Watch out for investment banana skins in 2014

January 10, 2014 7:16 pm

Watch out for investment banana skins in 2014

By Jonathan Eley

FT Money this week held another investor round table, bringing strategists and managers of retail and institutional money together with some of the newspaper’s own well-known columnists. What follows is an edited transcript of the discussion, which took place on Thursday.JE: Let’s start this year as we ended last – by talking about the “T-word”. Is the US economy now growing strongly enough to allow companies to increase their earnings even if central bank support starts to wane?

AR: The Fed started signalling tapering last year and got the “tantrum” out of the way. It feels like the market has now shrugged its shoulders and it’s going to be the non-event of the year. I think the interesting thing is the degree to which you’ll actually see rising rates prompt companies to do something they’ve not done for a very long time: reinvest.

It might seem perverse that they’ve not chosen to do this when rates are very low. It’s an interesting argument that low interest rates have pressurised companies into paying out more cash because people are searching for yield from the corporate sector. Rising rates might mean more access to yield from the bond markets, and that might lessen the pressure on companies to pay out. That might be an interesting turning point.

MSW: This is definitely a melt-up. Prices have moved so far away from earnings it’s started to look ridiculous. It’s an insane chart [of earnings forecasts versus the market; see below]. One of the most mean-reverting things we have in financial markets is profit margins. We know they’re at near historical highs and they haven’t been going up recently. We also know the share that labour has been getting [wages] has been remarkably low. We know these margins have to come down. I think it’s hard to make any kind of valuation argument for the US market at all. You can look at any valuation measure from ordinary p/e to Cape to Q – they’re all expensive. The only reason to hold US equities is ongoing QE. Look back at markets since the crisis; they’ve only gone up during periods of QE. No QE, no rising market.

So if we do have tapering coming through, however measured that may be, how does that affect the market if it starts to fall? If we don’t have QE, we have lousy valuations, we don’t have rising margins, then what? Do we move on to something else altogether – there’s been talk about combined fiscal and monetary policy. Debt monetisation by a different name. There’s a whole parade of fantastical things that could happen towards the end of this year.

ECW: I think it’s a bit more complicated than that. There was a lot of issuance of investment-grade and high-yield debt last year and a lot of that was used to retire equity. So what you’ve been doing is raiding the middle-upper end of the corporate structure in order to advantage the lower end. The cost of capital suggests that’s a good thing to do, but whether it’s good for the bondholder is open to question. Regarding the end of QE: it isn’t really relevant until the volatility of fixed-income spreads starts to rise. It’s easy to finance anything when spread volatility is low. But as volatility starts to rise, it gets harder to carry off that trick. I agree that profit growth is important but I think that the mechanics of the US market have been driven materially by this debt leverage point.

JO: I think the global equity markets need leadership from outside the US to sustain this rally. From the market perspective, last year was easy but this year is trickier. Another thing is that I follow this crazy five-day thing: if US markets rally in the first five trading days of the year, there’s something like an 80 per cent probability that it’ll be an up year. If they don’t, then it’s closer to 50-50 whether there’ll be an up year.

AR: We had six months when there was a lot of angst about how the taper was going to be managed. We’ve been through that. Markets are learning devices; at a certain point they internalise a risk and they have now internalised the taper risk. I think there’s more risk outside the US now, than inside it. You are seeing a bit of economic traction now, you’ll see more investment going into the real economy. It might not the be the most exciting year in the US, but it would take something unexpected, a big blow-up there, to really knock it back.

MSW: I do worry about this consensus, though. I agree the US looks OK, it looks like the best economy there is. But everyone agrees; we’re all treating it like it’s still the start of the recovery when in fact it’s quite long.

ECW: A surprise in 2014 could be that the euro weakens not because people are losing confidence in the euro but because the other side of the equation – the dollar – strengthens.

JM: That wouldn’t be a surprise, would it? That’s consensus!

ECW: The point about this is that European profits in 2013 didn’t grow at all. Almost all of the impact was the appreciation of the exchange rate. Back that out and profits grew 10 per cent. So we think European equities are a very interesting proposition at this time. If the currency helps, that will make it a double winner.

JM: Everyone’s been calling for a stronger dollar for at least a year. It’s stronger against virtually everything except the euro and the pound . . .

JO: . . . and the renminbi!

JM: The dollar has been strengthening; the surprise is that it hasn’t strengthened by more against the euro.

JO: But the US authorities don’t want the dollar to rise. There is a big consensus in the hedge fund world about that.

ECW: If the financial dynamic of the global economy in 2014 is that for the first time since 2010 the world’s four major developed market regions are growing simultaneously, and you get some emerging market growth too, then arguably the demand for dollars for trade purposes increases. If the Fed’s balance sheet is growing more slowly, maybe it forces the price of dollars up more.

JO: I’m not sure. There’s always a bullish scenario for the dollar but it never goes up because policymakers don’t want it to.

MSW: They can’t really afford not to at this point in their so-called recovery.

ECW: I don’t think it needs to be a big rise for the European case to be a positive one. A 5 per cent move would be incredibly helpful.

JE: What about this idea that lots of investors are still heavily in cash, that you’ve yet to really see the capitulation?

JM: Some sentiment indicators are more bullish than they’ve ever been, like investment trust discounts. Some have been at extremes and have come back down, like AAII [a US investor sentiment survey]. Investors Intelligence [another survey] has never been this bullish. What does that mean? Not necessarily anything.

MSW: Even people who aren’t bullish are bullish these days; look at Hugh [Hendry] with his “negative bullishness” . . .

JM: That’s the worrying thing. Everyone’s building the case for a further rise on the creation of a bubble: “It’s expensive but it’s going to get more expensive”.

AR: I don’t get the sense that most people are rampantly bullish. We are climbing a wall of worry.

ECW: If you look at the exchange-traded product market as a barometer, last year we had very substantial inflows again into equity. Starting off this year, we still see increasing interest in terms of equity. The rotation last year was in fixed income. Was 2013 the year that the 30-year bull market in fixed-income beta came to an end? If it was, then that’s a very considerable change in the investment landscape.

Is Japan still rising?

JE: Last time we talked about Japan we described it as a hope rally and that we now needed to see some real structural reform. Has Abe done enough structural reformsince then to keep people interested in Japan?

MSW: It started long before Abe. If you look back, one of the key points was at the start of 2012 when Japanese banks started paying taxes again – they’d used up all their historic tax losses. And Japan was one of the only places in the world to come through the financial crisis with solvent banks.

JO: What really did start with Abe was dollar-yen.

JM: And that’s what it’s all about. What the stock market tells you is that the whole of Abenomics so far has been about devaluation. The Nikkei has performed exactly in line with the S&P when you adjust for the currency.

ECW: What you see in Japan now is that land values are starting to increase on a much broader base than just central Tokyo; 80 per cent of districts are now reporting land values rising. I don’t know whether Abenomics will work from a structural point of view, but I don’t think it matters – that’s for economists to argue about further down the line. It’s much more about what the BoJ does and the behaviour pattern of domestic institutions.

AR: What has happened this time, and didn’t happen in previous rallies, was that they got their ducks in a row. He [Abe] created a sense of “animal spirits” which has allowed at least the beginnings of the more painful structural reforms to take place. There is a belief that this might work. In previous rallies there were more reservations.

JE: Can you construct an argument for owning Japanese equities separately from the structural reform – purely based on valuations and the exchange rate and improving corporate profitability?

JO: Only really if dollar-yen gets to 130.

MSW: You can make a pretty strong argument for the yen to continue weakening with this volume of QE. They’re really going for it here. For the first time, Japanese consumers are expecting prices to rise, or even rise significantly . . . over five years that’s a huge change.

JO: I’m pretty sure there’ll be substantive dialogue between Washington and Tokyo about how far that [the exchange rate] can go. Once you start going beyond 105, 110, Washington goes “Oi!”

ECW: To me the yen will only weaken materially further if Japanese domestic agents start switching from yen to non-yen holdings. Most of the selling of the yen has been driven by offshore agents but 95 per cent of the stock of yen is owned domestically. I don’t think it’ll happen. You’d have to have a big loss of confidence. To get to 105-110 you don’t need that. But the big move has already taken place.

Are we being complacent about the eurozone?

JE: Let’s turn to Europe. Are we all being extraordinarily complacent about the eurozone economy and the political risks?

ECW: The issue for European assets is whether the currency will strengthen further and I don’t think it will. European companies could produce 8-10 per cent profit growth in 2014. I think European equities could easily chew out a decent return this year. They did it in 2013 without any earnings growth. They need the earnings growth in 2014.

JO: Greece is already up 10 per cent this year . . .

ECW: But that’s four stocks and a couple of kebab-makers.

JO: Yes, but for me the most interesting thing to happen anywhere so far this year is the rally in peripheral European bonds and equities. I think it’s because people can see the ECB is going to have to find something else to do. Look at how low inflation is compared to their target.

ECW: The ECB won’t get political cover to do anything material without there being another crisis.

MSW: At some point the stock market will notice this deflation . . . markets are ignoring the fact that this is a genuinely deflationary environment.

AR: We mustn’t confuse economies and stock markets. The stress that is out there is not Germany or Austria, or even Greece and Spain. It’s the France and Italy lump in the middle. We need inflation and structural reform.

JE: What about the valuation argument – this idea that if you buy French or German companies, you’re not buying the French or German economy – you’re buying cheapish exposure to world economic growth?

AR: We certainly subscribe to that.

MSW: Valuations are OK. Not cheap like they were, but OK. We also subscribe to the view that the ECB will have to do something. We don’t know what it will be, but on the basis that when you create more money it always goes to those who don’t need it, we’d buy German equities.

JO: I do wonder how the Germans can be so stupid as to ignore an inflation target that they created when Italy is now seeing its debt burden rising sharply?

JM: But the Germans are quite happy with a crisis. Crises don’t affect them much but they force everyone else to react!

JE: Does anyone subscribe to the Martin Wolf view that the eurozone will collapse eventually?

ECW: Define “eventually”!

MSW: Eventually, of course. All the contradictions still exist. But these things can go on for yonks.

AR: In the long run, I don’t think the euro will exist in its current form. If you’d asked me that 18 months ago, I’d have said “give it three to five years”.

JE: Investors fell out of love with emerging markets in 2013 – are they going to fall back in love with them in 2014?

JO: From a value perspective it’s a no brainer to ignore all this rubbish and just buy a load of what are broadly called emerging markets. So many of them are just so cheap.

JM: They’re cheap compared with the last five years, but not compared to the last 10. If you want to buy a Chinese state-owned bank or steelmaker, yes it’s cheap . . .

MSW: But you absolutely should buy a Chinese bank or steelmaker. Buy them for the improvement!

ECW: On a price to earnings and price to book basis, yes markets look cheap. But on a price to cash flow they are really very expensive. That comes down to capital discipline, quality of management and corporate governance.

AR: We have seen a slight deterioration in corporate balance sheets . . . but I agree that the simplistic view of all these different countries as one is wrong. And look at what corporates did last year. What did Unilever do, what do Holcim do? They bought out emerging market subsidiaries because they can see that the traction they’re getting with the middle classes, particularly with anything consumer related, meant this was a great buying opportunity.

The markets to target in 2014

JE: Which markets would you be in?

MSW: We’ve been looking at this recently. We look at what’s cheap but with improving corporate governance, and in very general terms that takes us to China, Russia and Korea.

AR: We’d be underweight in all of those!

MSW: You can have Gazprom for 2.5 times earnings. Why wouldn’t you? What’s priced in here is practically a return to Communism and I really don’t think you’ll get that. Russia is cheap enough and I’d say the same about Chinese companies.

JM: I find it hard to find any; but if you can still class it an emerging market I likeKorea.

ECW: If a currency is materially undervalued, then that’s an interesting point in time to look at it. Take India – in summer we were pushing 70 [rupees to the dollar], I was delighted to buy a lot of Indian stock because the currency had overshot. When I look now, the cheapest currency is probably the South African rand . . . I agree on Korea – the won feels oversold – but I can’t get thrilled about southeast Asia.

JE: Looking ahead through 2014, what are the really big things to watch, and markets to be in?

MSW: For me it’s Japan, again. It’s the only market that you can look at and say it really is in a sweet spot.

JO: Either China . . . or peripheral Europe: Greece, Spain, Portugal.

AR: I think the US economy could well surprise on the upside in 2014. On the downside, North Korea. I think the tension in the region is growing and the Chinese are losing patience.

ECW: Equities over bonds for now. In developed equities, Europe and Japan, the latter with a currency hedge.

JM: In the short term I’d actually buy overweight bonds. It just feels like sentiment is way too negative on bonds and way too positive on everything else. That’s not a 10-year buy and hold, though!

MSW: That’s not investing – it’s speculation!

JM: It is speculation. Buying Gazprom is speculation too!

BITCOIN BRAVADO

We were keen to get the views of our panel on Bitcoin, the crypto-currency that was one of the big themes of 2013.

AR: I love the absurdity of humanity . . . Bitcoin is a bit like a central bank created by a rogue state. It’s a great story and the concept of a digital currency is a good one because it highlights the shortcomings of the current system. I just think it needs to be brought under some kind of control.

MSW: The thing I find so compelling about it is that it shows how there’s a generation of people that believed in gold as the “un-currency” and now there’s a new generation that doesn’t get gold but is still suspicious of state-issued fiat money – and they go out and create this.

ECW: It’s like financial Esperanto – a lovely idea but only a limited number of people are ever going to use it. Although I agree that people are searching for an asset that doesn’t have a liability attached to it.

JO: It does not satisfy the core three criteria for a currency. A currency is not an asset. The argument for Bitcoin as a currency is ridiculous. It’s like saying that Chelsea is one day going to be a proper football club!