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

An invidious choice

I find it hard to disagree with these comments from Sebastian Lyon, the CEO of Troy Asset Management, writing in the annual report of Personal Assets, the investment trust to which he and his colleagues now act as Investment Adviser, following the death of Ian Rushbrook four years ago.

The secular bear market in UK and US equities is now in its thirteenth year. How much longer must we wait until we can again be fully invested (or even geared!) and reap the double-digit returns we long for? Ask the policy makers! Stocks would be considerably lower were central banks not keeping stock prices artificially high by means of zero interest rates and quantitative easing. Despite these interferences, stock markets have gone sideways during the past year. Savers have not been rewarded for taking risk and hence our cautious strategy has paid off, for now, although we are likely to lag short term rises in the market should further monetary interventions be forthcoming.

Politicians in Europe are confronted with the invidious choice between severe austerity, which is likely to lead to periodic recessions and declining tax revenues, or incautious borrowing in the hope of buying growth. Both approaches will eventually force governments to pay higher rates of interest on debts. The maths do not stack up. No wonder governments are looking to extricate themselves from an intractable problem by leaning on central bankers to pull their inflationary strings. But our greatest concern is that the European challenges that have dogged markets since early 2010 are merely the dress rehearsal for the main event – a US fiscal crisis. While the UK and Europe have at least tried to tame their budget deficits, the United States has pushed ever harder on the fiscal accelerator. Stock markets swooned last August when they got a shock preview of what might happen should the brakes be applied. Following the public disagreement in Washington over increasing the public debt ceiling, the Dow Jones Industrials Index fell 13% in seven trading days.

During the past year, the Swiss National Bank and the European Central Bank have demonstrated the triumph of hope over experience by joining the Bank of England and the Federal Reserve as late entrants in the race to debase their currencies. Gold divides opinion among investors but, for us, the precious metal remains a cornerstone of the portfolio. Bullion protects us from the huge expansion of central bank balance sheets. It is the only currency that politicians and policy makers cannot print.

While markets have been busy going nowhere over the past year, we have been busy doing nothing. From our perspective, little has changed and portfolio turnover of our equities was less than 10%. Stock market valuations are not compelling. Historical earnings may be misleading as they have been flattered by two decades of self-destructive credit growth. Recent history, like past performance, is no guide to the future. Tesco’s woes provided further evidence of the challenges facing the UK economy. The company began to suffer from lower consumer demand in 2011. By holding on to the shares for too long we were (unusually for us) guilty of over optimism. Tesco’s problems are a microcosm of the new economic reality we face. Consumer and business demand is re-adjusting, which will be a prolonged and painful process.We have subsequently sold our entire holding of Tesco.

Sebastian concludes with a reference to the founding father of the Austrian School of economics:

Central bankers today would do well to heed the warning from the economist, Ludwig von Mises: ‘‘If the practice persists of covering government deficits with the issue of notes, then the day will come without fail, sooner or later, when the monetary systems of those nations pursuing this course will break down completely. The purchasing power of the monetary unit will break down more and more until, finally, it disappears completely”.

He is right unfortunately. The stakes for investors could not be higher than they are today.There are no magic bullets to solve the problem of over-indebtedness in the developed world.  The risks are a further deflationary shock in the short term and impoverishment by inflation down the line, leading to the demise of both the euro and possibly, without decisive intervention from the political leaders of the United States, the dollar. Not a happy prospect, whichever you cut it. Patience and realism remain the order of the day, notwithstanding the decent rally in stocks and commodities we have seen since June.

Written by Jonathan Davis

August 16, 2012 at 7:56 PM