MoneyWeek’s Roundtable: Finding bull hideouts in bear territory

Aug 15, 2008

In this month's roundtable discussion, we invite experts to discuss the sectors they think are bucking the down-trend. Just where should investors look for value?

Our panel is comprised of: Espen Baardsen, partner and macro analyst at Eclectica Asset Management; Jonathan Compton, managing director of Bedlam Asset Management; James Ferguson, economist and stockbroker with Pali International;

Bradley Mitchell, manager of the Royal London UK Growth Trust; and Tim Price, director of investment at PFP Wealth Management.

Merryn Somerset Webb: Commodity prices have fallen pretty dramatically recently. What’s going on?

James Ferguson: It looks like the boom is over. At least half the metals are in a serious downturn – off 50% or more from their peaks. Same with the agricultural commodities. Given the state of the global economy and how that relates to demand, I don’t believe you will have any inflation at all in 12 months’ time: it’s been driven pretty much entirely by oil and the energy complex as a whole. And whatever you think of oil long term, there is no doubt it has been strongly overbought – way above its long-term trend. I think it could easily come back to $100 or $90. As for agricultural commodities, the evidence is that they have regular mini cyclical spikes, lasting three years or so, and that we are in one of those right now. We’ve already seen an awful lot of fallow land get planted again and many inefficient farmers replaced by efficient ones. I think you are going to find a glut in softs as early as next spring.

Merryn: So no commodities to buy now?

James: Livestock maybe. One obvious point to make is that grain prices are still high, so it’s going to be expensive for farmers with sheep, cattle and pigs to feed over the winter. They’re going to be tempted to slaughter more of them. If they do, and we have smaller stocks coming through into the spring, then you may find that next year’s story is livestock.

Merryn: Espen?

Espen Baardsen: I agree with James on industrial commodities. At the beginning of this decade we’d just seen over two decades of low and falling real prices – there had been a huge level of underinvestment. Then from 2003 we had this global synchronised boom across the market. The first cracks emerged in late 2007, and now it is pretty clear that, globally, the economy is starting to turn. The Fed’s initial response – cutting rates fast – just pushed on the accelerator of countries that were already booming (China and the Middle East). That I think is what caused the tail-end boom in the likes of oil. Still, I wouldn’t dismiss agricultural commodities. They’ve had a long bear market and today the Rogers Agricultural sub-index is almost at the same price as it was in 2004. That shows you how much prices have come back – the overall movement has been small. I think over time agricultural commodities are less dependent on global growth than others and that gives them an advantage for the next year or two.

Merryn: Are you still holding miners, Tim?

Tim Price: I’ve sold off much of my holdings in Anglo American and BHP Billiton. Global recession means lower commodity prices. The only exception I’d say would be gold – a must-own asset as portfolio insurance and as a crisis hedge. But everything else is rolling over in the near term. Long term, I’m an unashamed super-cyclist – I believe in the idea that we are in the middle of a long-term commodities bull market. But super-cycles don’t move in straight lines and I think we are set for a correction.

Merryn: Jonathan?

Jonathan Compton: I agree on gold. But l also like agriculture. When the Berlin Wall came down you brought half the world’s population into the food system. You can’t assume the Chinese don’t want to eat as much as the Americans. The average middle-class Chinese boy already has the same body mass index as an American. They’ve really caught up in the fat stakes. So the long-term dynamics of the grain markets have changed dramatically. There will be hiccups in the market, but the Chinese like protein, so demand for it will keep rising. I wouldn’t buy grains firms, but those supplying them – the combine-harvester and fertiliser makers. Overall, I see rising grain demand and a real difficulty in meeting it.

Espen: Stock-to-use ratios are still very low, so it isn’t as if there is hoarding going on. There is a very, very low inventory-to-usage ratio in corn, wheat and soya beans.

James: But that’s because it wasn’t profitable or attractive to build up inventories, or even hold inventories.

Espen: True, but all it takes is one mistake or one bad harvest and there is no ceiling on the price.

James: But here, 12 months on from the sudden price rises in rice and wheat, everyone in the world knows that rice and wheat are worth hoarding.

Espen: But they aren’t!

James: That’s just because we haven’t had the required northern-hemisphere harvest yet. I think it’s highly unlikely that people are going to let stocks run down again. And isn’t a record wheat harvest forecast this year?

Espen: Perhaps, but there is also a huge infrastructure problem developing. Ukraine will grow lots of wheat this year. Chances of them shipping it? Zero. There’s three loaders, one’s broken. Can’t ship the stuff. There is plenty of land to be planted, but the problem is the infrastructure, it’s the transport, it’s the property rights, it’s the shipping.

Bradley Mitchell: Market sentiment is extremely negative on commodities that have done well. I still think the supply side is horrifically bad, but in the short term no one is paying any attention to that – it’s all focused on the latest bit of short-term demand data. That’s why you are seeing a lot of the more-liquid metals suffer. It’s been forgotten, for example, that most platinum comes out of South Africa and there is a chronic electricity shortage there and that smelting platinum ore into platinum is hugely energy-intensive. So platinum prices have come down. A year from now, I think sentiment will turn again and we’ll be back looking at more structural supply-side issues.

Merryn: In all commodities?

Bradley: Across the whole spectrum. I’m looking at share prices rather than physical commodities. Part of the problem is that the market is less interested in valuation and fundamentals than sentiment and momentum. So stock prices are simply a function of metal price movements, rather than implied valuations. And no thought is given to how you value mining firms through a super-cycle. The other positive is China, which has a lot of money and a very long time horizon. It’s taking the view that it needs these strategic supplies for the next 20 years.

Jonathan: But this happened in the last cycle in the late 1970s. China was buying strategic assets – all round Angola and Mozambique and Zambia. But when it got really painful, China pulled out. You can’t be certain that its holding power is any greater now, especially if investors start losing money.

Espen: You can’t rely on Chinese growth to bail the world out. We will reach a point where China won’t be competitive as a manufacturer. It has seen wage growth of 10% a year over the last couple of years, its currency has gone up 30% and it has still got to ship its goods half way around the world to get to America. Suddenly, that makes parts of the US Rust Belt look competitive. So that’s something I’d watch out for with China. Our favourite trade right now would be in the bond area. We expect that, in Britain, Germany and the US, yields will go down and prices up.

Jonathan: I’m sure you mean government bonds.

Espen: Yes. Only invest with the guys who can print their own currency.

James: Makes sense to me. It’s clear that with global growth stalling and commodity prices falling, there is deflation, not inflation, ahead. That makes government bonds the thing to hold.

Espen: The irony is you needed oil to move from $100 to $145, a final surge, to wipe everyone out of bond positions. That happened and pushed prices down. Now they’re starting to recover.

Tim: Where I struggle with the bond thesis is that, if the financial crisis worsens, the only way the system gets bailed out is with taxpayers’ support. That implies huge issuance of government debt.

James: Further down the track, I agree. But looking at the way things worked when the banks were in trouble in Japan in the 1990s, I think it’s a few years off.

Tim: So what you see, Espen, is deflation over the next one to two years, followed by massive inflation.

Espen: Yes. The central banks aren’t going to sit by and allow debt unwinding and debt deflation to occur. Bernanke will get out his helicopters and create vast amounts of money and at that stageI would sell bonds.

Tim: To me, the least-worst option is inflation-protected government debt. I guess what I’m thinking is if I can only be in one asset, say, for the next five years, I’m not going to bother with the deflation argument, I want to be braced for the inflation that comes afterwards.

Merryn: Any equity tips?

Espen: Over the next 12 months it’s going to be very hard to find stocks that can rise, and that’s why we’re preferring bonds right now – government bonds.

Bradley: There are always interesting stocks. If you look at the market as a whole and valuations, absolute and relative to other asset prices, it’s very attractive. The problem is that right now everyone is highlighting downsides. There is a little firm called HydroDec. It takes transformer oil, which is used in electricity sub-stations (nasty, polluting stuff), and recycles it. It has a massive cost advantage over the competition and is just starting to build plants in the States.

Jonathan: Bull market sectors for me are power generation, pharmas and agriculture. In Norway, I like fertiliser firms Yara and in the US Mosaic. In power generation, I like Siemens. In drugs, Novartis, AstraZeneca, Glaxo, and Takeda are all fine.

Tim: RIT Capital Partners, up 14% year-to-date against a market that is down more than 14%. These guys are complete stars. So go with what works. A single stock would be a FTSE 100 member, Smiths Industries (SMIN). It’s in the right kind of areas – security and medical devices. It has a well-respected CEO and there is a reasonable chance that the company is going to get restructured. It’s also up a little year-to-date and, in a market that’s pretty lousy, that speaks volumes to me.

James: I think there is scope to be in large-cap blue-chips with strong balance sheets and high yields. The FTSE is trading on a single digit p/e, and while earnings will get hit in recession, there is a massive earnings downturn priced in already. Possibly too massive, in fact. Look at the costs. If you are in the first world, your labour costs – which make up 80% of costs – are already negative in real terms and are jolly nearly negative in nominal terms and I see all other commodity costs as flat. That’s zero inflation. So yes, there will be pressure on profit margins – but not total collapse. I like BT – it’s defensive and it yields nearly 10%. A few years and we’ll all wish we had bought BT now. The same goes for the big oil companies trading on six and seven times. Even if the oil price gets hammered back down to $90, you are still looking at incredibly cheap companies rolling off cash. I think there is enormous value there for people who sensibly invest on a long-term basis to buy stocks for a high, sustainable dividend yield.

Where will the housing market go from here?

James: I think America has different problems to us on this. They generated a massive inventory overhang of new houses, so you’ve got two crises: the first one was a mis-selling scandal, subprime, and the second is the inventory overhang. Some say that’s as much as 50 years worth of supply in Miami, the hottest of the hot spots during the bubble. So prices have to come down a very, very long way. In Britain, we certainly had the mortgage guys offering loans far too cheaply, given the risks. But we didn’t build big inventory overhang, so it isn’t quite so bad here.

Espen: It’s a price bubble, not a supply bubble.

James: And it’s a price bubble based on the price of debt. As we’ve long argued, the price of property is not to do with the demand and supply of property, it’s to do with the supply and price of debt. And debt was far too cheap. Today, you can get any mortgage you like, as long as you want to pay standard variable rate and have a good deposit. This isn’t really a credit crunch, just the end of irresponsible lending, and it comes with a mean-reversion. Thing is that prices never just return to the right level: they go crashing through it.

Bradley: What is interesting now is that a lot of people are vaguely aware that there is a problem. But until they actually come to remortgage, they don’t realise just how high their rate will be. They know what the base rate is, 5%, so they think they may find their rate moves from 4.75% to 5.5%. But then they find it’s going to be a lot higher than that. It’s not £100 a month they are going to pay extra – it’s £300 or £400 a month.

Tim: At the same time as they are being clobbered by energy prices and food prices.

Jonathan: I can’t see that banks will grow their loan books in the next 12 months, given the state of their balance sheets – I just can’t see it. It might be the first year since I was born that lending contracts.

Espen: How do you grow your economy if banks can’t expand?

Merryn: James, house prices have fallen a lot already. Presumably you think there is further to go?

James: I think house prices will halve. In real terms, possibly, but they will definitely halve in nominal terms.

Merryn: How long will it take?

James: Well, the last one took six years – top to bottom, six years.

Merryn: We’ve already lost 10%.

James: It will be quicker in terms of the percentage amount it moves because this bubble was bigger – it had buy-to-let lending on top. So, if last time the first year you went down 5% and the second year you went down 10%, and the third year you went down 10%, and then you started going down 5% again – this time, maybe, we have to do 10%, 15%, 15%, 10%. We have to go a little bit further because we’ve got so far to drop.

Merryn: So you are going to wait four or five years before you buy a house?

James: The first really cheap ones will come in two years, maybe even 18 months. But you’ll have to wait a long time for them bounce back up again. The problem with the housing situation is that even once you get down to a price where lots of people would like to buy, they will still be impaired in their ability to do so because they are not going to get the financing. As Jonathan says, who can expand their loan book right now?

Merryn: Does anyone disagree with James?

Espen: I think that half is pretty extreme.

Bradley: If you had bought a house at the last housing peak, it would – in real terms – have taken 11 years for you to break even. People forget that you have huge, long periods during which house prices are below the previous peak.

Jonathan: No one really knows how far prices will go, but the trend is clear. What worries me in terms of the market is the relation of average income to average house prices. If a mortgage costs 7%, a single person on the average salary will need 135% of his net salary just to pay the interest. And a 50% fall in prices only brings us back to 2003 levels – when prices were already high.

Bradley: Everybody has a belief in the benefit of homeownership and the view that they are entitled to have that chance and it’s all to do with social mobility. Your parents lived in a council house and you want to own your own house, and no politician wants to turn round to the electorate and tell them that that aspiration is over for the next five years.

And the danger is that not only do they not want to tell the people that, but that they do quite irrational, panicky, short-term, stupid things so they don’t have to.“The bull-market sectors are power generation, pharmas and agriculture”

The Roundtable tips

HydroDec (HYR)

Yara International (OSX: YAR)

Mosaic (NYSE:MOS)

Siemens (NYSE:SI)
Novartis (NYSE:NVS)

AstraZeneca (AZN)
Glaxo (GSK)

Takeda (JP:4502)

RIT Capital Partners (RCP)
Smiths Group (SMIN)

BT (BT.A)

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