The Big Picture Part II

[private]This week I offer some further notes from the CFA Institute conference in Edinburgh, together with some additional comments, from Ken Fisher, Bill Mott and others, which I have logged in the past seven days. My overall feeling is that the equity markets continue to show surprising resilience in the face of generally bad news, growing fears about a slowdown in the world economy and a renewal of doubts about how the next phase of the Eurozone sovereign debt crisis will play out.  The markets seem to expect another wobble in the next few weeks over Europe and growth. In my personal portfolio I remain nearly fully invested, but increasingly watchful for what I suspect may be another serious deflation scare and market break at some point in the next 12 months. For the moment the bull market remains intact however.


At the CFA Institute, Gavyn Davies, the former Chief Economist at Goldman Sachs and an early independent member of the Bank of England’s Monetary Policy Committee, now running his own money management firm, gave a measured assessment of the current global market environment. His argument essentially boiled down to these key points:

  • The years of low interest rates and falling inflation which preceded the credit crisis (the so-called Great Moderation) created a sense of compacency amongst economists, who came to believe in an academic consensus – one shared by policymakers too – that inflation targeting was the key policy objective.  Asset prices could be left to themselves and only light regulation was needed to control essentially rational markets.
  • This belief was rudely shattered by the financial crisis, which demonstrated that systemic risk was much greater than anyone realised, that the deregulated financial system was more rather than less dangerous than before and that monetary policy alone was insufficient to stabilise either financial markets or the real economy. New policy tools had to be introduced to avoid a rerun of the 1930s.
  • The problem now is how to sustain the economic recovery in the light of the massive amounts of public debt and unprecedentedly large central bank balance sheets which have been created as a result of the measures taken to resolve the crisis. This has reopened a debate between monetarist and Keynesian economists – the former wanting early reductions in budget deficits and central bank balance sheets, the latter opposed to anything (including public spending cuts) which might jeopardise the recovery.
  • In Gavyn’s view, a lot of this debate is about timing rather than differences of substance. He argued that the central bank balance sheet problem is not an urgent issue to resolve, but that reversing the fiscal stimulus introduced to prevent a worse recession was the major challenge, given the unsustainable public sector fiscal deficits it has left many countries facing (especially the US and Japan) and the apparent lack of political will in those countries to resolve the situation.
  • Another related problem is the need to reverse the private sector’s natural tendency to retrench in the aftermath of a shock like the credit crisis. This will require an extended period of low interest rates and more governments embracing the kind of public spending reductions introduced in the UK and elsewhere, though notably not yet in the United States. Further foreign exchange adjustments (for which read a further fall in the dollar) will also be needed.

The good news is that policymakers have learnt lessons from the experience of Japan since 1990, and some recovery in the banking sector is taking place. Private deleveraging has slowed a little, but there is still a long way to go before the world can say it is out of the woods. A particular risk is that electors in Greece and elsewhere simply cannot live with the pain required to resolve their local debt crises, as happened in Argentina in 2001-03. “Precarious but not yet desperate” is how I would sum up his position.


A more detailed (and more pessimistic) analysis of the Eurozone crisis was provided by Willem Buiter, another former member of the Bank of England’s Monetary Policy Committee, now Chief Economist with Citigroup. Presenting an array of authoritative detail on government deficits and debt ratios, his conclusion, in essence, was that Eurozone governments will continue to try and play for time by spinning out the process of dealing with the ongoing sovereign debt crises in the “peripherals”, such as Greece, Ireland and Spain, for as long as they can. 

Whether they can succeed is far from certain, however, as the original plan to bail out Greece, Ireland and Portugal is already coming apart at the seams. Mr Buiter predicts that there will have to be at least one debt restructuring in Europe before the end of 2011, and that at least three countries will need to do so before the crisis is over. The serious problem sitting behind the sovereign debt crisis in Europe, he noted, is the potential insolvency of the European banking system, which has only been staved off in many cases (as in Ireland) by Government guarantees of bank debt. In Portugal and Ireland foreign banks have massively reduced their holdings of Government debt, leaving the domestic banks as the only significant investors. The fates of the private and public sectors have therefore been fatefully linked.

Behind the complex negotiations now going on lies a high level “game of chicken”, both between the countries with the greatest default risk and the various policymaking authorities (the EU, the Eurozone and the European Central Bank), and within the policymaking groups themselves, with Governments, responsible for taxes, keen to avoid having to pick up the bulk of the bill for bailing out those countries most likely to default, at least until a new European bailout facility is introduced and legally established in 2013, by when the banks may have had time to strengthen their balance sheets. The European Central Bank meanwhile is firmly resisting having to take more of the risky sovereign debt onto its own balance sheet, as the tax-raising governments would clearly prefer. 

A unknown factor is whether electorates in those countries simply decide not to accept the painful medicine that is being required of them. In the case of Greece, noted Mr Buiter, even a default or enforced devaluation would not necessarily save the country, as its economy is hopelessly uncompetitive and its debts particularly burdensome. This is what lies behind the recent discussions about “reprofiling” Greek debts, meaning exending the period over which those debts have to be repaid.  

Giving this process the cosmetic name of “reprofiling” does not disguise the fact that it would be a form of default on Greece’s part, something which the bond markets know full well. Any retructuring of sovereign government debt would be the first in Europe since Germany defaulted on its debt in 1948, and would be quickly followed by Portugal and Ireland demanding the same terms as Greece.

The only credible solutions to the crisis, in Mr Buiter’s view, are (1) Europe deciding to adopt fiscal as well as monetary union; (2) the ECB deciding to inflate away the sovereign debt of the most indebted countries; and (3) a new comprehensive bailout facility backed by new legislation. He thinks the eventual outcome will be a combination of (2) and (3). A break up of the Eurozone remains the least likely option, as it would not help anyone, even if it were politically acceptable. Governments have so far refused to take sufficient decisive action to resolve the crisis.

Meanwhile the biggest tests on the debt front, Mr Buiter noted, are not necessarily the ones facing the Eurozone, but the ones facing the United States and Japan. There is not one leading industrial country whose fiscal deficit reduction plans are yet sufficient to reduce their debt-to-GDP ratio to 60% by 2030. The three countries with the most to do to bring their fiscal deficits down to 60% of GDP are Japan, Ireland the United States, and all their plans announced to date fall well short of that target.

Mr Buiter predicts that the United States will lose its AAA credit rating by 2013 at the latest, while the only credible AAA rated country left in the Eurozone is Germany.  The markets are likely to force US bond yields higher by at least 3% in the next 2-3 years, and it may come sooner than that if one of its big cities, such as Chicago, looks about to declare itself bankrupt. This in turn will finally force politicans to confront their unsustainable debt burdens with more decisive action than they have shown so far. 


Some useful points of longer term perspective from the West Coast money manager Ken Fisher in his latest quarterly Stock Market Outlook. Here are three of the most pertinent:

  • However horrific they may be to observe, natural disasters, such as the recent tsunami and nuclear crisis in Japan, have never caused either a global recession or a bear market in equities. The economic impact of such disasters tends to be localised and fleeting.
  • World stock markets had a strong first quarter, despite a series of unexpected events, such as the Middle East uprisings, the Japanese tsunami and rising oil prices. Since 1969 there has never been a year in which the stock market finished the year down after recording a positive first quarter’s performance.
  • Unlike most observers, Fisher doubts that quantitative easing is the only thing which is currently holding up share prices. Nor does he think it will prove to be wildly inflationary. The reason is that the monetary stimulus provided by the Federal Reserve is simply going into bank coffers – and staying there, as the banks look to rebuild their balance sheets rather than lend.


Bill Mott, the veteran income fund manager, shares with Neil Woodford of Invesco Perpetual the view that the best bargain in the large cap universe at present can be found in the unloved big pharmaceutical stocks. This is what he has to say on the subject:

As the world recession is coming to an end the risk of policy error by Government is huge.  What is certain is that the economic rebalancing required will have a real effect on the markets: it’s a bit like having the flu and we are now left with a blocked nose. In this bracing and uncertain economic environment, dependability deserves a much higher rating.

I firmly believe that pharmaceuticals offer this dependability and they are currently greatly undervalued offering an outstanding opportunity particularly on a risk return basis.  I am as excited about the current situation as I was in March 2000 at the end of the technology bubble. The defensive, high yield, economically insensitive qualities of pharmaceuticals have been overlooked, offering a better yield than 10 year Government bonds. They represent outstanding opportunities on a total return basis and they could well do what tobacco has done over the past five to ten years.

They are the biggest overweight position in our portfolio and we currently hold 8 pharmaceuticals being almost 16% of the fund as we are confident of growth and good dividend progression. GlaxoSmithKline (GSK) is our single biggest stock overweight at just over 3% over benchmark, being 6.7% of the fund. Our conviction here continues to build. GlaxoSmithKline will probably see only 2-3% annual revenue growth over this decade, but by holding costs flat and using strong cash flow to buy back shares, this should translate into double digit earnings growth. It has a dividend yield of nearly 6% and will have very little correlation to broader economic activity.

Another sector where Woodford has fellow admirers is tobacco, as witness these comments from two fund managers at Artemis, James Foster, who runs the firm’s Strategic Bond fund, and Adrian Frost, its veteran income fund manager. Foster explains his holdings in the bonds of Imperial Tobacco (IMT) and BAT (BATS) as follows:

“Because regulation and legislation have put up almost insuperable barriers to entry, the franchises of existing tobacco brands with market dominance are exceptionally valuable. Secondly, because they fear litigation, tobacco companies pass as much of their revenues onto shareholders and deliberately keep their balance sheets weak. But their cashflows are exceptionally strong. This makes for a very attractive bond investment. Finally, tobacco company bonds are unloved. Investors are either scared of litigation, or object to tobacco on ethical grounds, or both. So tobacco company bonds have to pay a relatively high yield — and are relatively cheap”.

GlaxoSmithKline has been one of the few individual stocks in my pension portfolio over the past couple of years, so I am inclined to agree that as income stocks go, the big pharma companies still look attractive, given their lowly ratings and widespread negative sentiment. The yield differential between GSK shares, on a 5% yield, and the market as a whole, with the FTSE All Share yielding less than 2%, is as wide as it has been since the Clinton healthcare reform plans of 1994 last sent shares of the big drug stocks plunging to these levels. Looking at the charts, however, it has to be said that the shares do currently look somewhat overbought after their recent good run. I don’t own tobacco shares, currently yielding about 4%.