest rates will climb from sub-zero levels back to their historic norm of 2.75% to 3%, or even higher. The implications are ominous for long-term US Treasuries, Gilts or Bunds."

On that note, let me turn it over to Tim Price. What you'll find below is an excerpt from his report The Endgame: Surviving the final phase of Financial Martial Law. It's one of the free reports Tim has prepared for new subscribers to the London Investment Alert.

Rich man's inflation


By Tim Price

Editor, The London Investment Alert

If you were a gilt investor in 1973, it took you 12 years to claw your way back to breaking even on your portfolio. UK government bonds, or gilts, performed, in real terms, during the inflationary / stagflationary 1970s.

And bonds didn't perform dismally in isolation. Stockmarkets performed dreadfully too.

Anyone invested in the FTSE All Share index of stocks in 1973 had to wait for 11 years until they were back in the black. And along the way, they incurred a mark-to-market loss of over 70% on their portfolio.

That assumes that they held on many investors may well have bailed out in terror somewhere along the way, making their losses permanent in the process. In an environment of rising interest rates, bonds do badly, because they typically carry fixed annual interest payments, or coupons.

As interest rates rise, the relative value of those fixed coupons falls, as one might expect.

When you're earning 2% from your bond (many gilts today yield much less) and deposit rates are at 4%, who would want to own the bond?

Three ways governments dig themselves out of debt holes

The other reason for those terrible returns from the 1970s was inflation. Again, if inflation starts to rise, that also eats into the return available from fixed income assets. The drawdown in prices for our hypothetical 1970s gilt investor was over 35% at its worst the bondholder lost over a third of his money.

This is not to say that we face an immediate return of inflation but I do happen to think that inflation will be the end-game in this current crisis, since it's the only way out for desperately indebted governments.

Throughout the history of government borrowing, governments have always had three choices when it comes to digging themselves out of a debt hole. One is to generate sufficient economic growth to keep servicing the debt (maintaining coupon payments and returning investors' principal the initial amount of the loan).

The second is simply to repudiate the debt, and default on it. The more polite way to put it would be "debt restructuring". And don't be fooled even the UK government has defaulted on its debt in the past.

In 1932, in the grip of the Great Depression, Britain defaulted on its First World War debt to the United States the so-called inter-allied debt. Another example was War Loan, issued in 1917 with a 5% coupon. In 1932, that coupon was reduced from 5% to 3.5%.

This was deemed not to be a formal default because it was technically a voluntary reduction in interest (the then chancellor, Neville Chamberlain, appealed to people's nationalism: "For the response we must trust, and I am certain we shall not trust in vain, to the good sense and patriotism of the 3,000,000 holders to whom we shall appeal").

It worked inasmuch as 92% of gilt holders voted in favour, but it was a default all the same, voluntary or otherwise. But ordinarily, default comes in a time of crisis and is completely involuntary it tends to come about when governments don't have any other choice.

Since we live in a debt-based monetary system, a default by any major Western government would be more or less equivalent to economic Armageddon. The third option is the one to which governments return, time and time again: inflation. A stealthy way out from an otherwise unmanageable burden of debt.

The most important thing to remember about inflation

The great Austrian economist Ludwig von Mises recognised that inflation was not some

mysterious force, but a core part of governmental fiscal strategy:"The most important thing to remember is that inflation is not an act of God, thatinflation is not a catastrophe of the elements or a disease that comes like the plague.Inflation is a policy." (Emphasis mine.)

For some time now, bond investors have been fretting about the prospect of rising interest rates in the US. Not that you'd know it from bond prices though. US Treasury prices remain sky high, meaning that US Treasury yields remain at rock-bottom levels. (This is because bond coupons are typically fixed, higher prices equate to lower yields, and vice versa the same way that when stock prices rise, and dividends are unchanged, dividend yields fall.)

Fed officials are clearly undecided about if and when to raise rates. US interest rates have been kept at close to zero since 2008. The plain fact is that the longer they stay there, the more difficult it is to raise them.

The financial sector gets addicted to easy money and starts getting stroppy when the prospect arises of that easy money being taken away. Some Fed officials worry that with rates being kept lower for longer, inflation will be the outcome.

But there's an elaborate waltz going on here: the Fed needs to create inflation, and creating inflation was precisely what QE was all about from the beginning. So it's staggering, really, that with all the trillions of dollars that have been printed and invested to keep bond yields low, that there's been no resurgence of inflation. Or at least, no resurgence of inflation in the prices of many goods and services.

There's clearly been no shortage of inflation when it comes to things like stocks, bonds, property, fine art and collectibles. There's been plenty of rich man's inflation'. Both the US and the UK central banks face an exquisite problem. How to gently deflate what analyst Doug Noland calls a "global government finance bubble"' without causing mayhem in the financial markets and the broader economy? How indeed. It may be impossible.

John Stepek

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.