The Price of Everything: Woe, to be in England
"There cannot be a crisis next week. My schedule is already full."
- Henry Kissinger.
All these bank runs are getting exhausting. Two and a half years after the failure of Northern Rock and a year and a half after the failure of Lehman Brothers and most of the rest of Wall Street, Greek investors are finally joining the party. ??????! In this case, better never than late. On the one hand, you can believe that some kind of political settlement to Greece's seemingly intractable fiscal problems is possible. On the other hand, just follow the money. Depositors in Greek banks are weighing up the options and seem to have decided in favour of branches of HSBC, Société Générale – despite its awkward serial habit of employing massively fraudulent anomaly-causing staff – and sundry Swiss banks. According to the FT, Greek savers took €10 billion of deposits (or 4.5% of the total) out of the country's financial system during January and February. UK bank depositors should not be feeling too smug at this point. No matter how carefully you check your bank statements this year, the post May 6th new government will be on the prowl for any spare cash. Cynicism or realism might suggest that anyone luxuriating with surplus money in the bank will have at least some of it forcibly removed. For those on higher pay, the forcible money removal process has already begun, at source. Oh, to be in England, now that April's there. This is probably not what Robert Browning was thinking about.
There was once a time when government bonds were viewed as safe investments. Safe as houses, you might say, if you weren?t keeping up with events. But that was then, and this is now. Something rather ominous has started to happen in the government bond markets of the west. Under normal market conditions (remember them ?) corporate bond yields trade above the yields on government debt. This is logical insofar as corporate bonds carry higher risk than governments, which can print money and levy taxes to make good any shortfall in their requirements for income. But higher quality companies are now in the unusual position of seeing their debt offering lower yields than those on government bonds with the same maturity. Bloomberg points out that bonds issued by Berkshire Hathaway, Procter & Gamble, Johnson & Johnson and Lowe?s have all recently traded with yields lower than those of equivalent duration US Treasuries. If you want to see a mismatch between theory and reality, look no further than the bond market convention that the return from US Treasuries represents the so-called “risk free rate”. There can only be two conclusions, and they are mutually exclusive. Either the bond market is wrong, and the corporate bonds of these companies are mispriced (and by extension the price of US Treasuries is comparably mispriced but in the opposite direction). Or the bond market is right, and the perceived “riskiness” of US Treasuries (and certainly UK Gilts) has risen sharply. As Gillian Tett for the FT points out, 10 year US Treasury yields at the end of March also started trading above 10 year swaps (which represents interbank risk). Both the US and the UK enjoy „AAA? credit ratings from the major ratings agencies. This would be some comfort were it not for the fact that the financial crisis has revealed the ratings agencies to be a bunch of clueless and conflicted monkeys.
Wise financial counsel suggests that if you?re at the poker table and haven?t spotted the patsy yet, it?s probably you. On a similar basis, if a given investment looks terrible, sounds terrible, smells terrible, has terrible fundamentals, and is rushing through the markets screaming “I?m terrible,” then discretion might have to be the better part of valour in the interests of preserving both capital and sanity. This argument is even more clearly articulated when the one buyer of last resort – namely the central bank of the country (or countries) in question – stops buying government bonds, as the Bank of England has already done, albeit with the caveat that it might be back at the poker table if required, hurling more of the nation?s capital into the toilet. Meanwhile, having troughed at 3% during the financial panic of 2008, 10 year Gilt yields now yield 4%. It is not beyond the realms of plausibility that they rise further. This would equate to holders of conventional Gilts losing money. Relative to (increasingly risky) western market government bonds, why not consider high quality dividend-paying stocks which in some cases offer higher yields and the prospect of growth in real terms over the medium term, which in the case of government bonds looks practically impossible ? Kenneth Rogoff, co-author of the magisterial if not necessarily sexy study „This Time is Different: Eight Centuries of Financial Crises?, suggested last week for the FT that the bubble du jour is in (western market) government debt:
“..when debt markets collapse, there inevitably follows a long, drawn-out conversation about who should bear the losses. Unfortunately, all too often the size of the debts, especially government debts, is hidden from investors until it comes jumping out of the woodwork after a crisis.”
Unfortunately for all current investors, the markets are awkwardly polarised between fears of profound debt deflation and between fears of uncomfortable monetary inflation. On the basis that generals are invariably transfixed by the last war, it might be fair to suggest that Americans are determined never again to experience the debt deflation of the 1930s. In any event, given the role and extent of government indebtedness throughout the modern world, a debt deflation is a practically unthinkable outcome. But in their eagerness to pump money into the system to make up for the credit contraction caused by an ailing banking system, the politicians of today may be setting themselves up for the last financial war painfully recalled by German monetary officials, namely the Weimer hyperinflation. And if officials don?t deliberately design or ignite an inflation, it may come about in any case via the foreign exchange markets (or a surge in government bond yields). As Jens Parsson indicates in his superb but sadly difficult-to-obtain study „Dying of Money?,
“The spectre that waits in the wings of any inflation, including the American, is the general exodus of the people from the currency when they lose faith in it at last. When this spectre steps in from the wings, the government?s games are over and the final curtain is not far away.”
Here in the UK, we have a month to wait before we learn who inherits the Brown whirlwind. (A polite term for a rather unpleasant meteorological condition.) Over that period and beyond, both the Gilt market and the foreign exchange market will make for interesting watching. By the side of each of them sits gold, quietly appreciating in value.
Tim Price
Director of Investment
PFP Wealth Management
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15 comments
Here's a link to Ed Chancellor's GMO commentary on China:
https://www.gmo.com/Europe/MyHome/
you need to register, but its well worth it IMO. I believe its a question of when, not if, China will have an economic crisis.
A sure sign of a Chinese bubble!
http://www.ft.com/cms/s/0/e7fe4536-4716-11df-b253-00144feab49a.html
Shenzhen Sunyes Electronic Manufacturing +277%
Zhejiang Nanyang Technology, a film manufacturer, +174%
On first day trading!!!!!
Trading Chinese stocks was fun when I last tried. You can get burned easily however, and after making a reasonable profit it all went up in smoke - Esun, Ocean grand(which has seemingly been suspended for 3 years!)
Hi emptyend,
A few credible pundits like Jim Chanos and Ed Chancellor of GMO have predicted an economic crisis in China, and it seems from your comments that your share at least some of their concerns.
But surely such an event would cause the price of oil, and other commodities, to drop sharply. It would also have a severe effect on Australia. Wouldn't the price of oil stocks like Soco also drop sharply?
cheers
Dodge
...not if a lack of energy sources was part of the mix causing a crisis! ;-)
There is also the very important question of timing. For the next 2-3 years I think we'll have a tightening energy picture - and that should be enough for SIA to get done and dusted. My concerns over China (specifically) are a bit further out - though I think the west will start treading water much earlier.
Debt is the over-riding issue, though....as Mark notes.
ee
Well, I completely fail to see the attractions of the US$. Real, hard commodites, yes - but the US currency has problems pretty much as severe as the UK's AFAICS.... and if things go pear shaped in China/Asia, we're really in trouble. Why, for example, is GM seeing any recovery?: http://www.google.com/hostednews/ap/article/ALeqM5hn9VHtGiDjTa3mjiR5pWleoMMXmAD9F1FCF00
I prefer simply to keep cash than low yielding bonds, for at least the next year or so, as I maintain that I really can't see interest rates staying low for much longer. IMO the only politically acceptable solution to oversized sovereign debt in the the UK and the US is inflation (& associated interest rate rises) which means that there is significant risk of capital loss by sticking with bonds & govt securrities (relative to the currencies those bonds are denominated in)
IMO the "hair shirt" approach advocated by some would be disastrous and lead to a repeat of the 1930s. Fortunately, I think most politicians appreciate that and (I hope!) will not make the same mistakes made then (they'll probably invent some new ones!).
We are undoubtedly in dangerous and unfamiliar waters, economically. Where we agree, AIUI, is that it is wise to keep a goodly amount of cash available and that commodity linked investments that benefit from Asian development are a sensible area to focus on.
Over the last year, I have been communicating with Australian investors quite a bit and their view of the world (as well as that of my Brazilian relatives) is largely: recession, what recession? Outside the North/Western hemisphere things appear very different to the way they appear to us and are presented by the media and some bloggers I see posting here.
Regards,
Mark
Hi Mark,
Well I agree the caution re China, because we must remember that the "new economy" there is in its infancy - and the whole experience of a market economy there is new. When you consider the difficulty that established economies like the UK had in spotting the dangers of a debt bubble and excessive leverage, it is fair to worry that China's economy could see its debt bubble blow up too. The USD's attraction is simply that it is a reserve currency - and the fact is that the Euro, IMO, is going to be structurally weak for a decade or more from this point onwards. As you rightly note though, the place to be is in Australia and the AUD......where they have barely noticed any recession at all (0.5% off GDP and an immediate bounce-back, IIRC from Bloomberg TV).
Well I'm about 70% cash in my pension fund and only 30% bonds, so we aren't so far apart in preferences. However, whilst I think we will get inflation in some areas (the Eurozone for example, where they literally can't afford to let the project completely fall over and so have to keep printing money to bail out Greece....and Portugal....and Ireland ....and Spain etc etc - a problem that really does create debt spiral worries IMO), I think a new (Tory) Government in the UK would be extremely beneficial for the UK economy in the medium/long term....even if it will be a bit more painful in the short term. I really don't see why our children and grandchildren should be saddled with the problems created by our own generation (even if I didn't vote for the plonkers myself!). I therefore find myself in 100% disagreement with your comment here:
......and it will be made more viable because the Eurozone can't, and perhaps the US won't, follow a similar course.
Yup - I think we can agree on that, anyway ;-)
cheers
ee
Good post, ee, even though we disagree on some specifics and philosophical matters. :0)
Another thing I think we agree on is that the lending criteria for consumer credit in the US and the UK have been too lax for too long. IMO more rigorous lending standards are part of the solution to not saddling our grandchildren with problems we create. In the short term, I am pleased to see that market forces and capital requirements have caused this to happen. I am, however, worried that with a slow re-emergence of debt securitisation we'll get back to the bad-old days. ISTM that this is an area regulators should focus on.
On the issue of Far Eastern "bubbles", I noticed a couple of encouraging articles recently:
http://www.ft.com/cms/s/0/c645a194-4551-11df-9e46-00144feab49a.html
Whilst state control may be anathema to us, it does seem to be working pretty well for the Chinese so far and it would be nice to see some western regulatory authorities conducting similar "swoops" (if the report isn't just spin, of course)...
http://www.ft.com/cms/s/0/f22a3704-4248-11df-9ac4-00144feabdc0.html
Best,
Mark
Following up on my earlier post and this point:
I have just read a very interesting and controversial view of China's impact from the perspective of an Australian commentator: http://www.businessspectator.com.au/bs.nsf/Article/Next-in-line-for-superiority-pd20100414-4GRYC?opendocument&src=rss
Whilst I think that some of the assertions in the article are highly debatable, I do think it is well worth a read.
Regards,
Mark
See also...
http://www.stockopedia.com/content/re-did-shiller-just-say-us-stocks-are-30-overvalued/39543?comment=1#1
I think whoever wins the election is going to be in for a tough time. If it's labour, then expect little to be done and the ensuing financial crisis to be of even more epic proportions to the one we've already had. If the Tories win, the extent of the blackhole in the finances due to continued excessive government expenditure over income is going to give them,and us, a massive headache.
Either way, the pain that is in the offing(we've had lower unemployment than expected due to the public sector taking up the private sector slack by employing more jobsworths for example) isn't going to be pleasant. Severe austerity measures are required, a complete overhaul of the welfare state, reneging on the ludicrous decision of doubling foreign aid if the Tories win, 20% departmental spending cuts and major programmes abolished or put on hold.Taxes too will rise more significantly that people so far seem to believe.
Poses the conundrum of where to invest. Presumably Asia will keep growing whilst Western Europe suffers.What of America?Their recovery seems to coming along nicely.
My thoughts to investment positioning are:
Commodities -
Either through selective stockpicking in the likes of FXPO(Iron), MML/CEY(Gold),Enrc,Kazakhyms, Blackrock Commods
Oil - BP, SIA, TLW
Oil minors: Cop, COV,AEX, Pele,BNK,FPM
Oil Equip suppliers- PFC,Lamprell,Wood, Amec
China specific: WCC, CHNS,GNG
Utilities: Centrica, Drax, UU, Severn trent.
Any quality blue chip yielding 4-5% eg Glaxo, with extensive overseas operations included
Some adhoc stocks that others have highlighted. eg Fcam,MRS, XEL, HSD,CTO,BLVN,PSPI
and rounded off with some investment trusts
JPM India, JPM Brazil, Fidelity China, JPM China.
So if it goes pear shaped in Asia I'm up the creek without a paddle. Still, hopefully the dividend element of the portfolio will keep ticking over.
Well, plainly, the bond market is wrong. There is no way the UK or US government will actually default on their bonds (i.e. not pay coupons or redeem when due). Far more likely they will inflate the national debt away. And what would inflation & rising interest rates do to the price of corporate bonds? A short on this overpriced corporate debt wouldn't seem like a bad idea...
Mark
Hi Mark,
As a former bond market professional, that isn't a conclusion that I would rush to draw. I think it is perfectly logical (if very unusual) for the biggest multi-national companies to trade below government bonds. Yes of course you are right that governments won't default on debt issued in their own currencies (because they can print more) - but the Greece issue has highlighted that such an option isn't open to Eurozone countries.
It would be interesting (and I have no idea of current levels) to see how long-dated UK government bonds issued in dollars (of which there are a few IIRC) currently compare with similar bonds issued by large companies!
There is also the "rarity factor" at work. The likes of P&G, J&J, Pfizer, Merck, Exxon, Nestle, Unilever etc etc have always traded well below (interbank risk) swaps in part because they rarely issue bonds. In "the old days" when I was in the market, these rare issuers used to raise money at 50-60bps through swaps.......or, in T+ terms, at perhaps 10-20 basis points over Treasuries......
....so it really isn't a MAJOR move if these elite issuers are now trading 20-30bps or so tighter to the market than they used to - especially when one can consider that multi-national companies have robust multi-national assets, and are therefore not exposed to single-country political risks.
ee
ps.....a deeply depressing but probably very accurate article, IMO. God help us all if Brown is allowed to carry on ruining the country!
Hi ee,
Thanks for your informative reply.
Fair enough. However, it is surely all but inevitable that interest rates will rise over the next 2 years plus,in both the UK and US, both of which have (or will have) severe sovereign debt problems? I would not want to (and do not) hold low yielding corporate bonds or government debt (apart from index linked). Of course, our poor benighted pension funds may have little choice in the matter. Very glad to have taken matters into my own hands in respect of my pension fund.
One spin-off from this is that ISTM one should continue to be cautious about investing in those companies (e.g. BT) that have pension fund obligations that are large relative to their businesses. Before doing so, it is worth studying how those funds are invested and the likely impact on future deficits of the funds' investment decisions.
Regards,
Mark
PS I have zero confidence that Cameron would do a better job (even if he ditches clueless Osborne), FWTW. So maybe even more depressing!
Hi Mark,
Not IMO - it most certainly isn't "inevitable"!!
The reason is that, despite the potential sovereign debt issues and the probable serious rise in supply of bonds (and even the inflation risk), the fact that bonds offer vastly greater security than equities may yet come to be valued by the market (for the first time in around 50 years). As you may have seen from my comments in other threads, I think that the "cult of the equity" is now on borrowed time - and the thing that may well tip it over the edge will be another serious hit to market confidence. Whether that arises from sovereign defaults, renewed wars, security concerns over Saudi oil supplies or other matters such as governments raising taxes across the developed world in order to pay down debt is, as ever, tough to say. But there are plenty of catalysts out there to trigger the draining of confidence and those who have recently been seduced into buying equities for yield (and giving up cash and bonds) may well move the other way!
Accordingly I'm quite happy to stay in bonds (fixed and IL) and cash in my pension fund. Despite the very big rise over the last year, the markets are still nearly 1,000 FTSE points below where I sold out of equities in my pension fund and I now have only about 4 years to go (instead of 6.5 when I sold) before I may have to start making use of it.
I don't agree with you on that, given the appalling mess that has been made of the public finances (whilst Brown was repeatedly lying about his prudence!). What DOES scare the s*** out of me though is what they'll discover when they actually get to look at the books that Brown and Co have been cooking. How Brown has the gall to launch his manifesto in a PFI hospital that hasn't yet been paid for and that our children will still be paying for for decades to come I really don't know! Plainly he has decided that the voters are either/both too stupid to notice or they couldn't give a damn about the problem because it is "not their problem". They are right that it isn't "their" problem - it is ours!! And it is a massive one!
rgds
ee
ps...agree Fanghorn's broad stance. I'm staying with companies whose assets are effectively dollar-linked commodities - and in cash/bonds (because I'm expecting things to go pear-shaped....and not just in Asia!)
It's going to be a real eye opener this post election emergency budget.
And it isn't going to be pretty that's for sure, whoever wins the election.