The Investment Thoughts of the Hamilton Financial Panel: Chile, Gold, China and the Euro

About twice a year, Hamilton Financial, Independent Financial Advisors invites some investment luminaries to discuss the current global economic situation and make some predictions for the future.

I am pleased to set out below the bi-annual thoughts of our investment panel, Alex Hammond-Chambers (Chairman) (AH-C), Keith Falconer (KF), Robert Hunter (RH) and Max Ward (MW) with additional observations by me (AH) on the Chinese economy - gleaned from Archie Hamilton, a resident of Shanghai since 2005.

AH-C:  Good morning gentlemen. I would like to start off by congratulating Chile!   The Chilean stock market has gone up by nearly +50% this year; compare this with Germany +8.4%, Japan +7.4%, the UK +6.7%, Brazil +1.1%, France -9.7%, China -11.1% and Spain -23.5%.  OK, Chile has wonderful natural resources (particularly copper) but they have a government that exercises strict controls over state finances; compare this with America and most of Europe.  So Keith how would you summarise 2010?  

KF: The pressures on the Euro were predictable. And when it comes to inflection points, China is surely at one. There is mammoth change afoot – for instance, she has the biggest blue water fleet in the world. Most importantly, I would say you must now go short of bonds and be long of gold.

MW: We saw some really very good company results in 2010 – there were some truly fine business performances and these drove up share prices independently of macro developments. The big issue for me in 2011 will be whether I can continue to concentrate on corporate progress or whether I need to pay more attention to macro factors.

AH-C: I believe good investment performance comes from the combination of getting the macro scenario right and good stock picking. Finlay Park is a firm good at both these skills – that’s Jamie Finlay, who was at Foreign & Colonial, and Charlie Park.

Now, even though there have been some welcome surprises in 2010, what about the problems with the Euro?   Personally, I don’t believe that the Euro will break up – it’s the politics you understand! Economics are just not in charge of this. And here’s a further development: after France being “top dog” for years, Germany is now “in charge” and this will mean that the EU is much more disciplined.

KF: Yes, Germany is doing well. But I think the feeble members of the EU are still a worry.

AH-C: Certainly nightmare problems in Ireland, Greece and Portugal pose an entirely different stress to any attempt to bail out Spain or Italy.

RH: Well, I continue to doubt that the Euro can be viable; how do you have Monetary Union without Political Union?  In the last twelve months, the Germans have bailed out Greece and Ireland and it looks like they will continue to bail out indebted European members to support the Euro.  This policy devalues the Euro which in turn helps German exports – pretty crazy!

MW: There was a very good case recently made by someone in Credit Suisse to the effect that the cost of leaving the Euro would be so prohibitive that no sane country would contemplate the prospect.

AH-C: The Euro will break up only if Germany leaves it.

MW: Unfortunately, one cannot just wake up one morning and say “count me out of the Euro from today onwards.”  There are treaties to be renegotiated and it has to be decided which assets and liabilities of the banking system need to be redenominated.  This is where the trouble starts because all the borrowers will want their loans denominated in the weak currencies and all the lenders will want them denominated in the strong currencies.  It would be a lawyers’ paradise!

KF: Are the bail outs in fact legal?

AH-C: Well, if the Euro won’t and can’t break up – what’s to be?

KF: I think Ireland will default. Something amazing will happen! And that, by the way, gives Royal Bank of Scotland a further problem! I consider that the exchange rates were wrongly set at the outset – notably the Italian Lira with the Euro.

AH-C: Does this therefore mean that Europe is a slow growth scenario? For instance, Germany’s growth may be export driven, but it’s going to be very limited if it is just to the EU.

MW: Well if the Euro is to break up, what we need to do is to borrow Euros from a Greek bank and lend to the German government!

KF: You need to be careful with domicile here – borrowing from a Greek bank in Athens is likely to have very different consequences to borrowing from a Greek bank in, say, London!

AH-C: So if the Euro is doomed, what happens next? Trade wars? There will still be currency problems – maybe worse than ever. Now consider Brazil. They have drawn a line in the sand for their currency: 1.70 Reals to the Dollar.

Are we likely to see the imposition of capital taxes to stem flows of money across borders? This would be quite something.

KF: Switzerland did this years ago.

MW: This would be very bad indeed for the Global Village.

AH-C: Think back to the previous high for gold. It was killed by Volcker, Thatcher and Reagan – they raised the purchasing power of the Dollar, and gold receded as an emergency store of value. It’s axiomatic: if the purchasing power of the Dollar falls, the price of gold rises.

KF: I say “The trend is your friend”. Stay invested in gold and commodities.

MW: But gold has no USE! It’s just a symbol.  If you want commodities, pick those that have a use, such as aluminium or copper.

AH-C: Now I think we should also discuss the problem of inflation and China.

With China, is there really no risk given? Is her continued growth so simple and assured? Bear in mind that the government of China has printed 30% of their Gross Domestic Product! There is a massive transfer of wealth. Coastal towns in China tend to be prosperous, and those inland poorer. There is vast investment afoot internally, through their command economy.  So what is the risk with China?

KF: Inflation.  Chinese inflation has been skyrocketing.  In November, the consumer price index rose 5.1%, the steepest climb since July 2008.

MW: If it comes to worrying about what might derail the promising picture of growth, I say that the bond market is the red hot favourite for a major accident (i.e. rising bond yields and axiomatically falling bond values). Equity markets have paid no attention recently to bond markets, which have shown worrying signs of deterioration.

KF: Yes – it is remarkable to see equity yields high and bond yields low – below the yields of many equities.  Given continued concerns over sovereign debt and the financial weakness of banks I see bond yields rising further.  My worry is rising long term interest rates; I am less worried about any downturn in China.

AH-C: I come back to this: everybody seems to take the good China story as a given. Can this really continue to be so? Think of the fallout for shares such as Standard Chartered if problems erupt in China. And all this frenetic construction ...... isn’t there a risk that there might be many “bridges to nowhere”?  Andrew, your son lives and works in China, what does he think?

AH:  The number of empty apartments across the country is testimony to a property bubble which could burst.  Prices in Shanghai and Beijing have risen 200-300% in the last 3 years and other big cities aren’t far behind.  The government is taking steps to diffuse this bubble, imposing stamp duties, insisting on bigger deposits on first and second mortgages and bans on third properties; but with the stock market like a casino, people still have precious few alternative places to invest their wealth.  This probably suggests that current property prices are not unrealistic.

AH-C:  What does Archie think about the possibility of social unrest in China?

AH:  There is evidence that ordinary people are beginning to complain.  As already noted food inflation is a very real concern to the 800 million people who still live in the countryside and they are fed up with local governments and property developers profiteering at their expense from land confiscation. 

KF: Well, China certainly is a command economy. They shift people – millions of people are shifted. But this is not brutal uplift. Prospects in new towns are more attractive than peddling on the ancient treadmill in a simple village.

RH: How safe are these apparently wonderful new jobs?

AH-C: And what about inflation in China of some 7 to 8%?

KF: The Chinese save money furiously. They are very careful. And the government is very much in favour of health care insurance. Really, gentlemen, China is okay!

AH:  Yes, Chinese savings rates are still very high but the younger generation have no desire to save and are spending for all they are worth! However I  agree with Keith that the Chinese story is good for a while longer; but longer term, I am not optimistic that it can continue without real structural changes – changes which have not so far been forthcoming. 

AH-C: Thank you gentlemen.  Now, where should we put our money in 2011?

RH: I recommend “more of the same” – that’s to say, continue with those really good quality stocks that have proved sound investments in 2010. These are well financed companies with solid business franchises trading with emerging markets which are in a good position to pass on higher costs to their customers; for example Roche (pharmaceutical sector) and Unilever.  But you need to look out – not everything is moving up. 

AH-C: What about the tax and National Insurance rises in store and the VAT hike?

RH: Quite – I do think the outlook for the UK domestic economy is dreary.  There will be further job cuts in the public sector leading to reduced demand. 

MW: Don’t underestimate the UK economy: it has done much better than anyone expected recently, particularly in some surprising sectors such as retail.

I accept that we shall see a slowdown in 2011, but I think too much pessimism is already built into the UK market.  I continue to believe that there are plenty of attractive UK stocks and I am currently investing in two categories of stock.  First, defensives with high yields, such as tobaccos and utilities; and secondly in businesses with great economic sensitivity, but strong finances, such as recruitment agents.  In deference to the risk of a macro upset, I am holding significant cash balances.

KF: Consider what we tend to see along the streets: one restaurant is closed, yet the one next door is booming. It is all down to really good management. Seek this in the companies you invest in.

AH-C: Gentlemen, many thanks. I will add only one thing more.  With currencies being a major issue in today’s debate, my Rip van Winkle repositories of choice would be the Singapore Dollar, Norwegian Krone, and Chilean Peso – currencies belonging to well managed nations!