What next for the British and American economies? Where should investors look for profits? John Stepek talks to our roundtable panel of experts to find out what they're buying now.
John Stepek: What's your take on the British economy right now?
Max King: The double-dip is a myth. Car sales, John Lewis' sales, the employment data all say the economy's been growing steadily. This year's data will be revised upwards. But Britain faces three major headwinds: firstly, declining North Sea oil output; secondly, over-dependence on Europe for exports; and thirdly, a high historical dependence on financial services, which are in long-term decline.
I think the biggest danger is that the government tries to correct a problem that's not really there a lack of growth. The fact is, growth isn't inadequate it is probably getting to be as good as it gets.
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Jane Coffey: We still have to sort out the deficit and the banking system still needs to delever, which will all hold back growth. But since 75% of profits from FTSE 100 companies come from outside Britain, I don't see why the picture has to be equally bleak for stocks.
John: Are you worried about all this talk of tax dodging?
Charles MacKinnon: I am. There are institutions that currently choose to have their headquarters in London that may choose not to. That has a huge long-term impact. If somebody doesn't like the fact that somebody else is a successful entrepreneur and makes tens of millions of pounds, they need to get over it.
Charles: Look, Starbucks pays £320m a year in tax in Britain. It employs more than 10,000 people, all of whom pay income tax. It rents shops. It pays a shed load of tax. What it does not do is pay a large amount of corporation tax and that's because the government chose to set up the tax laws so that it doesn't need to.
Max: And you can't draft laws that will get you the tax from where you want it without discouraging businesses. It's not a question of fairness, so much as of practicality it's impossible to tax anything not physically nailed to the ground.
People, trade and companies are very mobile, so trying to attach taxation to companies always fails. The lesson governments never learn is to restrict their taxes to what is actually collectable; things like VAT and taxes on housing.
Jane: Also, the more you simplify tax the more likely you are to collect it. The government has done the exact opposite in the last ten to 15 years, particularly during the last Labour government. If we had more of a blanket tax at a lower level, the government would raise more revenue.
Max: The wider context and the reason the government's fiscal plans aren't working is that tax revenue has been disappointing. It's not just corporation tax, but VAT and income tax too. An old lesson is being re-learned: every time you try to raise taxes by a £1 you collect 50p. Every time you cut by £1 it only costs you 50p.
So if you want to control the deficit you have to rely on cutting spending for 75%, and not more than 25% on raising taxes. But how do you balance public concern for fairness in taxation with the practicalities of actually raising revenue? There isn't an easy answer.
Jane: Ironically, in the City most people are PAYE and actually pay the full whack of tax. Eliminating City bonuses is happening naturally, because the City is not making as much money as it was. But that means tax revenues will drop further.
Marcus Ashworth: The great thing about the American situation is that it can be solved [clicks fingers] like that. But I think that maybe we'll go over the cliff a little bit, just enough to scare us. What worries me is how an eventual deal is structured. Capital gains tax and dividend tax hikes would hit small-business owners hardest. In the US, 65% of GDP is contributed by small businesses. If you're trying to recover, that's not who you want to hit.
Max: The problem America has is that monetary policy is very loose, as is fiscal policy. Meanwhile, the housing market has turned up, so monetary growth will probably accelerate, and quantitative easing part three is already under way. That means the States badly needs tighter policy, both fiscal and monetary. The best time to tighten is right now, otherwise we'll be off on another boom-bust cycle. If nothing is done, it could create real problems in 2014/2015.
Marcus: I agree that the American economy is turning up. But are you really more worried about inflation than about deflation, as Ben Bernanke evidently is?
Max: If they don't start to put the squeeze on fairly soon, I think you'll get inflation occurring 18 months down the road.
Charles: I don't agree I think there is huge spare capacity in America. Deflation is a far bigger risk. The Japanese spent years pumping money into a black hole, and that money is just locked up in banks.
Marcus: And housing isn't having a strong recovery yet. Yes, they are starting to solve some things, and the mortgage market is picking up slightly, but only after dropping off a cliff face. There is still plenty of shadow inventory [repossessed houses that haven't yet come to market] to work through.
Jane: But at least it's starting from a really low base. In other places Britain, for example prices are still very high relative to affordability. I think it'll be good news if America does some fiscal tightening.
Charles: That's like losing weight by cutting your arm off it would be nuts.
Jane: In Europe it is. But things have already corrected quite a lot in America. American banks aren't in a great situation, but they are in a better situation, and the consumer has deleveraged quite a lot.
Peter Walls: Falling energy costs in the States and the resulting improvement in competitiveness will lead to further industrial production growth and more near-shoring', which means rising manufacturing activity in Mexico. I think this will help Barack Obama drive a period of sustained growth in America.
Marcus: So you're saying this was actually the election to win?
Peter: I think so. I'd be trying to get a bit more US equity exposure, notwithstanding the fiscal cliff.
Max: In any case, investment returns aren't about what Obama does or what the Middle East does, or the China thing, or the eurozone thing. It's about companies. I think people get far too obsessed by the top-down macro stuff.
John: So what are you buying Max?
Max: I like equities valuations are good, not rock bottom, but good. And decent earnings growth is likely to continue. But I'd avoid megacap dinosaurs stocks with nice yields that look reassuringly cheap Vodafone, HSBC, Shell, BP, Glaxo, AstraZeneca.
I'd look for the quality growth stocks of the next cycle that's probably mid-caps, small caps, and the smaller end of the FTSE 100. Buy reassuringly expensive quality, rather than cheap, distressed value.
Marcus: I am with you on equities. Avoid bonds of any shape, form or size. Why has the world hung onto bonds?
Charles: Because they've delivered outstanding returns in the last five years. They offer a better risk/return trade off than buying equity. Yes, we're avoiding government bonds, and high-grade corporations. But sub-investment grade high-yield bonds have been attractive.
Max: It's an illusion to think that government bond yields can soar and equities do well at the same time.
John: But what if the bond bubble blows? What do you own? Cash? Gold?
Jane: It depends on why the bubble pops!
Charles: Yes if interest rates in Britain were to hit 10%, there are several ways that could happen, none of them good. Well, one is potentially good which is that the economy is just roaring away and the government is trying to slow it down. But that doesn't seem likely.
But as to where the money goes, it's going to have to go into equity. It might go into infrastructure projects, or it might go into physical assets, but the goal of the government in cutting interest rates is to force you to take risk, which means buying equities.
Charles: I think demographics is a hugely powerful force, which is why we're very interested in the developing world. I like a fund called Goldman Sachs Next 11 (tel: 00 1 800-762 5035), which is focused on Mexico, South Korea, Turkey and Indonesia. Those countries have some fabulous small businesses, and they're incredibly cheap.
I also like the Fidelity Global Real Assets fund (0808-252 8432). We're worried about devaluation in many areas, because that's got to be the ultimate end game. So this fund invests in real' assets at the moment it has a lot of exposure to energy.
The third fund is Alex Darwall's Jupiter European Fund (0844-620 7600). We see some great European companies in there that are being beaten up simply because they're listed in Europe.
Peter: I still like Herald Investment Trust (LSE: HRI). Katie Potts took it over in February 1994. Since then, it's up 460%, compared to 69% for the FTSE 100. It's effectively a small-cap technology fund, with a 250-stock portfolio. The great thing is it's quite heavily weighted to Britain and Europe. There's going to be merger activity in this area we know how much cash is sitting on the balance sheets of large US tech companies.
Sadly, while we're quite innovative in Britain, we're not very good at monetising. So if you're a believer in technology, buying this fund today on an 18% discount to net asset value (NAV) looks a steal. On a five-year view I think you'll make an awful lot of money.
Elsewhere in the sector, I like small-caps: Strategic Equity Capital (LSE: SEC) trades at a decent discount of 18%. I also like some listed private-equity funds F&C Private Equity (LSE: FPEO) is on a 28% discount, with a 5.6% yield.
Jane: I'm looking for quality stocks, with good balance sheets and defendable positions. My first is BSkyB (LSE: BSY). We know what it's paying for football rights and film rights through to 2016/2017. It also pushed through price rises in September, for the first time in three years.
It is growing revenues, not necessarily by getting loads of new households on board, but by selling more services (such as HDTV, telephony and broadband) to existing customers. Customer churn is down to 10.9%, which is good, because getting new customers costs a lot of money, whereas selling more to existing customers is profitable. Customer satisfaction is high and the kit is easier to use (many problems can be corrected online these days).
My second is Tate & Lyle (LSE: TATE). It used to be a sugar company, but it's out of that now the bulk is high fructose corn syrup, the stuff that sweetens soft drinks. Its main growth driver is speciality food ingredients. Lots of analysts are going out to Tate & Lyle's new distribution and research and development centre in Chicago in December, where new innovations will be showcased, and I think that will lead to a re-rating for the stock.
John: So it's a play on high-tech food?
Jane: That's it. It's on 12 times earnings, with a yield of around 3.5%. My final pick is TUI Travel (LSE: TT). Despite the rise of budget airlines, you still have a section of the market that wants package tours, because if your plane doesn't fly, the company is responsible for dealing with it.
But the biggest boost for TUI is that its main rival, Thomas Cook, has a terrible balance sheet, so any hotel that's negotiating rates for next year wants to go with TUI rather than Thomas Cook. This means that TUI is getting much better rates, which in turn means it can offer better deals. And you're paying less than ten times earnings.
Max: I like the small-cap space around the world: my preferred funds as well as our own are BlackRock Smaller Companies Trust (LSE: BRSC) and Aberforth Smaller Companies Trust (LSE: ASL).
I also agree with Peter onprivate equity HG Capital (LSE: HGT) is on a discount of more than 15%. The third area I'd go for is a bit of a turnaround story: gold miners. I expect the gold price to stay up and meanwhile I think they're learning about cost control about time too. I'd invest via the Investec Global Gold Fund (0800-389 2299).
Marcus: The truth is, taking into account the big picture, there are very few attractive opportunities out there. Fixed income is going to be the biggest sell of all time. I'm not saying it's going to happen now, but bonds are not going to be your long-term friend.
US equities are super-expensive just now. China is going straight down the plug hole; they're lying about their economic statistics. Japanese equities are super-cheap, but where's the catalyst? And I'm really worried about the Japanese manufacturing industry, which I think is at tipping point. I think we'll see some of the big names go under.
John: What about the yen/dollar rate? The Bank of Japan is starting to pay attention to that.
Marcus: It's too late to worry about the exchange rate now. Yes, the strong yen killed them, but now the Koreans are eating their lunch. Samsung has managed to agree a 20% rise in the price of its micro-processors from Apple, of all companies. Think about that Samsung can tell Apple that prices are going up 20%.
The fact is, the Koreans have the technology and the ability to produce it quicker than anyone else, whatever you need. I still think the Japanese index will be a great trade at the right time, as they devalue the yen. But the manufacturers are in deep trouble.
To be honest, right now I'd be holding onto quite a lot of cash there will be so many buying opportunities in the next two or three years. And I would definitely buy some gold.
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He 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.
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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