Editor’s Notebook 30 May 2011

[private]It can be painful to be right

The recent decline in Government bond yields on both sides of the Atlantic, coupled with a comeback by the dollar on foreign exchange markets, has caused some pain for those fund managers who, like William Littlewood at Artemis and Philip Gibbs at Jupiter, have been running short positions on sovereign debt in the US and UK. This is the kind of setback that can make even the best money managers look stupid for a while.

Strategically, however, even with the markets starting to worry about slowing economic recovery and the interminable Eurozone debt crisis – which I am confident will be patched up again for now in due course, although the crisis is real enough – the bet against Government bonds has powerful logic behind it. I am sure it will be vindicated before too long. As an investor with both fund managers, I have no intention of selling. But nobody likes to be caught the wrong way of a move like the one we have seen in the past month (see the charts below).

This is Littlewood’s most recent view:

We do not like bonds for two reasons. Firstly, they offer poor value in real or inflation-adjusted terms. The 10-year bond yield in the UK is below the current inflation rate. Secondly, government debts have become so large that many governments will fail to repay these bonds. This will be exacerbated by the poor demographic background in many parts of the mature world.

The risk premium being offered by government bonds, in my view, is way too low. Portugal has been forced to apply for a financial bail-out. Portuguese 10-year bonds yield nearly 10%, reflecting their poor financial situation. It is instructive to compare Portugal with the UK. According to the IMF, the net debt to GDP ratio in Portugal at the end of 2010 was 79%. In the UK, the corresponding figure was 69%.

So Portugal’s debt burden is only slightly worse than the UK’s. The Portuguese budget deficit was 9.1% in 2010 and is forecast to be 5.9% this year, coming down to 3% by 2013. The UK had a budget deficit of 10.5% in 2010. That is forecast to be 8.6% this year, coming down to 5% in 2013. These figures are actually slightly worse than Portugal’s.

Obviously there are other differences. Crucially, Portugal is a euro member country so cannot print its own currency, and is locked into an exchange rate that is too high for it. Also Portuguese GDP growth will probably be worse than the UK’s in the next couple of years. However, the underlying government financials in the UK are only slightly better than those of Portugal.

I do not believe this is properly reflected in the bond market. The Portuguese 10-year government bond yields over 600 basis points more than the UK 10-year gilt. I could also select Japan, where we have our largest government bond short positions. The Japanese net debt to GDP ratio at the end of 2010 was 117% and is forecast to be 142% by 2013. Their budget deficit is forecast to be over 7% in 2013. Clearly these figures are worse than Portugal – but the 10-year bonds yield a paltry 1.2%.

Right, right, right – and yet wrong, if you judge these things only by short term price movements, as the charts show.

Only three years ago, as Littlewood points out, Portugese Government bonds were trading on lower yields than UK ones – classic market myopia that looks incredible now, such was investors’ blind faith in the Eurozone project at the time. The downward move in these Government bond yields now looks overdone from a technical perspective.

Don’t give up on those commodities

As regular readers will know, my working assumption for some time has been that the next big setback in the equity markets was more likely to come next year, rather than this. This is after all the third year of the US Presidential election cycle, a famously good one for the stock market, and the economic recovery had started well. As Ken Fisher reminds us, there has never been a negative year for the US stock market after a positive first quarter and this year’s first quarter was surprisingly positive in the light of various unexpected events, including the Japanese tsunami and upheavals in the Middle East upheavals.

Reported earnings have generally been very strong, monetary policy remains very loose (though not necessarily effective) and despite the evidence of rising inflation around the world, most of the big negatives have been sufficiently well aired for one reasonably to conclude that any deterioration in outlook was “already in the price”. Commodity prices have corrected sharply, but it is too early to say that this is the start of any significant change in the secular balance of supply and demand that makes commodity price inflation one of the dominant themes in the current investment environment.

The renewed crisis in the Eurozone has provided a good pretext however for rethinking that relative optimism, which is why equities have been weak in May and Government bonds, in all but the obvious basket case countries at the heart of the Eurozone’s problems, strong – ditto for the US dollar, seen for now by some as “the least worst” currency to hold (the longer term is another matter). It is fair to say that some seasoned market commentators whose opinions I track are now starting to change their tune on equities (though not on commodities) as a result.

One such is Don Coxe, the experienced investment strategist at BMO Capital Markets, a large Canadian broking firm. In the latest issue of Basic Points, his strategy publication, he urges his institutional clients to reduce their equity exposure in favour of higher allocations to cash and bonds, while increasing their exposure to agricultural stocks (the most soundly based corner of the various components of the commodity complex, in his view), and maintain their holdings of gold and gold shares.

Here are a few short extracts. Coxe, for those who do not know him, is a master phrasemaker as well as a market follower of high repute. On the equity market:

On balance, we believe that the environment for equity investing is deteriorating, and investors should reduce their exposure. The S&P’s powerful rally fed on itself and took little notice of the etiolation of much of the US economy. European optimism—which was never ebullient—is turning back toward Euro-pessimism. Interest rates may not rise amid such sluggishness within the OECD, but spreads should widen. The sovereign credit quality issue is a wild card in formulation of investment policies, and could muddle capital markets.  It is an ominous sign for the economy and stock market that bank stocks underperform the S&P consistently despite (1) these massive stock buybacks, (2) zero-cost funding and (3) a steep yield curve that would have made Alan Greenspan proud.

On the Eurozone crisis and bonds:

The euro is the first paper currency without the specific, unconditional backing of any government, taxation system, army or navy. It is backed only by a theory, and is therefore the utterly perfect opposite to gold and silver—a Keynesian dream and a hard money believer’s nightmare. We would expect that, in a year or less, long Treasuries will trade at higher yields than many high-grade corporate credits. The municipal bond market is becoming a minefield. We expect many states’ general obligation bonds will trade—if at all—at yields far above lower-grade corporate.

On the case for agricultural stocks:

The investment case for agricultural stocks is that these companies are the world’s best hope for fighting hunger and food inflation. They are the commodity stock group that is least at risk from a slowdown in global economic growth, but, paradoxically, they are one of the commodity groups that stands to gain the most from a large increase in incomes in the emerging economies. Agricultural stocks therefore have the least endogenous risk of any commodity sector, while still having great upside if economic growth improves.

On the likely permanence of food inflation (and its link to one of Coxe’s bête noires, the US policy of wastefully using crops to make ethanol for fuel):

It may seem ironic that we are discussing commodity-driven inflation at a time commodities have been experiencing sharp corrections. Most commentators have focused on the big selloffs in oil and silver as proof that “the commodity boom is turning into the commodity bust.” This is roughly the twentieth time since the commodity boom began that big names in the stock markets have published commodity obituaries. Each of these deaths (apart from the capital markets crash of 2008) turned out to be a reprise of the funeral of Tom Sawyer. It took much longer for commodities and commodity stocks to recover from the Crash, but once they emerged from their crypts, most of them took on new lives of their own.

We consider it likely that food inflation will prove to be more pernicious and durable this time than in the Seventies. Why? Because, back then, food shortages generating food inflation were almost entirely caused by weather or crop diseases. Today, we still have problems with weather disruptions in key grain-growing regions, but pesticides and herbicides have dramatically reduced crop losses of earlier times.  However, we now have man-made assaults on food supplies, and they have every indication of being both dangerous and durable. The reason corn prices doubled is that demand for feed and fuel continued to rise, while the US corn crop came in well below expectations. The principle is called supply and demand. The most obvious reason why corn and soybeans are in such demand is that not all the world is vegetarian. We can produce enough food to meet global food demands. We cannot produce enough food to meet global food demands and a growing percentage of global fuel demands.

Corporate buying remains the key

A more consensual view is that of Andrew Smithers, the economic and investment consultant whose speciality is contrasting the shortcomings (read “idiocies” in his view) of “stockbroker economics” with the real picture as it is eventually painted in official national economic data. In his latest World Market Update he argues “We remain optimistic for equities over the next few months, despite their large overvaluation, as we expect US corporate buying to continue. Bonds are also overvalued, but lack a similar source of support”. (Smithers is an advocate of measuring the valuation of Wall Street on the basis of Tobin’s q, a measure that compares the market’s market capitalization to the replacement cost of its component companies’ assets).

His argument is that a significant factor (already mentioned by Don Coxe) behind the resilience of the stock market is that the CEOs of corporate America are taking advantage of current market conditions to boost their share prices (and the value of their share options, many granted at the bottom of the bear market in 2009) through share buybacks. It is these buybacks, just as much as quantitative easing,  which are helping to keep equity prices afloat through a diet of bad macroeconomic news.

He also summarises his other views as follows:

Both inflation and deflation are serious risks but not, we think, in the short-term. The worldwide rise in inflation is hard to explain if there are, as commonly claimed, large output gaps. Clearly there is no current spare capacity for the production of food and raw materials but, if output gaps were large, falling prices in other goods and services should have offset their impact. Possible explanations include (i) inflationary expectations are rising, (ii) output gaps are small to non-existent; and (iii) changes in corporate behavior have increased resistance to price cuts. Each of these seems likely to have made a contribution. Growth seems to be slowing and should dampen short-term inflationary worries. But output gaps are probably smaller and trend growth rates lower than current consensus views.

Inflation rather than deflation is thus the greater short-term risk. Thereafter deflation is the greater risk: (i) as a consequence of inflation and (ii) when fiscal deficits are reduced. France and Germany have the most robust economies among G5 countries, but the need to refinance their banks is likely to hold back their equity markets. While defaults seem inevitable, the apparent intention is to postpone them until 2013 when the European Stability Mechanism will be in place. So the zone’s problems are unlikely to be quickly resolved. Investors should avoid bonds, particularly corporate issues.

The last point, about the timing of the Eurozone crisis, is well made. The reality is that, as I have noted previously, there is a tremendous political battle going on in Europe over how the latest outbreak of sovereign debt anxiety should be resolved. There is a lot of posturing and a lot of brave talk that may or may not prove to be something other than negotiating tactics. The game plan on all sides is to spin out the question of how the sovereign debt of the worst affected countries is restructured and refinanced (as it must be in the end) for as long as possible, and ideally until 2013 when the new proposed financial stability mechanism has been introduced by legislation in all Eurozone states.

The European Central Bank is meanwhile adamant that it won’t be left holding all the junk sovereign debt when the game is finally over. It would prefer national governments to pick up the tab for the debts of Greece, Portugal and Ireland. But the Governments have no appetite for committing more funds to bailing out the basket case economies, and worry – rightly, it seems – that their domestic banking system is in no position to survive the consequences of a default. Another fudged solution again looks the most likely outcome to this ongoing crisis, though every time there is an election in one of the affected countries it changes the dynamics of this complex, multi-polar game once more. That makes forecasting what will happen difficult. Although the end game – a restructuring of debt that is tantamount to a default in several of the weaker European economies – is not in doubt, how quickly we get there remains effectively unknowable.[/private]