Will oil keep falling? Have commodities finally hit bottom? John Stepek chairs our Roundtable discussion.
John Stepek: This time last year, the big story was the oil price. It still is. Max, any thoughts?
Max King: It’s taken longer, and gone deeper, than I’d have thought – I had expected oil to stabilise at around $50-$60 a barrel. But it can’t fall forever. Given the money that has been wasted on capital expenditure in the resources sector over the last ten years, the next time there’s a shortage of any kind, no one will spend a penny – they won’t want to get burned again. So resource-price volatility will be higher in the long run as a result.
David Guild: There doesn’t seem to be anything fundamental to suggest the oil price will rebound. Oil cartel Opec isn’t doing anything about supply, and demand is questionable. We’ve seen the price go a lot lower in the past. Why not $25?
Charlie Morris: Someone needs to go bust before this reverses – the falling price is the mechanism to make that happen.
John: But is falling oil really a problem?
Tim Price: Before now, lower oil has always been seen as an unmitigated good. Now the media seem confused. It’s not black and white – Japan is dependent on imported oil, so it’s not bad for Japan to see resources prices plunge. Even in emerging markets it’ll have different effects, according to whether they’re consumers or producers. I think the confusion arises from the fact that you’ve got asset-price inflation in just about everything except commodities. And that points to troubles a bit below the surface.
Max: Falling oil prices are putting more money into people’s pockets, and with inflation virtually at zero, it’s beyond me how anyone can have a terribly bearish view on the world economy. Spending power is going up sharply and that should reduce our concerns, not increase them.
Tim: But perversely this is exactly what central banks are fighting to prevent. Jim Mellon: I think we’re very close to the bottom in some commodities. We’ll have to see a major bankruptcy first, probably in iron ore. That will mark a turn. Also, there is now probably potential upside from China. So although the Chinese are still flooding the market with steel and killing steel manufacturers around the world, the likes of iron ore and copper could well be good buys very soon. But I’m buying the commodities rather than shares.
John: What about oil?
Jim: I don’t think it’s the same for oil. I think fossil fuels face structural death. The climate change deal in Paris is one example of that, and cars today are more fuel-efficient, and we’re heading towards electric and hydrogen fuel-cell cars too.
Max: I read that you’ll eventually be able to drive from London to Edinburgh and back on a single battery charge.
Jim: I’m sure that’s true. But the other key thing is autonomous vehicles. When they arrive, we will need less than half of the cars, buses, and trams that are on the road right now, because they’ll be shared. And when it happens, it’ll happen quickly – there’ll have to be a sort of legal diktat that either all cars are autonomous, or none are, because you can’t have just a few being autonomous.
In some US states you’ll see a rapid shift – California obviously, and Nevada – and we’ll see it pretty quickly here too. About 45% of the average vehicle’s value these days is electronics anyway, so there is already a lot of built-in autonomy – many cars can self-park and avoid driving into the back of other cars and so on. The adoption rate for new technology is faster in each cycle.
John: Part of what’s hurt commodities is the dollar bull market. Do you think the strong dollar will continue?
Tim: Long dollar feels like a crowded trade. But if Federal Reserve chief Janet Yellen is putting rates up, even by an infinitesimally small amount, then I’d back the dollar over any other currency.
Max: But a strong dollar combined with factors like tightening credit markets tells you that monetary policy is already quite tight. So while I’m sure there won’t be just one rate rise and done, I don’t think there’s going to be an awful lot more.
Jim: I’d have thought the dollar is overvalued at the moment. It’s certainly showing in the trade figures for the US. At this level, I would be neutral on the euro, and a buyer of the Japanese yen.
Max: Definitely. My son lives in Japan and it costs him half the price to send Christmas cards to the UK from Japan, as it does the other way around.
Charlie: But remember how expensive the dollar was in 2001. That was the last time it had a major peak, and that followed an era just like this. In 1998, we had low oil, an emerging-market crash, and then a tech boom. So it’s a similar playbook, and the dollar bull then carried on for much longer.
James Ferguson: I agree with Charlie. If we look at the very long-term relationship between the dollar and other currencies, it’s actually about average, and has come back from being very oversold. And this is not about interest rates – it’s about dilution. When the dollar was being diluted by quantitative easing (QE – money printing) after 2008, we had crisis after crisis in Europe, yet the euro held firm, because it wasn’t being diluted.
But now the euro is being diluted by QE, and the Americans have stopped. And we should expect a lot more European QE. It has just been extended to 24 months from its original start date. But if you look at the amount of QE that the US and UK both did – around 25% of nominal GDP – then Europe needs five years of QE at this rate, not two. So the risks for the euro will constantly be more QE, more dilution and more disappointment.
Jim: Or a break up. I’m particularly worried about France and Italy, because I just don’t think they can ever repay their debts, and the Germans have neither the capacity nor the willingness to bail them out. Once the markets realise that the European Central Bank can’t buy all the Italian and French bonds, I think you’ll see a very big gap in relative interest rates. At that point, I don’t know for sure, but I would have thought that the euro breaks up.
In those circumstances, it’s dangerous to play the dollar going up against the euro, because we just don’t know what would happen – a stand-alone German currency, for example, would shoot up by 50%-60% straight away.
Max: I don’t think it’s just about dilution, it’s about relative growth rates. There’s been a wide disparity between the US and Europe, but I think that will probably shrink as the European economy picks up somewhat. So they’ll probably trade sideways for a while. I agree with Jim on the yen – Japan’s economy is doing better than expected, and that suggests the yen should rally. But I don’t think either the Europeans or the Japanese want their currencies to appreciate.
Tim: The wild card is that US monetary policy is going in one direction, and eurozone monetary policy in the other. There are six or seven instances of America and Europe going in different directions over the last 50 years, and half the time it ends in a mess.
James: It’s worth bearing in mind that the dollar isn’t going anywhere, it’s the euro that’s going to fall – because they have to keep printing money, because Europe’s banks, unlike America’s, are still a long, long way from being fixed.
John: So what is your take on America just now? If the banks are fixed, presumably everything’s hunky-dory?
James: US bank lending is growing and has been since the start of 2014. The problem is that, during the crisis period, when the banks had stopped lending, the authorities had to artificially stimulate the system. They did that via Wall Street – the financial markets. So now that main street – the “real” economy – is coming back, Wall Street will suffer. For the last seven years, stockmarkets did fantastically, and the economy was rubbish.
We’re now looking at seven years where the economy will probably do fantastically, but the stockmarket might be rubbish – because liquidity is being directed towards main street, as opposed to Wall Street. The only financial beneficiaries are likely to be the banks, who will finally be able to grow their interest margins.
Max: So QE worked in the end.
James: You always have to bear in mind that with these things we’re just robbing Peter to pay Paul, and then later we have to do the reverse, to get back into balance. So I think the Fed will let the real economy and banking system run hot for a while, which is good for the economy, but pretty poor for financial assets. Given that US equities are significantly overvalued on any long-run measure, that means there’s a lot of downside. If you look at the big hits that markets have taken in the past, these usually happen when a bad fundamental hit coincided with a very richly valued market.
John: So what would you invest in now?
Max: I think it’s dangerous to be a contrarian right now – it hasn’t really worked for quite a long time. So while resources and emerging markets are probably bottoming, I think it’ll pay to go with the trend. Areas I like include health care: I’d opt for the Worldwide Healthcare Trust (LSE: WWH) and Biotechnology Growth Trust (LSE: BIOG). The US healthcare sector is cheaper than the overall market, having corrected for a variety of reasons, and it has much better earnings growth.
I also like Scottish Mortgage Trust (LSE: SMT) and Edinburgh Worldwide (LSE: EWI). They know how to play today’s bifurcated market – there are the companies that are going nowhere, because their business model has been disrupted by new technology and globalisation; and there are the new companies, which may look expensive, but which are on their way to being global companies. These two funds are good ways to play those.
James: There is nothing like enough margin of safety for me in highly valued equity markets, such as America or Germany. I’d prefer markets that aren’t pushing those boundaries – Japan, the UK, France, Spain and Italy, are all at or below their long-run trends. Given that QE dilutes your currency and boosts your risk assets, you should do well in European equities, other than overvalued German ones.
But I don’t really look to invest in things that will go up – I look to avoid things that will go down. The outstanding risk in the world today has nothing to do with equities – it’s all about bonds. In the UK, in the last 35 years or so bonds have done as well as equities. If that’s the case, then we have to assume that what we’ve all been taught about bonds being less risky than equities (and thus offering lower returns) is wrong.
At a minimum, we should assume that bonds have exactly the same volatility now as equities, which means they won’t even have had a bear market until they’ve gone down by 20%. And because the coupon compensation is now almost zero (because bond yields are so low), then when bond prices go down by 20%, or 30%, or 40%, it’s going to really hurt. So rather than worrying about whether you’re in the right equities, I’d worry about whether you’re in any bonds.
Max: Bonds are expensive, but I don’t see them as a disaster.
James: Well, my most likely scenario is that bonds will lose 1% to 2% in real terms (after inflation) per year for the next generation – 30 years of grinding lower.
Jim: But James, the Japanese government bond short has been the widow maker trade for as long as I’ve been in the business. What’s to stop the Treasury short, or gilt short, doing the same?
James: Ah, but being long Japanese bonds hasn’t made you any money in the last 20 years either. So my point – to quote Tim – is that bonds represent return-free risk. That risk may not bite you for ten or 20 years, but you don’t even need to take it. So if a bond crash in the near term creates a temporary sell-off in equities, it’s not bonds you buy – it’s equities.
John: Are you all worried about this junk-bond panic?
David: The recent high-profile “soft closure” in America could be a prelude of things to come. I don’t think there will be a full-blown crisis, but I certainly wouldn’t want to be at the junk end of the debt market right now.
Max: I think high yield is quite interesting, actually. It became an overcrowded trade – money went in because the risks seemed low and the yield high, and now there’s been a bit of a panic, but much of that is associated with the energy sector. I’d have thought that it’s getting quite attractive.
Charlie: But people conventionally look at junk bonds and credit generally as a spread over government debt. And as James says, government bonds are pretty punchy at this price. So there could be a double whammy – if there is a normalisation of the government yield curve, then credit markets have a long way to fall.
David: But given that the big players – the pension funds, etc – have to hold bonds to ensure their liabilities match actuarial forecasts, are they suddenly going to sell? And if so, what can they do with the money? Presumably it’ll have to be recycled into other debt. That’s got to offer a bit of a liquidity backstop.
Max: The weakness of the market will pull in buyers too. That’s how markets work. Prices fall, it creates an opportunity, the buyers come in, and it stabilises.
Tim: I’m much less sanguine. These problems in junk feel an awful lot like 2006, 2007. The difference is that, firstly, this time, the sub-prime sector is much bigger. But also the inventory held by the establishment is far smaller, courtesy of the regulators. There is no proper trading of this stuff going on any more. I heard a line at a conference in LA recently: “If you’re a distressed seller of an illiquid asset, it’s worse than being trapped in a crowded theatre that’s on fire. It’s like being trapped in a crowded theatre that’s on fire, and the only way you can get out is by persuading someone outside to swap places with you.” It’s just a disaster. And again, it’s an unintended consequence of financial regulation.
David: One thing we haven’t touched on is geopolitical risk: aggression by Russia and China; ongoing difficulties in the Middle East; and terrorism from Islamic State, etc. There are big risks to financial markets here, even though you can’t quantify them.
Jim: There are always risks. You have to have a bit of gold and silver in your portfolio, it’s as simple as that.
David: I don’t think many people make money in gold, correct me if I’m wrong.
Tim: I don’t think you hold gold to make money, you hold it to keep money over the long term.
David: Yes, but many people lose money in gold.
Jim: You only hold around 5% as part of your portfolio.
David: But if it’s only 5%, it’s not going to make a blind bit of difference, is it?
Tim: I disagree – in an “end-of-days” scenario you’ll be glad that even 5% of your money is in gold!
David: So it’s a massive put option? Anyway, to answer your question on opportunities, I think valuations among small, under-researched – and in some cases, not researched at all – companies in Japan look interesting, and elsewhere in the Far East there’s a strong long-term demographic argument to invest in the likes of Vietnam, for example. There’s also value in certain areas within private equity, as we’ve seen recently with Sherborne taking on Electra. These guys have spotted valuation anomalies, and there are likely to be others around too.
There are also opportunities in selective European property markets – several northern European economies, specifically Holland, have quite glaring valuation and yield opportunities, particularly in commercial property. There’s value in mid- and small-caps too, among firms with strong cash generation, reasonable multiples and earnings growth, and reasonably well-covered dividends. These stocks don’t grow on trees, but they do exist. Gervais Williams’ Diverse Income Trust (LSE: DIVI) is one way to play those sorts of opportunities.
John: Which other funds do you like?
David: There’s a new property vehicle coming to the market that will invest in Dutch property in the same way as Summit Germany has done in Germany. There are also good opportunities in UK property – shopping centre manager NewRiver Retail (LSE: NRR) is a case in point. It’s not particularly cheap on a net asset value basis, but it’s an interesting business model. As for the Far East, and those under-researched Japanese stocks, I like Greg Fisher’s Samarang Japan Value fund.
On private equity, while Electra is running a bit ahead of itself, Apax (LSE: APAX) looks attractive. I like closed-end funds (investment trusts) in general. If dividends are going to be squeezed – and I think they might, particularly among large caps, where dividend cover looks weak – then I think you’ll find that closed-end funds in some cases, will have enough reserves to cover up to a year’s worth of dividends. That could be a big plus, so I’d favour them over open-ended funds, particularly if you can get them at a discount.
Jim: I agree with David on Vietnam – it’s one of the most interesting Asian markets. Elsewhere,I’d be short the Swiss franc against everything. It’s probably the best trend there is on the macro side. The Swiss National Bank is desperate to get the currency down, because it’s basically vastly overpriced, making Switzerland totally uncompetitive. I’d also buy the Japanese yen for a few percentage points. And I still like the Japanese market – I would buy the Nikkei up to 25,000. If you want one buy, then Hitachi (JP: 6501) encapsulates transport and the revolution that’s going on around the “internet of things” and controls for energy systems.
Finally, Steve Dattels and I have taken over a shell company that we’ve renamed FastForward Innovations (LSE: FFWD). Effectively it’s an investment trust with no fees. The idea is to bring small start-up, or near start-up, firms to the retail investor.
We’ve invested in the blockchain – not Bitcoin itself, but blockchain technology as a way of facilitating payments. We’ve invested in a shoe firm that cures diabetic foot ulcers, and in an education loan company in the US, among other things.
Tim: There are only two sustainable ways to make money out of markets over the long run. One is to buy value, and the other is to follow momentum. It’s probably bad form to mention one’s own vehicle, but I’m going to do so, it’s the VT Price Value Portfolio, which happens to have two of its single largest positions in Japan and Vietnam. That’s a portfolio of the best value managers we can find.
The corollary to value is momentum, and one decent trend-following fund is Montlake Dunn WMA. Bill Dunn is probably the longest-serving trend-following manager in the world. He started this firm in 1974 and its annualised returns are about 18%, which is top of the charts. In 2013 it was up 28%, 2014 up 18%, year-to-date it’s up about 5%. I’m convinced that a combination of value and momentum is the way to go.
John: Thanks everyone.