Inveighing against “economic vandalism”

This is the original, slightly fuller version of the interview with Bruce Stout, manager of the Murray International investment trust, which appears in the November 7th issue of The Spectator.

As that great financial innocent P.G.Wodehouse reminded us in another context, it is never difficult to distinguish between a Scotsman with a grievance and a ray of sunshine. But it is not hard to warm to Bruce Stout, the lead manager of one of Scotland’s most successful investment funds, as he outlines his rage at the “economic vandalism” which the world’s monetary authorities have inflicted on savers in the years since the global financial crisis.

Mr Stout, a softly spoken son of Dundee, is the lead investment manager for Murray International, a global income trust which has defied conventional thinking and years of relative obscurity to grow rapidly to rank in the top five of the UK’s investment trust sector. The object of his ire is the policy of quantitative easing, the centrepiece of the unconventional monetary policy that central bankers have turned to in their desperation somehow to cough their stuttering and debt-laden economies back into life. The Federal Reserve, the Bank of England and the Bank of Japan have all been at it for some time, creating money to flush into their broken banking systems. Now the European Central Bank, faced with a moribund Eurozone, is under growing pressure to do the same.

“I call it economic vandalism” Mr Stout tells me, on one of his occasional forays to London, where his employer Aberdeen Asset Management occupies a modish new office block it picked up on the cheap from one of Iceland’s bust banks, “because the ones who are penalised are savers. Savers are always the victims. Anybody who has managed their finances properly continues to be penalised for their prudence”. In the sixty years leading up to 2008, he points out, the average return on a savings account in the UK was 2.5% above inflation. Since 2008, the year that Lehman Brothers went bust and the world teetered on the brink of financial collapse, the average return has been a mirror image: 2.5% below inflation.

The loss of purchasing power has badly hurt anyone who formerly relied on cash and government bonds to preserve their capital and generate an income. Interest rates are the lowest they have been since the Bank of England was founded in 1694. Most gilts yield less than the rate of inflation. “The obvious flaw in economics today” notes Mr Stout “is that for the first time in a generation there is a negative real interest rate on bonds. The authorities are not allowing the bond market to reflect reality. They are artificially manipulating the market to a level where savers are bound to lose money. And the reason they are not allowing the market to reflect reality is that the reality is so grim.”

What he means is that the UK, like the USA, Japan and most of Europe, is so bogged down with debt that were the authorities to allow interest rates to rise to their natural level, it would bankrupt both the banks and the governments that bailed them out in 2008, as well as causing havoc for millions of mortgage holders. As a timely report form the International Centre for Banking Studies pointed out last month, despite six years of so-called austerity, far from running down its borrowings, the world has accumulated roughly 30% more debt today than it did before the global financial crisis broke.

And the problem for savers, says Stout, is going to get worse, thanks to the demographic landmine that is the postwar baby-boomer generation reaching retirement age. “What the policymakers are doing for the first time in 30 years is letting all these newly retired people see their savings eaten away by inflation. And you can’t do that. You can’t run an economy without savings. What you get without savings is a whole contraction of a country, because nobody is interested in investing in fixed capital any more”. The result: low growth, stagnant wages and no imminent prospect of improvement, the grim scenario which Japan has lived through for the past 25 years and which now faces the rest of the developed world.

What the central banks are trying to do, I suggest, is to allow inflation to erode the value of the debt pile over time. Yes, but that is a short-sighted endeavour, Stout replies, even if it was working, which it clearly isn’t at the moment, with inflation weak or falling in most developed countries and economic growth mostly well below its former trend rate. The whole policy regime is “a massive political failure, driven by the misguided belief that by creating some kind of asset price inflation, you will generate some kind of wealth effect which in turn generates confidence and spreads to the rest of the economy. That is just wrong. All you do is line the pockets of a very small minority”.

While he is outraged by the folly of QE, and increasingly fearful of outright debt deflation, the corrosive reluctance to spend that happens when consumers and businesses expect everything to cost less tomorrow than it does today, Stout insists that he has no political agenda. When asked for an answer, at first he simply shrugs and says “I don’t know. I don’t have any answers. I have never seen anything like this before. Except that it can’t go on like this indefinitely”.

All the money printed by the authorities, he points out, has simply disappeared into the banks and stayed there, because they need to recapitalise. “It is just a completely futile exercise. What you should do is let the banks go bust and start again. That is what any normal country would do. Sweden, Mexico, they have all been there and done that. But not us, oh no, we have to keep the banks alive as zombie banks. The conduit for capital in an economy is the banking sector and if the banking sector is in a zombie state, then that is what your economy is going to be in”.

The fundamental problem now is that with all the monetary stimulus asset prices have risen so high that hardly anybody below middle age can afford a house. That stops new household formation, “the most powerful dynamic in any economy”, in its tracks. The average house in Edinburgh, Stout points out, now costs nine times the average worker’s income. Thirty years ago it was less than half that. The average age of first time buyers is 33 and rising. Maybe, he suggests, with governments so unwilling to take hard choices, their next unorthodox step will be to write off all outstanding student loans.

Amidst all this, his primary concern remains the pragmatic one of how to invest his trust’s capital profitably in a period of such economic uncertainty and stunted growth. Murray International, founded in 1907, has had a remarkable late flowering, thanks to its impressive performance in these difficult times. Shareholders who invested in the trust 10 years ago have more than trebled their money. Despite a nothing year so far in 2014, the share price is up around 75% over the past five years. The trust continues to offer an attractive dividend yield of 4%, attracting a flood of new investor money. As a result shares in the trust have consistently traded at a premium to net asset value, an almost unheard of phenomenon for an investment trust now valued at over £1.3 billion.

So what is the trust’s formula for success? With the developed world facing stuttering growth and companies obsessed with boosting their share prices through financial engineering rather than investing in new capital projects, Stout says you have to go where there are still some positive tailwinds. That means looking to emerging markets overseas. “In emerging markets, they still have real income growth. They still have inflation, so prices go up, not down. Companies can have volume increases. And as real income rises, you get people trading up from lower margin products to branded products and higher margin products. You have also got increased access to credit, you have got household formation, and you have got young populations – 80% of Mexicans are under 40”.

These conditions are the exact opposite of those in most developed countries. The key remains finding companies that can deliver profitable growth in these markets, and you have to be selective. It is not enough, says Stout, to think that big western companies can dominate these markets. “You have got to have distribution. You have got to have the right connections. You can’t just go into India and buy the best supermarket shelf space. The local competition is not just going to say ‘Come on in, please yourself’ ”.

A look through the Murray International portfolio shows a variegated bag of 16 developing country bonds (good for income) and shares in 51 companies, whose only common thread is their exposure to growing markets. Some are locally based entities that Brits will struggle to identify easily, such as Tenaris, a steel pipe manufacturer. Others are more familiar names, such as Petrochina, or the French supermarket group Casino, which made a conscious decision several years ago to expand into emerging markets and now gets two thirds of its earnings from them. The contrast, Stout points out, with a Sainsbury or a Morrisons, struggling to get by with wafer-thin profit margins in a sluggish UK economy, is marked.

Isn’t Stout worried about what will happen to emerging markets when US interest rates finally start to rise, as many expect they will next year? Not really. Yes, he says, there may be a kneejerk reaction, as there was last year when Mr Bernanke first talked about starting to taper the Federal Reserve’s QE programme. But just look at how much better prepared many emerging markets are now compared to earlier crises, when nearly all their external debt was in dollars. Stout has been topping up his holding in emerging market bonds in recent weeks for just that reason.

And in any event he isn’t expecting any big rise in interest rates for years to come. “If you think that they (the Federal Reserve et al) have just spent five years keeping 10-year rates at between 2.5% and 3.0%, and they are suddenly going to let go to 5.5% to 6.0%, you are very naïve”. But what that means, he adds, returning to his central theme, is that “savers will be watching their savings being eaten away for a long time to come”.

In this environment, developed country bonds will remain uninspiring, while shares in companies with a 4% dividend yield and a dividend growing at 7% or 8% a year will continue to look “very attractive indeed”, although finding enough of these equities at the right price remains the biggest challenge. After such a strong run, the trust notes in its latest report, “capital preservation remains the prime investment objective of current investment strategy”. No ray of sunshine just yet, in other words.