Welcome

Welcome to the II Today blog, where I  post brief comments on the public views of leading professional investors and recent market trends. For more detailed analysis, please feel free to try my newsletter Independent Investor.  I have been following financial markets for more than 30 years, initially as a senior correspondent on The Times, The Economist and The Independent, more recently as an investment professional and author/columnist for the Financial Times and The Spectator.  Although I am a director of three investment companies,  any views expressed here are entirely my own.                                                                                                                                      Jonathan Davis

The Cost of Europe’s Deal

The latest Greek deal appears to have a fair chance of working in the short term, but it has not been without significant costs, especially for investors in European sovereign debt, as Jim Leaviss of M&G explains in this latest comment on the firm’s always excellent Bond Vigilantes blog. Of the five lessons he draws from the latest deal, his last is probably the most important from a long term perspective.

This was a bad deal, not because bond investors took losses, but because the losses they took were too small.  Even under heroic growth assumptions Greek debt to GDP will barely get down to 120 percent. The population will live with austerity for years and Greece will probably default again anyway.  And as others implement extreme austerity too, we’ll see the rise of extreme politics across the Eurozone. One lesson that policy makers across the world keep missing is that imposing punishment on moral hazard “sinners” is a luxury we don’t have in the middle of this series of crises. There have rightly been comparisons made between the terms of the Greek restructuring and the reparation terms that Germany was forced to accept after the First World War.  The biggest wave of defaults has yet to happen – not in the bond markets, but with the breaking of promises (retirement ages, pension entitlements, healthcare) made to complacent western populations.

Whether the Greeks default sooner rather than later, we will all be living with the consequences for a long time. The security of European sovereign debt has been downgraded, without yet solving the problem the deal is designed to address. It may have.prevented a short-term crisis, in other words, for which investors could be grateful, but at what longer term cost we don’t yet know. More government promises will inevitably be reneged on in the years ahead.

Looking Beyond Greece

We don’t know whether the Eurozone agreement on Greece will hold – let alone for how long. My guess is not for long. In any case, for investors this long-awaited deal looks like a classic case of buy on the story, sell on the news. Financial markets have run up so strongly in anticipation of such an outcome that equities now look massively overbought, implying that the short-term reaction is more likely to be negative than positive. Longer term it is still impoosible to know for certain how this great drama reaches its endgame.

My view remains, as it has done for some time, that the best outcome now, as Bill Emmott was saying in The Times yesterday, is for a managed default (and probable exit) by Greece at some point in the course of this year, as it becomes apparent that the country cannot meet the demands which have now been placed on it. I suspect that this is the outcome which the Germans have been after for quite a while now, without of course being able to say so in so many words. It is also in the best interests of the Greeks themselves over time.

New Year Hopes

My suspicions back in the autumn that a market rally was on the way have, I am happy to say, been borne our by events. Not for the first time, the peak of rhetorical despair – this time about the dire outlook for the world economy should the Eurozone crisis not be resolved – has turned out to be the moment to turn bullish. The rally since the failure of the Cannes summit has been impressive.

The MSCI world index is up by more than 20 per cent since its October low and has risen for seven straight weeks in a row, something that has not happened since the spring of 2009, according to the equity strategists at Societe Generale. Equity markets have made an even stronger start in 2012, with January producing one of its best monthly returns for many years. Contrarian sentiment indicators, such as the venerable Investors Intelligence survey of investment advisors in the United States, once again proved invaluable in identifying a turning point back in the autumn.

Talking Markets: Jim Rogers

Global investor Jim Rogers thinks that the world is heading for an economic depression unless political leaders finally grasp the nettle of the debt burden they have accumulated over the past decade. He is not optimistic about the outcome. Bankrupt countries such as Greece need to default – and soooner rather than later. The longer they leave it, the worse the eventual outcome will be. Hear more of this – and how Jim is seeking to protect his own wealth in these difficult times – in my latest podcast, a 30-minute interview with one of the smartest investors I know. It is available to download from the Independent Investor website now. An edited transcript will be available in the New Year.

Mark Mobius on the Eurozone Crisis

How does Mark Mobius see the outlook for investors in the light of the ongoing crisis in the Eurozone? You can find out by listening in to my latest podcast interview, which can now be downloaded from the Independent Investor website (link). Dr Mobius, who next year celebrates 25 years running the Templeton emerging markets funds business, with $40 billion of assets under management, discusses the threats and opportunities which the crisis has created.  This is the first of a series of podcast interviews with leading professional investors and advisers. Other to be interviewed in the series include the global investor Jim Rogers, author and economist John Kay and Guy Monson, the Chief Investment Officer of the Swiss private bank Sarasin.

Why Are Company Profits So High?

An interesting note today from Andrew Smithers, the always stimulating independent economic strategist in London. He tackles the question: why are corporate profits as strong as they are at the moment – and can they be sustained? His analysis suggests that profits in the United States are three times the level they would be if they had reverted to average historic level. The wonder is that profits have widened dramatically over the past three years despite a sharp contraction in GDP – something that has rarely if ever happened before.

His conclusion is that the chief cuprit is not fading union power, nor the rise of China. It lies in the revolution in the way that corporate managements are now hired and rewarded. Short tenures and bonus-rich remuneration schemes linked to share price performance have resulted in a dramtic refocusing of management’s efforts away from long term investment towards much risker, short term profit maximisation. We all know this has been happening, but Smithers demonstrates it tellingly with a couple of powerful graphics.

Many managements, he points out, announce absurdly high returns of equity – typically two and a half three times the long run average. As a result it is no accident, he says, that corporate profits have become more volatile, that leverage has increased and that share buybacks have accelerated.  The worry of course is that this new focus is bound to lead to below average share price performance in the future.

Just as Eurozone leaders cannot go on kicking the can down the road with failed sovereign debt initiatives, so corporations cannot expect to sustain their businesses unless they are prepared to invest in new capacity.  “If we are lucky”, Smithers concludes, overdue changes in management remuneration will help to restore the balance towards investment, but “if we are unlucky, the distortions produced by the bonus culture will only be broken by another severe recession”. It is certainly not going to happen overnight.

Forecasts Be Damned

If someone told you that the end of the world was coming tomorrow, and the day passed without incident, would you be inclined to believe the same person the next time they came out with a piece of radical advice? I doubt it.  Yet one of the wonders of markets and economics is how quickly even sensible investors will switch their assumptions about the future without missing a beat.

The latest example of this bizarre phenomenon was evident in the Chancellor’s Autumn Statement. The independent Office for Budget Responsibility, run by Robert Chote, a formidably bright former economist colleague of mine on The Independent, has drastically reduced its forecasts of future economic growth. They are radically different from the forecasts the same body presented just a few months ago. Yet by some magical process they are already being treated as gospel truth.

Good News, Bad News For Equities

Why have I mentioned more than once the possibility of a strong stock market rally coming soon? There are several factors at work here. The normal end of year experience of markets finishing strongly is one of them. The oversold technical position in many markets, allied to very low trading volumes, negative headlines in the media and deeply bearish sentiment, is another.

More fundamental though is the possibility – which I now rate quite high – that Germany will in due course sanction some kind of ECB involvement in the Eurozone crisis that will provide a trigger for all the investors currently sitting nervously on their hands to rush back into the market. It may not yet happen – the politics of the Eurozone remain fragile and complex, and nothing is certain – but if it does the effect in the short term could be very powerful.

The Eurozone Crisis: Not Insoluble

The Eurozone crisis is a political mess that can only be solved by a political solution, which you don’t need a degree in politics to see is not proving easy, given the variety of interested parties involved – 17 eurozone member countries, 10 other EU member states and the governments of every other major economy on the planet also feeling the need to have their say. Much to the chargrin of some Eurozone leaders, voters too have to be consulted.

Given how many warnings there have been of the risk of a depression and financial meltdown if the Eurozone is not saved, the wonder is that financial markets have not been more affected than they have been by the failure so far to arrive at an agreed solution. The equity markets in particular have been surprisingly resilient. How can that be explained?

This is how one sensible wealth management firm, Saunderson House, is addressing the issue in its client comunications. Implicit in this view is that there will be an endgame in which the Eurozone survives, at least for now, without triggering an economic crisis, which must mean Germany eventually sanctioning some action by the European Central Bank once the various peripheral countries with the worst debt problems (Greece, italy, Spain) have their new governments in place.

Views on Europe

Back from a two-day trip to Paris, it is no surprise to find that the markets are still obsessing about Europe. In the absence of elections political change is rarely a straightforward business, as this week’s tortuous attempts to form new governments in Italy and Greece are demonstrating. The markets remain volatile, but as yet nothing has happened to change my view that we are moving towards an endgame that will ultimately prove beneficial, howver messy it becomes in the short term.

What is noticeable is how opinion is at last slowly shifting away from arguing over how the eurozone in its present form can be saved towards the (more sensible) view that the eurozone cannot continue exactly as it is, whether or not it survives the immediate crisis.. See for example an excellent piece by Lord Owen, the former Foreign Secretary, writing in The Guardian on Monday which begins:

A eurozone may survive, but it will not be the present 17 member state eurozone. What will emerge, if it is to survive, will be smaller and more focused around German financial and monetary disciplines

Bye Bye, Berlusconi

The word now is that Berlusconi is on his way out in Italy, as I predicted on this blog a week ago. Assuming that happens, as I am sure it will, it means that we have lost two credibility-shorn prime ministers in the troubled countries of the Eurozone in just 24 hours. In this long and tortuous process, nothing is certain, but I can’t help thinking that this is good news for the markets, as indeed in time the failure of the Cannes summit will also turn out to be.

Why? Becuase it means that the Eurozone is finally getting ready to deal with ugly reality, rather than utopian and impractical dreams. The one premise that has only rarely been challenged throughout this whole drawn out charade has been the belief that the Eurozone could not survive unless it continued exactly as it is now, with all its members on board and Greece and others facing permanent but unsustainable austerity.

That was – and is – a pipedream. What we are seeing now is a process by which failed incumbent political leaders are having to face the consequences of their past errors, not least clinging to such a dogmatic and unproven assumption, which has never been put to the popular vote. Having done more than anyone to talk the Eurozone into recession, with his doom-laden warnings about the consequences of a Greek default, M.Sarkozy faces his own rendezvous with the voters next May. Mrs Merkel, now calling the shots in Europe, probably has until the following year to face the electors.

Whether the new Governments in Greece and Italy can do any better than their predecessors remains to be seen, but the markets are driving the Eurozone to a less worse outcome than wasting all its firepower on saving a bankrupt country, uncertain and potentially disruptive though the consequences may be in the short term.

Those Damned Voters…

Did I say there was a need to take these markets one step at a time yesterday? Make that one day at a time. The unexpected decision yesterday by the Greek Prime Minister to call for a referendum on the eurozone package clearly introduces a whole new element of uncertainty into the outlook for financial assets. It almost certainly brings forward the date when Greece defaults and leaves the euro (as eventually it must).

It has never been obvious to me that staying in the euro is the best option for the Greek people, and that may well turn out to be what they think too.  They may opt to take the Icelandic route and vote for the devil they don’t know in preference to the one they do, which has little obvious to commend it.  The decision of the Eurozone to go all out for monetary union without waiting to establish the necessary fiscal  and political regime that was needed to make it workable has always been its most serious flaw, but sadly not the only one. 

A consistent failure to consult or carry public opinion has been another hallmark of the whole EU project, and one that may now prove very costly to its architects. Markets hate uncertainty, but if the prospect of a referendum in Greece now forces the Eurozone leadership to start planning properly for the consequences of at least a partial breakup of the single currency, instead of trying to do everything to avoid even thinking about such an outcome, it will be no bad thing. Look out next for the departure of Berlusconi.

Nose Out Of Book

After several weeks immersed in completing the book I have been writing on the investment methods of Sir John Templeton, to be pubished in the spring next year, this week sees the return of this blog to active duty. The past three months in the financial markets have been amongst the strangest and most volatile I can remember for some while - certainly since the great crisis of 2008. Two main things (the Eurozone crisis/horror movie and an apparent slowdown in the recovery of the US economy) have dominated market sentiment throughout these months, leading to a huge amount of displacement activity by anxious investors, and a good deal of hyperbole amongst the commentariat.

Suffice it to say that the news on both counts appears to have improved in the last few days. Although the Eurozone crisis is clearly still a long way from being resolved, the US data does appear to point to things picking up on the other side of the Atlantic, which should silence the most extreme prophets of doom for a while, at least.  Having broken out of their trading range, it will be surprising if equity markets do not finish the year on a relatively strong note, perhaps even crawling their way back to the level at which they started the year. The prospect of new bouts of quantitative easing by the Federal Reserve and Bank of England have dampened yields on long term Government bond, but the sovereign debt of overborrowed developed countries continues to look a/the most vulnerable asset class on any but the shortest of time horizons.

Mr Bernanke, Japan and the US Debt Problem

Today saw the start of a significant rally in the US stock market for the first time in several days, and a significant day for the UK stock market, where the yield on the equity market briefly rose above that of the 10-year bond yield, traditionally an early warning signal that equities will deliver good returns over the medium term. It still looks like being a long hot August, however, with the Eurozone crisis showing little immediate signs of easing.

It was naughty - but oh so pointed – of Albert Edwards, the very bearish  market strategist at Soc Gen, to point out what Ben Bernanke, the chairman of the Federal Reserve, had to say in the now infamous “helicopter Ben” speech nine years ago. That was the speech, made well before he succeeded Alan Greenspan in the top job at the Federal Reserve, in which he expressed absolute confidence that the US would never again be allowed to experience a deflationary recession.

The Fed, he said, quite unequivocally, had the tools, in the shape of the printing presses, with which it could be sure of preventing deflation (and boy, you might say, has he used them already!).  But then, he asked – rhetorically – in his speech:

Time To Watch That Basket Very Closely

An interesting range of views from market-watchers in this story from the Financial Times today.  Investors are slowly waking up to the lopsided nature of the currrent global market dynamics, in which there is an apparently real risk of a severe negative market event – either in Europe or in the United States – but one which still falls short of being a likely outcome.

How to position yourself  if you rate the probability of this occurring at say 20%? Is that high enough to justify taking extreme defensive action in anticipation of just such an outcome? That will ultimately depend on your tolerance for risk. A number of well regarded fund managers whose opinions I track have taken their holdings of cash to higher than normal levels in recenet weeks, although few have taken it as far as George Soros, whose Quantum Endowment Fund,  as I noted yesterday, is reported to be 75% in cash (although this is likely to include a range of currencies, which these days are often treated as proxies for other types of investment).

A $100 Billion Dollar Warning

There is an interesting profile in the latest issue of the New Yorker about Ray Dalio, the founder of Bridgewater Associates, one of the world most successful macro hedge fund businesses, in the tradition of George Soros and Julian Robertson. Mr Soros has meanwhile just announced that he is closing his Quantum Endowment Fund to outside investors, ostensibly because of the impact of new regulations, and will in future run it solely as a family office.

Bridgewater Associates has around $100 billion under mangement and both anticipated and weathered the credit crisis with some success. Unlike the Quantum Fund, which until it changed its objective in 2000 from aggressive return-sekking to wealth preservation was famous for its big concentrated bets, the firm’s Pure Alpha fund is up around 10% this year while most hedge funds have struggled to make any money at all. Its style is to make a wide range of bets, many of them paired – buying platinum or selling silver, for example – in an effort to do what hedge funds were originally designed to do, which is to reduce correlation to the market’s overall movement. Dalio’s speciality is making calls on bond and currency markets.

While a lot of the New Yorker article is devoted to the unusual way in which Bridgewater Associates is run, it also contains Dalio’s judgment on current market conditions. “We are still in a deleveraging period” he says, and “we will be in a deleveraging period for ten years or more”. The article continues:

Dalio believes that some heavily indebted countries, including the United States, will eventually opt for printing money as a way to deal with their debts, which will lead to a collapse in their currency and in their bond markets. “There hasn’t been a case in history where they haven’t eventually printed money and devalued their currency,” he said.

Other developed countries, particularly those tied to the euro and thus to the European Central Bank, don’t have the option of printing money and are destined to undergo “classic depressions,” Dalio said. The recent deal to avoid an immediate debt default by Greece didn’t alter his pessimistic view. “People concentrate on the particular thing of the moment, and they forget the larger underlying forces,” he said. “That’s what got us into the debt crisis. It’s just today, today.”‘

But he also makes the obvious point that timing is the key to getting these big calls right. “I think late 2012 or early 2013 is going to be another very difficult period” is his reported view. That has always been my expectation too, but recent events – the muted response to the latest Greek bailout plan and the ongoing stalemate over the US debt ceiling (which Soros dismissed last week as “theatre”) -  may of course be bringing the point of crisis nearer.

That may of course also be one reason why the Quantum Fund is currently reported to be sitting with 75% of its assets in cash. However if the debt deal is done, which still looks the more likely outcome, there could be a decent rally in risk assets over the last few months of the year.

A Right Old Mess

The risk that the sovereign debt crisis could spiral out of control in the face of inadequate political will to resolve the crisis is clearly growing the longer that the impasse in the Eurozone (over peripheral country debt) and the United States (over lifting the debt ceiling) continues. Suggestions that we are in danger of a rerun of 2008 are not, alas, fanciful, and are growing by the day.

This is how the hedge fund manager Crispin Odey summed up the situation today, noting first the standoff in the United States, where both political parties seem blissfully unaware of the stakes for which they are playing.

The markets should be scared of such political madness, but instead the dollar benefits from greater madness emanating out of Europe. Greece is bust. Easy. However Germany and the Netherlands need to realise the necessity of recirculating the savings flows back into Spain and Italy. This current malaise provides an anvil upon which those countries can be hammered. A Euro in which deposits from southern Europe flood to Germany and are not re-exported except reluctantly by the ECB is ultimately doomed to expire. The timing of this is dangerous. Politicians are going away on holiday, but the markets will not wait.

Mixed Messages From The Markets

Two contrasting views today that neatly sum up the current rather feverish market dynamics. This link summarises Deutsche Bank’s view that the worst case outcome the Eurozone crisis could be a 35% fall in global stock markets. And here, on the other hand, is the latest weekly view from fund managers Artemis, citing six reasons to be cheerful.

Of course the whole world could still go to blazes in debt’s handcart. It might well. But on balance, we prefer to remember that the FTSE 100 is (just) above its level as 2011 began. And that’s despite, it’s worth remembering, Japan’s tsunami, war in Libya, Arabian unrest, nemesis in Greece and the end of American QE.

Corporate health. Sure, there’s more bad news to come, we reckon, for most UK retailers. But there’s still much less credit risk in most companies than there is in governments. Take a stock like Hunting (oilfield services). It has cash of £300 million, a third of its market cap. Or publisher Reed. It’s priced at 11.5x, has a 4% yield, diversified earnings and improving margins. Japan’s NTT Docomo (mobile telecoms, 3.8% yield) has more cash than it knows what to do with.

M&A. Weaker sterling makes UK assets even more attractive to foreign (war) chests. Negative real interest rates in the west. These force investors, reluctantly or otherwise, into (high yielding) equities. Pessimism. It’s pronounced. If history has any predictive power, the gloom suggests this is a ‘buying signal’. Emerging markets. China seems to be Goldilockian. The prospects are patent, and the growth is good. The best western companies will continue to make their money there, not here. QE2. Its positive effects will take time, but will benefit the US economy.

What all this confirms to me is that the market, as always, has great difficulty in finding a level when there is a wide range of potential outcomes, some of them extreme. The Eurozone crisis is a good case in point.  The way the crisis has evolved is as much an indictment of the inadequate way that Europe’s political class have responded to the new threat of sovereign debt default as it is about the underlying gravity of the potential problem.

Meanwhile, the interesting part about Mr Bernanke’s recent testimony, to my mind, is the reaffirmation that his whole approach to running the Federal Reserve is rooted in his paramount desire to avoid deflation at any cost.  if he does restart a further round of printing money (quantitative easing), it will be because the Fed sees a real risk of deflation once more.

The odds are still against a worst case outcome at this point, but there is no denying that it is a possibility, and that is what sends risk-averse investors scuttling for protection. In these circumstances remember all those stories about a big turn in sentiment towards gold and other commodities in the early part of the year? Gold’s continued ascent to new highs tells a different story.

Economists and Banks

Some observations on economists from veteran US investor Laslzo Birinyi, writing in the Financial Times.

In my experience, economists are not equipped by training or discipline to provide insight and guidance on stocks. As manifest by an number of cliches, the bond market is about here and now, while stocks are always looking ahead. Hence economists, almost by definition, “lead from the rear”.

Their recent concern regarding the banks and the implication for the financial system may indeed be correct, but I would note that the recent weakness of the traditional banks is actually the norm. In the nine bull markets back to 1962, 48 per cent of banks’s ultimate gains was made in the first two months of the rally. In the last two bull markets, after the first two months, banks not only underperformed, they were actually down the rest of the rally.

US bank shares certainly have been going nowhere for some time.

Meanwhile, as the market has been indicating since the weekend, the narrow Greek vote in favour of the austerity programme – although it does nothing but defer the country’s inevitable sovereign debt default  - looks likely to be the trigger for a reversal of the straight line fall in equities and bond yields which has been such a striking feature of the last two months in the markets.

The Conundrum of Cash

The current phase of “financial repression” (negative real interest rates that penalise the virtuous while inflation erodes the liabilities of imprudent borrowers)  is creating difficult issues for financial advisers and wealth management firms, many of whom have no experience of living through such an unusual environment. Central to that is the issue of what to do with cash at a time of market uncertainty, when conventional valuation measures are being distorted by the impact which quantitative easing and other monetary policy measures are having on government and corporate bond yields.

Look for example at this interesting report on Trustnet about the way that one of Cazenove Capital’s fund managers is preserving cash in his cautious managed fund, which has a benchmark of beating the CPE by 4% per annum.

Marcus Brookes has defended his 20 per cent cash position in the £707m Cazenove Multi Manager Diversity fund, even though he acknowledges that the UK’s high inflationary environment is set to endure. With the consumer price index (CPI) at 4.5 per cent and base rates at a historic low, cash is losing a substantial percentage of its real value by sitting in the bank. However, Brookes says he has no plans to cut his exposure to money markets any time soon. “Although there is a lot of talk about inflation at the moment, we are even more worried about the government bond market, particularly as a long-term bet,” he explained.

“The fund maintains a third of its assets in equities, a third in either fixed interest or cash, and a third in alternatives, no matter the market environment. We think the potential capital losses in government debt are so high that we’d rather hold cash for the time being.” Although Brookes could invest this 20 per cent in corporate debt, he says this would go against the fund’s risk profile. According to Financial Express data, Cazenove Multi Manager Diversity is one of the least-volatile funds in the IMA Cautious Managed sector over a five-year period.

“We could move into investment grade and high yield corporate debt, but at this point of the economic cycle we think this would increase the risk of the fund,” he said. “A lot of people are saying that the end of QE2 has been priced into the market but we are not so sure. The data coming out of the US has been poor and we anticipate another soft patch. The cash position also keeps our options open when certain areas of the market get cheaper,” he added.

Being prepared to sit on holdings of cash when the market appears to be offering few opportunities  is, as I argued in my most recent FT column, one of the hallmarks of the most successful money managers. The two advantages are: (1) avoiding drawdown during market falls and (2) having the firepower to take advantage of the valuation anomalies that always appear when the market slumps.

To do so requires good judgement and a lot of courage however, since such a stance is easy to criticise if markets remain buoyant.  To do so in an environment where cash is providing negative real returns - and the opportunity cost is therefore higher than normal – makes it an even braver thing for a fund manager or financial adviser to do. However that does not mean it is wrong.