An independent professional's take on the latest news and trends in global financial markets

Notes and Quotes

Here are some comments that have caught my eye in the last few days (a regular feature on this blog).

From Don Coxe, long time Canadian market strategist and commodity fund manager, in his always excellent Basic Points monthly strategy report, noting IBM’s recent offering of a three-year bond yielding (remarkably) less than 1%:

When a $1.5 billion offering of a single “A” three-year corporate bond with a 1% coupon is over-subscribed and routinely trades above-par in the after market, any talk of near-term inflation must be coming from the under-informed or the perilously paranoid.

That IBM offering came days after Johnson & Johnson sold $1.1 billion of bonds at the lowest interest rates in decades for ten and 30-year corporates — 2.95% for the tens and 4.5% for the thirties. Norfolk Southern, a BBB+ rated railroad, has joined the deflation-hedging party with a $250 million offering of 95-year bonds at 6%.

So gold is not trading at $1250 because of rising fears of inflation. It is there because (1) it is very scarce and because investors are beginning to worry about a double-dip recession at a time the US government has lost political support for further bailouts. And (2) because so many investors are in a funk in which they see the longer-range American fundamentals deteriorating by the week.

Guy Monson, Managing Partner of Sarasin Partners, the Swiss private bank and fund management company,  is a regular contributor to Independent Investor. This is a short extract from a much longer  Q and A interview we published last week for Independent Investor subscribers (see for more details).

Fear of deflation and a new banking crisis doesn’t seem very rational. A double-dip is not the most likely scenario. Central banks could not have made it clearer that they will do whatever is needed in the way of monetary stimulus to avert a rerun of the 1930s. The Chinese authorities will come in if needed. Nevertheless high uncertainty is driving investors into the arms of the government bond markets, and condemning even the very best blue-chip equities to a frustrating market trading range, seemingly regardless of the quality of earnings or dividends they produce.

My hunch is that this won’t last for much longer. Either economic growth is going to stabilise, bond yields normalise and stocks rally, or else central banks will release more liquidity, yields will fall further and ultimately investors will buy blue-chip stocks for their balance sheets and yield.  Investors should be starting to follow the natural progression, moving from money market funds to bond funds and then on to equities. Equities certainly look the most attractive asset class.

Global debt-equity valuations mean that bonds have become very expensive in relative terms. In fact, the yield ratio is close to the post Lehmann lows of March 2009, which itself was the 45 year low – lower than in 1974, 1979 and 1987. Corporate bond market spreads are mingy for the risk you have to take. As for emerging market bonds, unfortunately every man and his dog is already there. The main oddity in equity market valuations is that the higher the quality of the company, and the better its cash position, the lower the valuations. Rolls-Royces are selling for less than Volkswagens.

I think we are moving to a new kind of Nifty Fifty market, by which I mean a market where the best equities – companies with net cash, consistent dividends and strong cash flow – start to behave like high quality bonds. The free cash flow of large cap stocks as a percentage of GDP is now the highest since 1950. In three years time we could be looking back at stocks such as Novartis, with 11 years of dividend increases and growing at 7%-8% per annum, and see that they, rather than Government bonds, have become the risk-free asset.

This is from an interview that George Soros gave to Reuters this week:

“Gold is the only actual bull market currently. It just made a new high yesterday. In the present circumstances that may continue. It will be very interesting to see if there is a decline in the next few weeks because practically everything that makes a new high almost immediately afterwards reverses and disappoints. I called gold the ultimate bubble which means it may go higher but it’s certainly not safe and it’s not going to last forever.”

Soros first made the “ultimate bubble” comment on gold back in January at the World Economic Forum in Davos, Switzerland.  However, his hedge fund, Soros Fund Management LLC, still held 5.24 million shares of the SPDR Gold Trust (GLD), a stake worth about $650 million, and equity holdings in miners of gold and other minerals worth almost $250 million as of June 30.  Soros was the third-largest fund in the Gold Trust ETF at the end of the second quarter.

Finally I thought this comment from Dylan Grice, the always thought-provoking strategist at Societe Generale was pertinent and important (agriculture being a topic in which I have a close professional interest).

The 1973 spike in world oil prices is usually attributed to OPEC’s spectacularly successful embargo. But commodity markets face disruptions all the time and the effects are short lived. Why did the 1973 oil markets disruption lead to permanently higher real prices? The OPEC embargo was merely the trigger. The cause was a structural shift which saw a rapid surge in the import needs of oil’s biggest consumer, the US, as its oil production peaked in 1970. Today, the grain market’s biggest consumer – China – is undergoing a similar shift.

Why might this shift be permanent? With 7% of the world’s land and water, but 22% of the world’s mouths to feed, China’s fight to retain grain self-sufficiency was always going to be a losing battle unless the economy was devoted entirely to agriculture. Of course, prior to Deng’s 1978 reforms that’s exactly what China was. But the logic of industrialization in such a land and water constrained country implies scare water and land be effectively imported via grain and livestock, while abundant labour be exported through manufactured products. And while China has excelled at the latter, it has understandably resisted the former.

But how long can it defy the arithmetic of natural resource endowments? The dismantling of the agrarian economy in favour of an industrial model has seen scarce land built upon. Roads, car parks, factories and shopping malls increasingly take the place of farms. Industrialization also implies richer households eat more protein and, paradoxically, meat-rich diets require much more grain than vegetarian ones (apparently around seven times more). None of this would be a problem if China was capable of increasing its agricultural productivity as spectacularly as it is increasing its living standards. But so far at least, it isn’t coming close.

My comment:

Whether or not it is justified, fear of an economic slowdown in the United States is clearly very real. It is one reason why gold (the ultimate two-way insurance bet in a world that cannot make up its mind whether inflation or deflation is more likely) has been strong and bond yields have fallen to historically low levels, not just for Government bonds, but also, as Don Coxe notes, for leading corporate issuers.

More monetary stimulus may soon be on its way – watch out for Obama’s reaction to the midterm elections. The Japanese have meanwhile nailed their colours this week to stopping the appreciation of the yen, just as several fund managers, such as Jonathan Ruffer, have been predicting. Their intervention is the first for six years, and if successful will probably – finally – support the bull case for Japanese equities that looks so clear-cut on valuation grounds (but has stayed that way for years).

Meanwhile commodity prices – which historically trade in inverse proportion to the stock market – have also been strengthening, which appears to paint a rather different story about global economic growth. The battle for supremacy between both sides of the polarised debate therefore rolls on. My money is on Guy Monson looking smart with his prediction about what history will judge to be the new risk-free asset. The Chinese grain story may however yet be the biggest story of them all for this decade, just as oil was for the United States in the 1970s. As for gold, the message remains: it pays to listen to what investors do, not just what they say.

Written by Jonathan Davis

September 18, 2010 at 12:09 PM