Sunday, February 15, 2009

Blàr Allt a' Bhonnaich : Hendry style

From The Sunday Times
February 15, 2009
By Kathryn Cooper

Investors could be forgiven for feeling confused: authorities around the world warned last week that the economic downturn was deepening, while some stock market indicators suggested the first green shoots of recovery.

Mervyn King, governor of the Bank of England, said Britain faced its deepest and most painful economic slide since the second world war — bad news for savers as interest rates are likely to approach zero.

However, stock markets tend to trough before recessions reach their nadir, and there are some reasons for cautious optimism. The Baltic Dry index, which measures the cost of shipping raw materials and is seen as a bellwether for the global economy, has doubled over the past three months after crashing 94% in the second half of last year. Copper and timber prices are also edging up.

There are also tentative signs the credit freeze is easing, with companies issuing $246 billion (£173 billion) of debt in January — the most since the crisis started.

In Britain, house prices rose 1.9% in January and retail sales were surprisingly strong. While many analysts dismissed this as a blip, others say it indicates interest-rate cuts are having the desired effect.

So what are investors to make of these conflicting signals? We invited some top fund managers to The Sunday Times to discuss the outlook.

Kathryn Cooper, Money editor: When we held our last roundtable in the autumn, the US government had just bailed out the country’s mortgage market to the tune of $200 billion. Since then, the UK and the US have had to pump in billions more. Are you still bullish?

Andy Brough, Schroders: What’s changed since then is that interest rates are down to 1%, and investors are going to have to look for somewhere to get a return. Gordon Brown is going to be issuing gilts like crazy to pay for the bank bailouts, which should ultimately make them an unappealing investment. I wouldn’t imagine investors would be prepared to go back into property either. That leaves shares.

In my area of smaller companies, you will get a positive return this year. There will be disappointments, but overall I think companies aren’t in bad shape.

You could see economic growth turning positive as early as the third quarter. Disposable income is going to be up 3%, against 1.5% the previous year and flat in 2007. And all this money pumped into the economy has to come out somewhere.

Julie Dent, F&C: I’d say I was cautiously optimistic. The people who borrowed on their houses to buy 10 buy-to-let flats in Manchester face a tough time, but they are not the majority. Most people are better off — mortgages are down, energy costs are falling. The banks probably need to do more, but the stock market will discount a recovery before it is seen in the real economy.

Felix Wintle, Neptune: I am keen on the US relative to the UK and Europe. It is a more flexible economy. If you need to take action by cutting jobs because your earnings have fallen, you can do that. In Europe, you are restricted by labour laws. The US will lead the rest of world out of recession because it has taken pre-emptive action on cutting rates; it is a good nine or ten months ahead.

Hugh Hendry, Eclectica: Come on, guys, wake up! The problem is everyone here has to sell financial products and as soon as you say you are pessimistic, or bearish, or God forbid you say sell, someone from the hierarchy comes down and tells you to shut up.

On the US — okay you have flexibility, you can cut costs. But you are firing your consumers, so it becomes a vicious circle.

Brough: Recessions have happened before and we’ve come out of them.

Hendry: Yes, this has happened before, it was called the Great Depression. The market fell 12% the first year, 29% the second, 45% the third and 15% the next year.

KC: So go out on a limb for us, Hugh, how long will it take to recover?

Hendry: It is all a function of society’s willingness to take risks and the best metaphor for that is debt. In the 1920s, our predecessors became, like us, addicted to debt. They took on debt three times the size of US gross domestic product (GDP). And then the crash happened and people regretted it.

The process that began in 1929 and ended with the bankruptcy of the US financial system in 1933 wasn’t resolved until 1974
, when debt was one times GDP and we had all changed our behaviour. You couldn’t get a mortgage — or you could but it would take nine months. The market didn’t get back to its peak in real terms until 1949. When an economy deleverages (pays of its debts), it takes a long time and it can be deeply damaging. Japan demonstrates that. I would say 10 years is a nice start. Bear in mind this began 10 years ago, another 10 would take us to 20, and then add on another 10. That would be in real terms.

KC: You mention Japan, and bonds have been a great investment during their bear market. Does the same hold true here?

Ariel Bezalel, Jupiter: Yes. Confidence in the system has been obliterated and that’s why the government is having to lower interest rates, which is good for bonds (bond prices tend to rise when rates fall as they pay a fixed income, which is more attractive when rates are low). Without doubt, though, default rates on higher-yielding corporate bonds are going to pick up, quite possibly to double-digit territory from 4% now.

KC: Are you as positive on government bonds?

Bezalel: There is a bit of a tug of war right now in government bonds. There are the deflationists like Hugh, who think they will continue to do well as rates come down further, and there are those who fear huge amounts of issuance in future.

Brough: I think inflation is more likely to be a problem than deflation. An increase in disposable income will first be used to rebuild savings but ultimately lead to an increase in spending. House prices went up in January; it could be the first sign.

Hendry: We have the rest of our lives to worry about inflation. You have no concept of how weak places such as Taiwan, Korea and Thailand will become. Japanese exports are collapsing (down 15 per cent on an annualised basis in the previous quarter).

And we are at a point where the euro probably doesn’t persist. If it does, it requires inflation in the Pigs (Portugal, Italy, Greece and Spain) to fall between 10% or 20% in the next five years.

And yet I can go into Germany and buy German 30-year at 4.5%, almost 5%.

Brough: Which do you think will be the first country to leave the euro?

Bezalel: The markets are saying who the prime suspects are — the Irish, the Spanish, the Portuguese.

Brough: I think it will be Germany.

Hendry: Well, they should come out. I would if I was Germany. That’s why you should short German credit. I am long their bonds (buying in the expectation that they go up) but also long credit default swaps (which rise when the risk of default rises) because you have to fear that Germany will bale out the Pigs.

KC: Are you short UK banks, Hugh?

Hendry: There isn’t a positive price where you would lose money shorting British banks. They are insolvent.

The paradox is we have this left of centre party behaving like investment bankers and doing everything conceivable to preserve an obfuscation — the notion that the banks are viable entities, but they are not. The government should have secured 100% ownership, then it could have done whatever it wanted, but we have this pretence that they are a going concern — that’s why we have this debate over bonuses.

Brough: I disagree with Hugh; I don’t think all banks are bust. In the next three years, on analysts forecast the new Lloyds (which I own) is going to generate a total of £50 billion of pre-provision profits; that means it can absorb a lot of write-offs.

Dent: There was a solution in Japan — it took quite a long time, it took 10 years to repay the debt, but there are still banks in Japan. Nationalisation is one option, but I am not convinced it is the only option.

Hendry: Japan just shows you how tough it is going to be — bonds in Japan have made you 7% a year over the bear market, but every time equities rose investors sold bonds and bought shares and allocated away from what would have made money.

Dent: During the bear market in Japan, there have been companies you would have made a lot of money on — Nintendo, Toyota and Kao Corporation. They are the big global companies and I would similarly recommend big UK blue chips now.

KC: So where should ordinary investors put their money?

Hendry: I am not a buyer of gold just now — I want to buy it at lower levels. The rest of my portfolio I would split between the US, Japanese and European government bonds. The rest might just be cash, with some in yen because no-one else is buying.

Dent: But what about Mr and Mrs Jones, retired of Edinburgh, who have lost money on RBS and HBOS shares. They have £50,000 in cash, what are they going to do now? They are getting 1%.

Hendry: What I would do is lend to the UK government — buy 18-year gilts and get the 4%, and I think I will be 40% up in the next 12 to 18 months.

Dent: Because you think we are heading for serious deflation? If you’re wrong and inflation and interest rates head up again, there is a big risk to your capital. I like the idea of having a portfolio of decent dividend-paying cash-rich companies.

The likes of Glaxo Smith Kline, Vodafone and BP are yielding 4.7%, 5.7% and 6.4% respectively and I see them remaining strong. But buy blue chips on a bad day.

KC: And what about for the optimists out there. What would you buy if you want out and out growth rather than income?

Dent: I am big supporter of what is going on in China in the long term.

Hendry: You were there in Japan — tell me China doesn’t seem the same.

Dent: Japan is a developed economy, whereas China is in the early stages of an industrial revolution. Central control is key at this stage.

Hendry: The two big shocks this year in terms of expectation — in other words, my two big shorts — are going to be China and (president Barack) Obama. About 40% of the Chinese economy is exports. They are having an industrial revolution like the Victorians — and the Victorians had booms and busts because of the volatility of the cost of building factories. In booms it grows 40%; but with boom comes bust. Then you get Obama coming in and the policy response is remarkably aggressive against the Chinese.

Wintle: There are indeed very high expectations, but I think the bull case for Obama is a very strong one. Compared with Bush, it really is a 180-degree turn in terms of him being more collaborative.

My favourite sector at the moment is healthcare, where many businesses are still showing earnings growth. This is especially attractive now as earnings stability, let alone growth, is hard to find in today’s market.

Our favourite sub-sector in healthcare is biotechnology, which has been remarkably defensive over the past 12 to 18 months.

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