What our experts would buy for 2006

Jun 15, 2006

We invited seven of the best strategists we know to join us for dinner and tell us what they think looks interesting in global markets. Here they reveal what they would buy today

Merryn Somerset Webb: What is the key thing we should be thinking about as we go into 2006?

Andrew Smithers: The key thing is often the oddest thing, and that is now the US bond market. We’ve got a very flat yield curve (long-term interest rates are much the same as short-term interest rates), which suggests that the bond market is forecasting a serious recession quite soon. So is the bond market wrong or right? Will we have a recession or not?

Jonathan Allun: The bond market has a good forecasting record – a flat or inverted yield curve (when the yield curve is inverted, long-term interest rates are lower than short-term rates) usually suggests trouble ahead. But it may be wrong this time. Long-term interest rates may be being pushed down not because the market is anticipating recession, but because of the way pension funds are all looking to buy long – or even very long – dated bonds to match their liabilities, and so are willing to pay higher prices (and accept lower yields) for such bonds than they would otherwise.

Tim Price: Look at it like that and I wouldn’t say the bond market was wrong. I’d say a lot of institutional managers are wrong – they’re distorting the market by buying at the wrong price. However, the long-bond rate in the US is the one that everyone uses as the benchmark interest rate for everything else – they look at prices for other assets and interest rates on other assets relative to this. It’s considered to be the risk-free rate – there is not supposed to be any risk involved in buying US government bonds. But if the market is distorted, as I think it is, what it means is that everyone is pricing assets off the wrong rate. The long-bond rate in the US is in fact not the risk-free rate at all. I also wonder if people aren’t beginning to realise this already. Credit spreads, particularly in emerging markets, are as tight as they have ever been – ie, the gap between the yield on an emerging market bond and that on a US bond is much smaller than usual. But perhaps this reflects not that people think emerging markets are lower in risk than in the past, but that the US government bonds are no longer risk-free. Perhaps the correct risk-free benchmark should be something else.

MSW: What do you think the bond market is telling us, Andrew?

AS: I agree that bond yields are currently giving the wrong message. I think the world economy looks to be pretty robust and therefore I rather agree that the yield curve is likely to steepen (long-term rates are likely to rise), rather than invert. That said, I did listen the other day to the chief economist of the European Central Bank speaking. And one of her conclusions was that if there was anything that had been a reliable forecaster in the past, it was the yield curve.

James Ferguson: Well, the inverted yield curve is the only measure the Fed has that has always been right. The problem is that it doesn’t invert often enough for its success to be statistically significant.

TP: Of course, it is also possible to make a case that low yields, and hence high bond prices, are simply symptomatic of a global environment where all assets are expensive – equities, debt, property, etc.

Max King: One other reason why yields are low is that there is not much sign of inflation, so the bond market can’t see a reason why interest rates should rise. If you are buying long-term bonds, you are not getting a premium for any inflation risk any longer.

TP: How are you defining inflation? There’s inflation in property assets, there’s inflation in school bills, there’s inflation in distribution costs. There’s a lot of inflationary pressure that isn’t in the data – everything that has gone up in price has been taken out of the data by the Government so that it is impossible for there to be any official inflation.

MK: So it looks like we all think, for various reasons, that bonds aren’t good value.

SW: I’d agree on a secular basis. But on a cyclical basis, I’m not so sure. There is a risk of a major financial crisis in the world and if that happens, bonds will benefit. At the moment, people are taking on a lot of risk, but if something nasty happens, they’ll move into what they see as a safe haven – bonds.

MK: I can’t see a crisis coming. The US economy had looked like it was growing too fast, but now it seems to be slowing. That’s a benign outcome. It looks as though the Japanese economy is picking up – that’s a good outcome. And the European economy may or may not be picking up. So there is some sort of global rebalance in growth and that’s a pretty good thing.

MSW: Are there any equity markets that look reasonable value now?

AS: I think, as Tim says, we are in a world in which liquidity has been flopping everywhere and every single asset known to man is extremely overpriced. Recently, the gold price and bonds have been rising at the same time. Traditionally, one goes up and the other goes down. So when they move up together, it is a good indication of the fact that markets are moving not because of the fundamentals, but because there is too much money about. It seems unlikely to me that there’ll be anything but poor returns from equities. I think that the financial industry is pretty aware of this. The result is that they now have a tendency to look for what’s called ‘alternative investments’, private-equity hedge funds and property. Huge amounts are flowing into these on the grounds that nobody’s quite sure what else to do. But how can this be a good idea? It seems to me highly improbable that alternative investments and the like will raise the total levels of returns.

JF: I disagree that returns from equities will be poor. Historically, what drives bear markets is rising interest rates (and hence bond yields). Now rates are very low at the moment, so they might rise over the medium term, but if you are taking a view over, say, one to two years, no one really thinks they will go up sharply. And that makes this a reasonable environment for equities.

AS: James, there is no relationship whatever between bond yields and equity yields. Just because there was a strong correlation between 1996 and 1997, people assume that there always was. But in fact there is a slightly stronger negative correlation between 1948 and 1968. Daniel Murray from the London School of Economics and I have done some work on this. We went right back to 1871 and we found there was no correlation whatever over the long term. And if there is one, how do you explain what happened when the stockmarket index in Japan fell from 40,000 to 8,000 even as bond yields fell from 6% to 1%?

JF: That’s easily explained. If you have a credit crunch, then bond yields stop meaning anything. What do you think real interest rates in Japan were during that time? Average lending rates were actually about 30%. Real interest rates in Japan at that time were not falling, but rising horribly. So it’s not surprising that earnings yields were coming down – far from being able to borrow cheap money, companies couldn’t get their hands on any money at all. There may be periods when rates and equity returns are not obviously correlated, but there’s always a good reason why.

SW: Another way to look at the equity market is in relation to the commodity market. In the past, when you have had what I consider a bull market in stocks (ie, p/e ratios are getting higher), you have had bear markets in commodities, and when you have had bull markets in commodities, you have had bear markets in stocks (p/es contracting). We are currently seeing a bull market in commodities and I think we will see p/e contraction too over a ten to 12-year period. Once you enter a bull market in commodities, corporate profitability becomes more volatile. The cost of capital starts to rise at some point and so does the cost of labour (thanks to rising inflation). Firms have three main costs: raw materials, capital and labour – and a commodity bull hits all three. When the markets realise this, they discount it, and value current profits at lower levels. That’s how you get these periods of contracting p/es. A bear market could be a period where stocks rally for three years, as they have just done, then consolidate for another two years, and rally for three. But if you take the whole period, prices won’t have moved much.

AS: Profits can’t stay this high regardless. What we’ve got at the moment is high profit margins and high p/e multiples. This is massively dangerous because both margins and p/es are reverting to mean. Clearly, markets are extremely overpriced.

MK: I think we will see profit margins stay high for the next five, and perhaps ten, years. They may revert to the mean, but it will take a long time. The lean period is probably ten years out.

AS: Actually, historically the mean-reversion of profits has been much brisker than that and I think it will be again.

MSW: None of this is very encouraging. Is there anything we can safely invest in next year?

SW: Agricultural commodities. People are having a hard time making any money out of farming, particularly as commodity prices soar. Costs are up massively – farming inputs are oil intensive – but the prices you can get for your produce are pretty much the same. At the same time, a lot of the subsidies keeping farmers in the US and Europe are under threat, thanks to tighter budgets. This sounds bad for farmers – and it is – but it is also a catalyst for change. We can expect yields to plateau in some areas as farmers who aren’t making money cut down on expensive pesticide use, and we will also see farmers being forced out of business. Yet just as supply is threatened, demand is growing. There are imbalances here that should push prices up over the next three to five years.

MSW: Do you see the bull market in other commodities continuing?

SW: I do. There’s been a long period of underinvestment that has now coincided with a pick up in demand. The result is that there isn’t enough capacity and there won’t be until producers step up invest¬ment. But the long bear market has scared them and they can’t believe it is over. And even when they do start trying to expand, it won’t be quick. They’ve got to find their commodities, fight the environmentalists, build the mines, and dig the stuff out. As far as I can see, we are not even a third through this bull market. Look at demand. There are 2.5 billion new consumers entering the market. Its not just China building an industrial base, it’s also India and eastern Europe. And because they are all just getting started, they need a lot more commodities to grow than we do. For every dollar of GDP that Indonesia produces, it needs four times more raw materials than Germany.

MK: What about oil? 

SW: The oil price is just a reflection of demand around the world. We know exactly where supply stands and we know it’s very tight, so all price moves are explained in terms of demand. So if we see a slowdown in the global economy next year, we will see a setback in the oil price. But that would be a golden opportunity to buy. The global economy will reaccelerate and there is no reason why the oil price shouldn’t move into three digits. There will be cycles within this secular bull market, just as there are in all bull markets. There are also going to be changes in leadership between the three segments of the market – oil, metals and agriculture. Oil was the leader. Recently, there has been some rotation towards the metals, and now I think it will be the agriculturals. They’ll all go up – it’s just that there will be leaders and laggards. People should be paying more attention to this market. If they got the story we wouldn’t be talking about stocks at all here, just commodities, just like people talked only of equities in the 1990s. There are opportunities everywhere – in palladium, cotton, grain, cocoa and coffee.

TP: If you are bullish on global growth in the long run, and I would defy anybody not to be on the grounds that that’s the way the world has always worked, it is not possible to be bearish on commodities and hence on resource stocks.

JF: What is the story on copper at the moment? It has been very much the leader in the metals boom. I’ve heard that inventories are very low and that the market is mainly beingmoved by financial interest – hedge-fund buying and so on – rather then real industrial demand?

SW: I think that’s a bit of a red herring. The financial money isn’t very significant. There is $1trn in hedge funds around the world, but only $60bn is invested in commodities. That’s a drop in the ocean, given the size of the market.

TP: There are single-equity funds with more invested in them than that.

SW: There are 40,000 mature stock and bond funds. But only a handful of specialised commodity funds. Anyway, the financial money doesn’t affect inventories – funds never take delivery. They just roll contracts in the commodities markets over. 

MSW: Let’s look at Japan. Jonathan, I gather you’ve turned less bullish?

JA: I have become more cautious, yes. Japan has had a very decent expansion over the past three years, but it is now slowing a bit. The labour market has tightened, which is good economically, but also means that the slice of the pie that accrues to companies is falling just as p/es have gone up. It is far from an Armageddon scenario, but it does mean we won’t keep seeing profits going up so much faster than sales anymore. We are going from profits growth of 16%-20% to sub-10%. I’m not sure that justifies a market that has gone up this far.

JF: I’m not sure you’re right. Japan is just coming out of a 16-year bear market, so it is hard to say how much is enough in terms of a market move. If you look at the moves Japan had back in the late 1980s, there were lots of these big extended moves. It is only because all we can remember is the last 16 years that the 45% move we’ve just seen so terrifies us.

JA: The problem is that it isn’t cheap anymore. If you look at long-term charts of Japan, you will see that it looks cheap compared with itself 15 years ago, but it has now performed so strongly that is isn’t cheap by global standards any more.

MK: And given that profits aren’t rising like they were, that can’t be justified.

AS: The average Japanese investor clearly doesn’t trust the stockmarket very much either. Buying has been entirely foreign.

JA: That’s not quite true. There has been a lot of net buying by investment trusts, which means individuals once removed (they’re invested in the trusts), and there’s also been a lot of net buying by individuals on margin. The big net selling from domestics has all been coming from the trust banks, but they have now sold out of most positions and so are only small net sellers now. I actually thought they would have stopped selling by now, but they haven’t. This is partly because they have pre-set ratios for what percentage of assets they want to hold in equities, so they sell as the market rises to maintain them. But I also think that there is a possibility that there’s a general trend away from equities around the world.

TP: That makes sense. Stocks are just second-hand paper assets. And people increasingly want the real thing. So there is, I think, real opportunity in venture capital and private equity. There is a cult of equity we are all used to and that the financial industry has made a bomb out of, but that may soon come to an end. 

JF: That may be right long term, but today I still think equities look OK. I’m bearish on the economy, which means I expect long-term interest rates to fall, something that will keep making equities look relatively attractive. I don’t think that a tracker fund would disappoint particularly – a rising tide lifts most boats – but I think you can probably make a good amount of money by finding the better ones. The cheapest stock I can find in Europe is Shell (RDSA, 1,748p). It is still trading at below its 2000 levels, and that was before the oil bull market even began.
 
MSW: You think 2006 will work out OK too, don’t you Max?

MK: Yes, I’m cautious about the market short term, but I think overall next year will be decent and in the first half there will be some good times to buy. I wouldn’t get into equities dependent on the UK consumer at the moment – there is weakness there – but there are some other good areas. I think the UK banking sector will come back next year. Royal Bank of Scotland (RBS, 1,746p) may well have a good year. Otherwise, I quite like the technology space – Cambridge Silicon Radio (CSR, 875p) is one to look at.

MSW: Peter, what would you tip?

Peter Warburton: I remain convinced of the long-term bull case for gold, but I don’t think the metal is particularly attractive just now – it’s part of a frenzy that I think will have to be unwound to a degree, so let’s put it on one side for now. Instead, my favourite place to look for equity investments would be Canada. Canada is a country of 30 million people, comfortably fully employed – the energy sector is a big and very generous employer. It doesn’t have an overheated housing market, but it does have a budget surplus and a trade surplus. Also, the market is expecting short-term interest rates to rise 2%, but they may not – so there’s potential upside there.

JA: The thing I find interesting at the moment is the fact that so many companies have built up such large cash flows. So far, much of it has gone to pay back debt or into dividends and buybacks, but now I think we will begin to see more capital expenditure in areas where there has been underinvestment for some time. This doesn’t mean technology. Instead, I’d be looking to buy stocks in firms that make or carry basic stuff – like ships. Globally, there have been good moves here, but the world is still very underinvested. Hitachi Construction Machinery (6305, ¥2,595) would be a favourite stock in Japan.

TP: Into next year, I still think it is hard to find value, so in the equity market I’d be looking for defensive yields. That means tobacco. I like BAT (BATS, 1,290p) – it may not be as cheap as it was, but I’m comfortable taking that risk over the long term – also Gallagher (GLH, 894p) and Imperial Tobacco (IMT, 1,763p). In the utilities sector, try Severn Trent (SVT, 1,053p) and United Utilities (UU/, 685p). My perennial favourite is the diversified mining sector – I’d still buy BHP Biliton (BLT, 906p), Anglo American (AAL, 1,903p)and Rio Tinto (RIO, 2,564p).

Our panel

Jonathan Allun, Japan strategist at KBC, www.kbcfp.com
Max King, Equity portfolio manager, Investec Asset Management, http://www.investecfunds.co.uk/
Tim Price, Senior investment strategist, Ansbacher & Co, www.ansbacher.com
Dr Peter Warburton, MD of Halkin Services, international asset allocation and risk service
Andrew Smithers, Chairman of Smithers & Co Ltd, www.smithers.co.uk
Stephan Wrobel, Partner at Diapason Commodities Management, www.diapasoncm.com
James Ferguson, Economist and stockbroker at Pali International

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