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The truth about bonds

There was more interesting research out today from Dimson, Marsh and Staunton, the three London Business School academics who produce the annual Global Investment Returns Yearbook in conjunction with the Credit Suisse Research Institute. This has become established as the world’s most comprehensive database of asset class returns, covering as it does equities, bonds, cash, inflation and currencies for 19 countries from 1900 to the present day.

I will be publishing a more detailed review of this interesting study on the Independent Investor website shortly, but five points are worth highlighting here today. The main focus of the research this year is on Government bonds and the related issue of investors’ search for yield:

  • While investors look to fixed income as protection against the kind of severe losses (drawdown) which we all know characterise the equity market, history provides no assurance that this is a safe assumption. In fact, the LBS professors say, “historically bond market drawdowns have been larger and/or longer than for equities” (as anyone who remembers the period before 1980 will know from experience). US investors who bought bonds in December 1940 experienced a 67% loss in real terms on their investment over the next forty years and it was not until September 1991 – more than half a century later – that they finally became better off in real terms than they were at the outset. For UK investors who bought bonds at the peak in October 1946 their investment remained underwater for 47 years, thanks to the devestating losses produced by inflation. Read the rest of this entry »

Written by Jonathan Davis

February 28, 2011 at 5:11 PM

Woodford and McLean Q and A

Colin McLean founded his fund management business, SVM Asset Management, 20 years ago in Edinburgh. He is one of the professional investors who was featured in my book Money Makers. An experienced stockpicker, he summarises his market views and how he is positioning his portfolios in the latest Independent Investor Q and A, which has been posted to the Independent Investor website today.

Here is a short extract:

How generally do you see the equity markets at the moment?

The global economy will slow next year, but still deliver robust growth.  Many companies have yet to get back to peak margins, but are cutting costs sufficiently to do so.  Quantitative easing will drive the US Dollar lower, and continue to boost most asset classes; emerging markets in particular. Equities are not over-valued, and more M&A activity is possible given the low returns on cash held in corporate balance sheets.  I see an analogy with the period post the initial recovery in 2003, when it was followed by a good further three years for equity markets and a lot of UK M&A in 2004 and 2005.  I am not sure if the rally will last three years, but I do think we are still in the recovery stage for many businesses.

This is a link to the whole interview. All Independent Investor Q and As are currently free to view. As expected gold has corrected this week after its recent strong run and the dollar has also paused from its previous oversold condition. However the long term prognosis – bullish for the former, bearish for the latter – remains unchanged. The case for owning large cap equities with strong cash flow and balance sheets is however clearly now becoming more widely held than it was earlier this year. Read the rest of this entry »

Written by Jonathan Davis

October 22, 2010 at 2:17 PM

Andrew Dalton’s Market Review

Andrew Dalton is the Founder and Chief Investment Officer of the Dalton Strategic Partnership. This is his latest global market review, as at March 30th 2010. These reviews will be posted regularly on the Independent Investor website and in the forthcoming new subscription-only publication.

As we come to the end of the first quarter, it is worth reflecting on what has happened in world stock markets. Generally equities are higher, despite a sharp correction between mid January and mid February. Asian markets have been mixed but North American equity markets, by contrast, have shown considerable strength. The great surprise has been the Japanese equity market, which has done well both in absolute terms and in currency adjusted terms. The impact of currency movements has been considerable. Both the pound and the euro have fallen sharply against the US dollar.

In effect, the UK has seen a major devaluation from its 2008 peak and that process of depreciation continued in the first quarter of this year. As a result of this devaluation, UK industry and business has become more internationally competitive. Markets, of course, have worried about the size of the UK government’s deficit and the outcome of the general election likely in May this year. The euro, meanwhile, has been overshadowed by the problems of Greece and the fear that these problems are both more fundamental and likely to have a more widespread impact elsewhere in Europe too. So far these problems have been contained and Europe, as a whole, has benefitted from a modest rerating of the euro. It is an open question as to how much further this has to run.

Throughout the period, we have remained as fully invested as possible in equities, taking the view that equity markets remain in a primary bull trend. We have taken this view since early May 2009, and had been building up towards that position over the six months prior to that.

Over the quarter, there have been some significant shifts in our asset allocation between equity markets. For a fully invested equity portfolio, we have ratcheted up our exposure to North American equities further – such that at the end of March, our total exposure in this area is around 46% of net assets compared with a 34% exposure at the end of last year. Our Japanese exposure has also risen to around 7% of net assets, for a fully invested portfolio, compared with 2% at the end of December.

This has been possible as a result of a relatively low exposure to Continental European equities (around 5% at the end of March) and by squeezing our exposure modestly in Asia ex-Japan. The latter accounted for 14% of net assets at the end of March, compared with 17% at the end of December. We have avoided bonds, partly because our risk budgets have been fully absorbed holding equities and partly because we remain concerned about the deterioration in government finances in various parts of the world. Our sense is that government bonds are in a low grade bear market. Thus far the selling pressure has mainly been felt in the peripheral euro area bond markets.

The UK budget last week provided a snapshot of the UK’s fiscal position. The UK Chancellor’s budget judgement was relatively conservative. The UK Chancellor revised lower his forecast for the UK fiscal deficit from this fiscal year and the subsequent five years by an average of £9.2 billion a year with the biggest downward revisions in the first two years. In essence, the UK government locked in the gains from the recent better-than-expected deficit prints.

Where previously the UK government had been looking to halve the deficit in four years, it now expects to more than halve the deficit over that period. As a result, the UK government expects to restrict the debt incurred by the end of 2014-15 by a further £75 billion or to 75% of GDP. This decision to save the benefits from improved economic performance contrasts with the Pre-Budget Report where the Chancellor ‘spent’ most of the benefit from positive revisions.

The UK government generally stuck to its GDP growth forecasts. Growth is still expected to be in the region of 1.0%-1.5% for this year which, as it happens, is broadly in line with market expectations but, for next year, the Chancellor nudged his forecast lower by 25bp to 3.0%-3.5%. On the revenue side, the Budget forecasts show a robust 6%-7% recovery in receipts each year from April this year. The main news on the revenue side was the decision to phase in fuel duty in three stages from April to January instead of a bullet 3p increase in April.

No doubt this gradualist approach reflected the imminent general election. There were no changes in VAT, income tax or capital gains tax rates. However, the higher income tax rates and national insurance rates announced in the Pre-Budget Report in December will go ahead as planned.

The UK government’s spending plans were kept deliberately value. However, there will be sharp spending cuts after the general election and there are indications that government departments are well advanced in preparing options for the incoming administration. Meanwhile, so called ‘efficiency savings’ have been stretched to the limit of credibility.

Within our North American equity portion, we have had substantial exposure to Canadian equities which, of course, have a bias towards natural resources. This has been helpful. Canada is a major beneficiary of strong resource prices. Rising commodity prices have helped its currency to rise steadily in recent years. Somewhat more effective regulation has helped Canadian banks to avoid the massive losses that caused havoc in the US and European financial sectors. The fiscal picture also is the best among the major developed countries and the Canadian economy’s performance compares favourably to that of most other developed countries.

The likely strength of the cyclical recovery in the US has been central to our view of the world for the last nine months and that view appears to be working out. The US now has a competitive currency, competitive labour costs, robust corporate balance sheets and economic data confirms that the country is on a solid recovery path. This has been and is likely to continue to be positive for equities. The prospect for US dollar bonds is less obvious. As US economic and financial conditions continue to normalise, real yields should also normalise. Indeed, yields on US Treasuries have been rising – recently US Treasury bond auctions have been received tepidly and 10-year swap spreads have turned negative. In this sense, markets are making a return to the mean move.

In the event, the EU heads of government provided some sort of back up undertaking to Greece last week. There was no commitment to concessionary terms and a role was provided for the IMF which, frankly, is the only institution with the experience, people and processes in place to implement a package and then to enforce the fiscal discipline that will be necessary within a relatively concentrated three year timetable to close the Greek government’s fiscal deficit. This will be painful, as the latest Irish GDP numbers issued last week demonstrate.

We now know that Irish GDP fell by 2.3% quarter-on-quarter in the fourth quarter of 2009. This was far weaker than t he 1.0% quarter-on-quarter contraction expected. At the same time, the third quarter reading was also revised down to -0.1% quarter-on-quarter from a previously reported increase of 0.3% quarter-on-quarter. The contraction in the Irish economy has been led by declining investment (-9.7% quarter-on-quarter, after -10.3% quarter-on-quarter in the third quarter) – indeed, Irish investment has now fallen by a staggering 52% since the peak in the first quarter of 2007.

On the output side, that is reflected by ongoing weakness in industrial gross value added. Elsewhere on the expenditure side, private consumption in the fourth quarter fell by 0.3% quarter-on-quarter and government spending was down by 0.8% quarter-on-quarter. Net trade had little impact in the fourth quarter, with exports edging up by 0.1% quarter-on-quarter and imports falling by the same magnitude. As a result, the Irish economy has now contracted by 12.6% since its peak in the first quarter 2007 (and 18.7% in normal terms). Not surprisingly, asset values have taken the biggest hit. Household wealth has declined sharply.

All of this reinforces our view that European growth faces real headwinds in the months ahead as some deflationary forces are unleashed.

Written by Jonathan Davis

March 31, 2010 at 5:30 PM

Andrew Dalton On The Markets

As someone who is required to read a huge amount of written material about investment, I have spent many years looking for experienced professionals who can write both clearly and with integrity about the the changing dynamics of the markets. By that I mean experts who are not just easy to read and understand, but who have the judgment and experience to be able to distinguish between “noise” and substance – to pick out what matters from the daily torrent of information and data that is now available to all market participants courtesy of Reuters, Bloomberg, the Internet and traditional news media.

One of the few who meets this demanding set of criteria is Andrew Dalton, who spent 30 years as one of the key senior management team at Mercury Asset Management before setting up his own fund management firm, the Dalton Strategic Partnership, seven years ago. He is going to be contributing his weekly market reports on a regular basis in future for Independent Investor. This is his take on the events of the week ending 7 March 2010.

The rally which began in mid February has continued last week. The pressure associated with Greece lifted slightly. The Greek government completed a €5 billion bond issue, albeit at 35bp of yield above the market. This provided modest relief to the Euro on Friday. From a technical point of view, equity markets maybe slightly over-bought on a short-term basis. However, there has been a notable decline in selling pressure over the last three weeks, together with signs of greater buying power.

Markets have broadened, particularly in the United States, where it is now clear that mid cap and small cap indices are above their early January highs, even if the S&P itself is not yet there. Economic statistics, coming out of the US have been complicated by severely bad weather conditions in February. Nonetheless, the US Federal Reserve Beige Book gives some comfort that economic conditions continue to improve albeit at a relatively gentle pace.

The US non manufacturing ISM index rose to 53 in February, which was above consensus expectations. The details included solid gains in the employment and new orders components. The ISM indices typically are not particularly susceptible to storm related distortions, which are likely to have a bigger impact on payroll and consumer spending data.

Reports from the 12 US Federal Reserve districts contained in the Beige Book indicated that while economic activity remains at a relatively low level, conditions have improved modestly since the last review and those improvements are broadly spread geographically than in the last report. Ten districts reported some increased activity or improvement in conditions, while the remaining two reported mixed conditions. In the last Beige Book eight districts had reported increased activity or improving conditions. Most districts reported that consumer spending in the recent 2009 holiday season was slightly greater than in 2008 but still well below 2007 levels.

Retail inventory levels remain lean in nearly all districts. Auto sales held steady or increased slightly since the last Beige Book in most districts. Non financial services activity generally improved in districts that reported on this sector. Manufacturing activity has increased or held steady since the last report. Among districts reporting on near term expectations, the manufacturing outlook was optimistic but spending plans remain cautious.

This is all good news from the equity investor’s point of view – a positive story but not overblown. There is still enough weakness to reassure the banks that interest rates are not likely to go up soon. Towards the end of 2009, home sales increased in most districts, especially for lower-priced homes. Home prices, this time, appear to have changed little since the last Beige Book and residential construction remains at low levels in most districts. Commercial real estate was still weak in nearly all districts with rising vacancy rates and falling rents.

In essence this reaffirms that while there are clearly some divergences of opinion between FOMC members, the Fed will not feel any pressure to tighten policy or withdraw liquidity (beyond what is already scheduled). Elsewhere, notwithstanding the strength of the Japanese yen, Japanese exports are recovering quite sharply. Japanese exports have risen 46.8% from a year ago while imports are up 34.7%. The trade surplus in February was ¥99.4 billion, up from a deficit of ¥141.5 billion a year earlier. On a seasonally adjusted basis, exports have accelerated steadily from 0.6% growth (a month) in July last year to a record 8.6% month-on-month rise in January. Meanwhile, the Japanese stock market is cheap still.

The problem is to identify who will be the buyers. In Japan, foreign investors were net buyers of Japanese stocks for the third week in a row last week by a ¥82.5 billion margin (down from ¥100.5 billion the week before). Japanese trust banks, though, were net sellers of ¥86.6 billion shares. Individuals were net buyers but only by a ¥1.0 billion margin, although this compared to being net sellers of ¥49.0 billion the previous week. The press commenting on the Japanese Ministry of Finance’s latest corporate statistics report are still pessimistic and focused on the weakness of current corporate fixed investment spending instead of the 102% rise in profits. In fact, Investment spending has fallen 17.3% from a year earlier.

Our guess is that it will pick up. Anyway, Japanese corporate profits bottomed in 2009 January to March quarter, albeit at a historically low level. Looking at the four previous corporate earnings upcycles excluding the current one), on a simple average basis they have lasted 13 quarters, which suggests that the recovery will continue quite some more time. Capital expenditure has continued to fall but, historically, capital expenditure bottoms out approximately six months after capacity utilisation bottoms out, which has already happened. We remain modestly positive about Japan.

Written by Jonathan Davis

March 9, 2010 at 10:00 AM

The Need For Skin In The Game

One of the most powerful ideas to emerge out of the post-crisis reviews of the global financial system is the need for tradeable derivatives such as credit default swaps to incorporate in future an “insurable interest”, to make sure that we never again allow hedge funds and other short term traders to take free shots at their targets (today Greece, yesterday banks and mortgages) without having any “skin in the game”.

The point was well made in an article in the Financial Times by the former general counsel of Long Term Capital Management on Friday – an insight made all the more convincing by the fact that LTCM was itself a hedge fund whose over-geared trading almost brought the financial system to a crashing halt in 1998 before being rescued (nothing like a sinner who repents to talk sense!).

Here is an extract:

Wall Street loves a piñata party – singling out a company or country, making it the piñata, grabbing their sticks and banging it until it breaks. As in the child’s game, the piñata is left in shreds. Unlike the child’s game, in the Wall Street version the piñata is stuffed with money for the bankers to scoop up with both hands, instead of sweets. We see this game being played today, with Greece as the piñata.

Investors trying to understand why their portfolios have begun to melt down for the second time in five years are becoming experts in the fiscal policy of Greece. A look at the piñata party might make things clearer.

Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?

When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.

Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.

Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.

This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.

When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.

Comment: Mr Rickards goes on to make clear that he is not disputing that public finance in Greece is a mess, which it clearly is. The folly of allowing countries into the eurozone when they deliberately falsify statistics in order to meet the entry requirements is becoming all too apparent. Unlike the Irish, who have responded to the debt crisis with commendable determination, it is difficult to have much faith in the ability of the Greeks to put their own house in order.

Mr Rickards’  point is not that Greek fiscal extravagance does not need fixing, but that it should be dealt with in an orderly fashion by governments without the incendiary assistance of footloose traders. The argument against this line of thinking is that governments only get round to solving problems when it is too late and the damage has already been done (think of the UK and the Exchange Rate Mechanism in 1992). Even if you accept this argument, however, it is clear that financial market discipline would be more responsibly exercised if it was firmly rooted in an ownership interest.

Written by Jonathan Davis

February 15, 2010 at 11:37 AM

Posted in Commentary, Greece

Putting Emerging Markets In Their Place

The annual study of long run global investment returns by three London Business School academics (Dimson Marsh and Staunton) has the great advantage of puncturing popularly held but fallacious arguments much favoured by those hawking their financial service wares – be they brokers, fund managers, investment bankers or financial advisers.

The headline findings from the latest edition address the arguments for investing in emerging markets and/or countries where economic growth is highest (although there are other interesting findings that will be the subject of a separate comment in due course). The academics emphasise that in both cases the emerging markets/growth story is not quite as good as its advocates make out.

Here are some of their findings:

One, emerging markets have had a terrific decade, delivering on average 10% per annum between 2000 and 2009., while equities generally – as represented by the MSCI world index -  have produced a zero % return. Individual emerging markets have done even better.

Two, this exceptional relative return  has been offset in part by the higher volatility of emerging markets, which is roughly 50% greater than that of developed markets.

Three, the longer run superiority of emerging markets is less clear-cut. If you look at the data since 1978, for example, when the first emerging market indices were started, developed country stock markets have actually outperformed emerging markets by a small margin, though that is down to the early years, not more recent ones.

Four, such evidence as there is about the really long term historical record suggests that emerging markets can take a long time to make the transition to developed status. Of 34 countries that had stock markets in 1900, only five have made the step up from emerging to developed status in the 110 years since then, while two (Argentina and Chile) have gone the other way. (Three other countries that either did not exist or had no stock market in 1900 – Israel, Singapore and  Taiwan – have also joined the developed market club, defined as countries with GDP per capita of $25,000 per annum, in the meantime).

Fifth, what does remain the case for emerging markets is their value as diversifiers for western investors. Owning a basket of emerging market index funds reduces risk without reducing returns, the classic free lunch. Even here however, the value is diminishing as globalisation has sharply increased the correlation between emerging markets and developed markets, as the financial crisis in 2007-09 underlined. 

Sixth, there are a number of reasons why investors may be disappointed when trying to capture higher returns from emerging markets. Only a small proportion of an emerging country’s growing companies will be listed on a stock market. Those that are may not be growing as fast as the average; many are utilities or State-owned enterprises, often with small free floats.

In addition, there is the classic problem that investors may already have priced in the expected higher growth, reducing the potential returns on offer and risking disappointment for those who join the party too late. One of the clearest messages from history, one that academics have highlighted for many years,  is that investors always tend to overpay for a good growth story.

Finally, the professors produce some interesting research which shows that GDP growth is a poor predictor of future financial returns. This paradox is explained by the fact that GDP figures are only known for certain some time after the event: if you are smart enough to know for certain which countries will have the highest growth in future, you can make excess returns – but in practice that certainty is rarely available. In practice we don’t usually know what GDP was last year (let alone next year) until some time after the event.

It is important to emphasise that none of this is a reason for avoiding emerging markets, which will continue to grow in size and importance over the coming years – as everyone knows, China is on course to overtake the USA as the largest economy in the world by 2020. But investors make returns by buying at a good price, not just by being in the right place at the right time.

The case for emerging markets, in other words, is often oversold – or at least sold on poorly founded evidence. The LBS academics reckon that long run outperformance by emerging markets could be worth 1% per annum of additional return, but not much more. It is a reward for the higher risk, not for higher growth. How much you pay for that growth makes all the difference.

Written by Jonathan Davis

February 11, 2010 at 10:25 AM