Buy oil, Russia and gold, say our experts

published 14 June 2006

Six experts give us their views on the big investment themes at the moment: Chinese growth, US debt - and commodities

Merryn Somerset Webb: What are the big themes on your minds at the moment?

Dan Denning: For me, it's the relationship between the US and Asia. I see the US economy as fundamentally handicapped by debt - fiscal debt, current-account deficit and personal debt. That should mean a very weak dollar. But the Asian governments don't want to see their currencies rising against the dollar - it cuts the competitiveness of their exports - so they are intervening to prevent it happening. The Japanese in particular have been throwing money at the problem. That gives rise to a question: has the Japanese central bank - and other Asian central banks - created a series of mini asset bubbles across Asia by constantly accumulating dollars? That worries me.

Arild Eide: I agree. And at the same time, low interest rates in the US have caused various asset bubbles there. We just don't know how long this can last. I'm also worried about China and the commodities bubble that we are seeing - also a result of this global reflation. Chinese officials have made it clear that they will have to tighten monetary policy (see page 32). The result of this has been that on a local level in China people have been hoarding commodities in anticipation of a tightening. That's not good - it means that when a downturn in prices eventually comes, it is going to be much tougher than it would have been.

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Bill Bonner: My worry about China is that a lot of the demand for Chinese goods comes from the US. If you take the view that the American demand will diminish, doesn't that also mean that the companies that depend upon American demand have to take a cyclical hit of some sort? That means both China and Japan. It's all about the American consumer.

Robert Catto: It isn't that simple. Yes, the Americans are consuming finished products - electrical goods and the like. But the commodities in high demand - steel, iron, copper, coal, etc - are really going into the Chinese domestic market. They are not ending up in the hands of a Western consumer who has just bought a new PC, but in a Shanghai office building. That said, growth in the domestic economy does, to a degree, depend on foreign demand.

AE: And the demand from the US isn't real - it's based on the cash consumers get in from the constant refinancing of their houses. Eventually this is going to run out and US demand will fall sharply. When that happens, expect the demand from the US to go down rapidly. Economies like Japan and China will then no longer be able to export to the US in the quantities to which they have become accustomed. I can't see how we get through that without a complete worldwide recession.

DD: The only way is for the Asian economies to pick up the baton and start consuming more.

Sebastian Lyon: We're assuming Americans will stop consuming. But who knows when US consumers will give up? They've been amazingly resilient so far.

RC: That's because interest rates have been cut so much. Home refinancing has been at unbelievable levels. Even two years ago it was $2trn. That's a third of the US economy. But there's no further room for cutting rates in the US.

BB: Maybe not. But what looks like an imminent disaster could take years to play out. Don't forget, it took the Romans hundreds of years to completely destroy themselves. I keep saying that consumers can't continue. But maybe they can. Maybe the US can drop rates further, maybe Japan and China will continue financing it for much longer, maybe consumers can mortgage a bit more of their houses. Who knows?

DD: One thing that might bring on an end game to all this is inflation.

SL: But there isn't much of that about.

DD: I think there is. The official statistics give a misleading impression. In fact, consumer prices have soared - healthcare, education, gasoline - they're all up. At some point, consumers will not be able to afford things at the margin. That's when the spending stops.

RC: But that takes longer than you think. The biggest problem many in the West have is that they have no fear of debt. They don't worry how much they take on. They are convinced that the value of their house will just keep on going up. That drives them to keep raising cash against it. That's frightening.

AE: Today, people seem to miss the point about saving and consumption. You are supposed to save to finance future consumption, not borrow to finance current consumption and then save later to pay off the debt.

Jim Mellon: Perhaps we will end up with a very long, painful, gradual slowdown in consumer spending in the US as people start saving a little bit. They will say, "Right, I had a pay rise of 3% last year, I'll save 2% of that." That's a shift from spending 7% of a 4% pay rise, which is what they have been doing for the last three to four years. One thing I am finding odd at the moment is how optimistic the Americans are. Faced with huge global shifts - they are losing manufacturing and service jobs to Asia fast - they seem to be in denial. It's not a problem, they say, we don't have to worry about losing manufacturing, we'll replace it in our economy with new Microsofts and biotech. They don't realise that the Chinese can do that too. It isn't like it was in the Industrial Revolution, when it took 50 years to transfer technology from Britain to Germany. Today it takes five minutes over the internet. So the West has no natural advantage over the Eastern nations. It is only a matter of time before our incomes become their incomes.

RC: Not that much time either. Look at India - it's taking over from the West fast. It has numerous graduates who speak perfect English. Twenty per cent of all generic drugs are now manufactured there. It's right up there with the latest in the medical industry and software. In fact, I'd much rather be invested in India than China. It's growing far faster than anyone had imagined - it's got the biggest road-building programme in the world and a far more educated and entrepreneurial workforce. And Indian firms actually make high margins, unlike Chinese companies, where the margins are absolutely screwed. There, if you build a port, the guy next door builds one too. There are no margins in China and that means the banks there are absolutely bust.

DD: But the West isn't going to accept this inevitable shift in living standards - West to East - easily. The structure of living standards in the West can't be changed very fast.

JM: But change it will have to. I went to China last month and paid a visit to a factory that makes 80% of the world's OEM batteries. Everything is done by hand when it could be automated. Why? Because it's cheaper than using the machines they have already bought from a German firm. Ninety-nine per cent of the workforce is between 18 and 23 and female. They work a six-day week and get paid US35 per hour. There is no way anyone in the US can compete with that. So how on earth can GM workers continue to earn $40 per hour (when you add on their pensions, etc)?

AE: In the West we are living in denial of the fact that we no longer have any competitive advantage.

DD: Maybe, but retirees and pensioners are not going to go down without a political fight. That means we can't necessarily expect a rational response. Instead, the reaction of the voting population in the West will determine how the governments react. The environment of the early 1990s, when everyone thought the world was globalised and market forces ruled, is over for now. Today, governments are trying to act in the interests of their people by raising trade barriers or fighting wars with their currencies.We've already seen this in the US and soon it will be obvious in Europe.

JM: To see the consequences of today's situation you need to look back a long way - to World War I. Just before this, Great Britain was the sole super-power in the world. But its star was waning, a little like that of the US today. That meant there was a vacuum - into that vacuum stepped Germany. There is a similar vacuum today. We live in a very unstable world. And I see a possible future military conflict between the US and China. Watch out.

Bob: I think you are right that there may one day be a war between China and the US, but not soon. The Chinese are happy to let the Americans pour in lots of capital investment, and teach them everything they know. Right now, America is entirely beneficial to China - except for the odd criticism of the way they run their non-democratic form of government. It may not stay that way.

MSW: It's a pretty nasty sounding scenario. How do we invest inside it?

DD: I am pretty much out of the equity markets except for resource stocks - commodities and oil. I like the Goldman Sachs Natural Resources fund - it is 58% in oil, 14% in metals and mining and 14% in services. It's basically an energy index. Long term, I like most commodities given the cyclical nature of their prices. But some are overvalued right now, such as copper. On the other hand, I'd still be a buyer of gold stocks, particularly Newmont.

SL: I'm primarily an equity investor. But I'm not a particularly happy one. The UK market has been hard going over the last few months and now it looks like rates will soon rise again. So, given that you can get 4.5% on cash, it's not a bad idea to take it. Over the last two months I have raised the cash in our portfolio to 10%. I've also sold down all small caps. When the dotcom bubble was at its peak, everyone loved global large-cap firms - Microsoft and the like. Over the last four years in the UK we've seen the reverse. The yield on FTSE 100 stocks is 40% more than that on small-cap stocks. At the end of 1999 it was 40% less. That's a huge swing and makes the more defensive stocks, which are more cash generative and pay good dividends, look more attractive than they have for a while. I mean utilities like BT or Shell - which is very out of favour - and tobacco stocks. I particularly like BT. It has a current yield, paying out in March this year, of just under 5%, next year it's 5.8%, and in March 2006 it's 7%. That's pretty good. I also like the fact that management is focused on costs - something it hasn't been for five years.

JM: I am not convinced about BT in the long term. The internet is going to destroy all those phone networks. Look at Skype - they're a massive threat.

SL: Longer term, maybe. But BT have historically defended their market share well. And don't forget, they still have a 72% market share in the UK.

JM: I'm still keener on energy and mineral stocks. I also think that private equity opportunities are much more interesting than they were in 1999. People who are trying to raise money for non-public companies are much more realisticabout pricing.

MSW: Are there any markets you like?

JM: I still think Russia has a lot further to go - 20% to 30% this year. It is the ultimate energy market. And it's still cheap. The average price to cash flow is about seven times for the energy firms. And political risk doesn't seem to make any difference. Even when Khodorkovsky was thrown into prison, the market still went up. Putin is an autocrat, but the market still goes up. That said, there is always political risk in Russia, but it's much less than it was in 1998. Back then, I thought there was no possibility of a double devaluation - debt default and the currency. I was dead wrong. But the problems are different now: Russia's debt is low and foreign exchange reserves (defined on page 47) are $70bn-$80bn.

DD: The JP Morgan Fleming Russian investment trust is a very attractive way to gain pure exposure to Russia.

AE: What I like about the Russian economy is that it is not dependent on the US consumer - unlike China, Japan and Europe. That means that Russia has a different dynamic from anywhere else in the world.

RC: I'm pretty bullish on the energy sector too. There's still money to be made on commodities stocks, particularly junior exploration firms. My personal bet would be Uruguay Minerals - which basically has the whole of Uruguay as its playground (Uruguay is twice the size of Wales). Over here, I'm keen on start-up companies, many of which are fantastically cheap. A favourite is an Aim-listed company called Pursuit Dynamics, which seems to have no market recognition whatsoever.It has a technology that condenses steam in a contained area to create a vacuum. This can be adapted to do everything from powering boat engines to heating a tomato soup in two minutes to fighting fires. And if something goes wrong, there is nothing to replace - no moving parts. This is sensational stuff. It's a great technology and there is a great management running the firm responsible for it.

AE: I still favour energy commodities too. I am starting to get a little worried about how long base metals can run. But I think gold will have another run. I'm also not against all equities. There are 9,000 firms in North America, so there will always be something that will perform, even in the worst situations. Right now, I'd be buying oil exploration companies.

BB: I'm keen on gold too. I like Newmont, but in general I prefer to hold coins.

MSW: What about silver? Jim, I know you're a fan.

JM: I am, but I might be taking profits a bit at this level.

AE: Silver is the most manipulated metal in the world. As that unwinds, it could end up at $50.

MSW: And China?

BB: We in the West think that the whole world has moved in our direction, that capitalism is triumphant. But it is not true - China is doing what it always does, which is to figure out a way to swindle Westerners out of their money. You can invest in China, but you can't get your money out. Make a deal in China and you have no power.

JM: McDonald's and Proctor & Gamble are making money in China.

RC: Well, they do have power. When we say it's going to be difficult making money in China, we mean that it is going to be difficult buying Chinese companies that make money - they are so competitive and the margins are so slim. The average investor isn't going to make any money.