A Route Map To The Future?

The technical analyst Robin Griffiths, now working for the blue chip firm of Cazenove, was in more than usually ebullient form at an Investment Research of Cambridge seminar in London last week. With the precision that never ceases to amaze me about technical analysts, he laid out the dates when he expects the next turning points in the market to occur.

As someone who lacks any belief in the mumbo-jumbo theories that typically accompany most chartists’ projections, I nevertheless find the insights of the best technical analysts helpful in forming broad market views (by best I mean those who understand how markets behave in real life and allow their charts to inform, rather than dictate, their views).

The scenario which Robin outlined is certainly a plausible one that makes a lot of intuitive sense in a period when markets continue to yo-yo between fears of inflation and deflation. His starting point is the unarguable one that the big indebted countries, such as the US and UK, are on a different route map to those of the fastest growing developing economies. While the former are still toiling their way through a secular bear market, the latter are in a clear secular uptrend.

In practical terms what he thinks this means is that the US stock market will head down again from its current technical rally, with the S&P index falling from 1100 now to around 940 by late October, which is when he reckons President Obama will introduce a new set of stimulus measures, including a second round of Quantitative Easing. That will give the market one more short term boost before capitulation finally sets in and the market falls back to test its March 2009 lows some time towards the end of 2011, with both yields and p/es down to around seven, a typical end of bear market level.

Although that will probably mark the end of the secular bear market that began in 2000, it will still take some years, in Robin’s views, before the US embarks on its next sustained bull run. That is not likely to be in full swing until the next cohort of young in the American population reaches the economically influential age of 30-35 some time in the period 2015-2020.

For the best developing countries, such as Brazil and India, he argues, the short term pattern will be similar, but more volatile. The key difference however is that these two markets, unlike the US and UK,  remain in a secular bull market and so the medium term picture, helped by a vastly superior demographic profile, will be much brighter.

Robin sees the Sensex index in India (his favourite long term market) first testing resistance levels at 15,000 or 16,000 this autumn before revisiting the former peak at 21,000 next spring and falling back to its current level when Wall Street bottoms towards the end of 2011. After that however, it will be onwards and upwards, with the Sensex index powering on to a succession of new highs while the indebted developed world still stagnates in relative terms.

China and Russia, in contrast, are on quite different trajectories, which makes lumping them in together with the other BRICs less sensible. Robin’s view is that the Chinese market, which is already down 70% from its peak, has further to fall in the short term, but will then move on the higher ground once the current tightening has run its course. Russia has a terrible demographic profile – life expectancy is falling rather than rising, he believes - and is a market that most investors will want to avoid.

My View: I don’t know if the equity markets will retest their 2009 lows, let alone when, but a big setback is certainly still a possibility at some point in the next 18 months, as the ebb and flow of inflation/deflation news will continue to drive short term trading patterns in the market for some time. The consequent volatility will muddy the waters for many market participants.

My best guess for now is still that the markets will move higher towards the end of this year. While large cap equities and the best emerging markets both look extremely attractively priced for the long term,  the risk of a severe correction next year will deter the faint-hearted who cannot face the possibility of another testing down year like 2008.

UK and US Government bonds face the reverse of this outlook: periodic potential gains in the short term, driven by risk aversion and reaction to news flow, offset by the prospect of long term penury for those who buy and hold – rather than trade - them at their current historically low yield levels.

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Siegmund Warburg and Investment Management

One of the intriguing issues raised by Niall Ferguson’s absorbing new biography of Siegmund Warburg is why someone regarded, rightly, as “the most important City figure of the postwar period” should have had such an apparent blind spot about the growth and profit potential of investment management as a business.

Peter Stormonth Darling, the chairman of Mercury Asset Management, the business that grew out of S.G.Warburg’s Investment Department, records in his memoirs how his first instruction on being told to take charge of this backwater in the bank was to “get rid of it”. In 1979 the business was offered, says Ferguson, to two rival banks, Flemings and Lazards, at a giveaway price of £10m. They were, he concludes, “foolish not to buy at the absurdly low price Warburg asked”.

(Editor's subsequent note: In fact they were even more foolish than the book implies. According to the information I received from Mr Darling after this article appeared, the business was in fact offered to Flemings for just £1 and to Lazards for £100,000).

Even allowing for inflation, the asking price stands in striking contrast to the £3.1 billion for which the business was eventually sold to Merrill Lynch 18 years later. (A few years after failing to offload it, Warburgs floated the business on the London market as a largely independent business). More extraordinary still is that MAM’s exit price in 1997 was more than three and a half times that at which S.G. Warburg had itself been sold, somewhat ignominiously, just three years earlier.

As blind spots go, this therefore was something of a corker. Because shareholders in Warburgs retained a holding in MAM, to their eventual considerable benefit, the opportunity cost was nothing like as high as it would have been if the decision to sell had gone ahead. Yet Warburg’s decision was, as Ferguson makes clear, entirely consistent both with his own temperament and aspirations in business, and with the prevailing attitude in the City at the time towards investment management.

Warburg died in 1982, just as the great late 20th century bull market was getting under way, and four years before Big Bang changed the rules of the game in the City for good. While others, including Stormonth Darling, could see the way that investment management was already developing into a profitable business in its own right on the far side of the Atlantic, Warburg never seems to have deviated from his lifelong view that investment management was a second rate activity barely worthy of a high-minded financier’s time.

A number of factors can be detected behind this reluctance. One was Warburg’s strongly held conviction that what he wanted his business to be was an “haute banque” in the grand Continental tradition, a private bank which delivered first class advice and services to its corporate clients and acted throughout with the highest possible standards of efficiency and integrity. Relationship building with big hitters in business and Government, in his vision, was a high calling that invariably took precedence, in both social and moral terms, over the grubbier business of generating transactions for short term profit.

Managing client investment portfolios, an activity which absorbed a fair deal of management time and little (in those days) of profit, was an even lower priority. It did not help that Warburg himself had virtually no interest in accumulating personal wealth and retained an inveterate distaste for the stock market. Those who spent their time in market speculation, in his view, were among the lowest forms of business life, right down there with journalists and economists. There was no deeper insult in the Warburg vocabulary than to describe someone as a “Boersianer”.

As one of his colleagues observed, Warburg was a “capitalist by fate” who “despised money making for its own sake”. His own record as an investor was, perhaps unsurprisingly, mediocre. Deeply risk-averse, and ascetic in his personal habits, he lived well, but without ostentation, and died a much less wealthy man than many of his more money-oriented colleagues and contemporaries.

When he gave investment advice to others, the results, says Ferguson, were sometimes “wholly inadequate”, as in the early 1970s, when despite identifying the roots of the inflation that was about to plunge the Western world into a deep recession, he could come up with nothing better as an investment strategy than a 50-50 allocation to equities and Government bonds. Yet this was also the man whose brilliant mind just a few years later helped to pioneer the index-linked Government bond, a simple but invaluable innovation which has benefited millions since (as even Paul Volcker, scourge of the innovations of investment banks, would surely readily concede).

Another of Warburg's besetting personal characteristic was a lifelong inclination to pessimism. His own experience, he noted once, was “that if one expects miraculous results from investment management, this is the best way to do badly...In the long run the most favourable achievements are obtained on the basis of modest anticipations and by way of policies which rather err on the side of being solid and pedestrian than original”.

Ironically, of course, there is a lot of wisdom in that observation, although it has taken three decades of academic research to confirm quite how soundly based it is. Is investment management a high calling? Not self-evidently. There is plenty of money to be made in it, as history has shown, but at the aggregate level it is by definition a zero sum game. To succeed at it, it definitely helps to believe in the triumph of hope over experience. Siegmund Warburg, a Jew who had fled from the Nazis in 1934, was neither temperamentally nor intellectually inclined to think that way.

High Financier; The Lives and Times of Siegmund Warburg, by Niall Ferguson, is published by Allen Lane. You can search for and buy a copy at a competitive price in the Independent Investor bookshop.


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A Measured View of the Debt Crisis

Edward Chancellor, the financial historian now working for Jeremy Grantham's fund management company, has done more than anyone to illuminate the imminence and consequences of the global debt crisis. In his most recent White Paper on the subject, he picks a measured path through the thickets of what soveriegn debt problems mean for economies and for investors. Among the key points I picked out from his eight page study are these:


1. Rapid increases in sovereign debt don't have to lead to default or high inflation, although more often than not they do. One classic example is Britain after the Napoleonic wars. More recent examples, we know, include Sweden, Finland, and Canada in the 1990s. Swedish gross government debt fell from a peak of 84% of Swedish GDP to below 45% within three years.

2. Inflation and/or currency debasement is however more often than not the way out. It is politically more convenient and generally the easier option. Sometimes, when things have really deteriorated, it is the only option. Because repaying debt rewards the wealthy at the expense of the poor, devaluing the currency is, to borrow a phrase from Keynes, “the line of least resistance… it is, so to speak, nature’s remedy, which comes into silent operation when the body politic has shrunk from curing itself.”

3. The biggest problem today is that many countries today have very large structural budget deficits that cannot be fixed as readily as Britain was able to solve its Napoleonic war debt. The largest structural deficits, according to the Bank for International Settlements, are in the UK (10% of GDP), US, Ireland and Japan. What is more, these calculations exclude both the growing burden of unfunded liabilities such as pension and healthcare costs, which as we all know are enormous, and the bank guarantees given during the recent crisis.

4. A further problem is that large proportions of the outstanding debt of the worst affected countries are held by foreign investors. For Ireland, the Netherlands, Spain and France, the figure is around 60%. In the case of the USA, it is nearly 50%. In the case of the UK, it is around a third. This matters because, if you are looking for comfort from historical experience, in those cases where excessive levels of debt have been successfully reduced to more normal levels, most of the debt has been held domestically, reducing the risk of destabilising capital outflows and/or currency collapses.

Chancellor makes the valid point that it is easy, but wrong, to extrapolate naively from the cases of Japan (since 1989) and the Club Med countries in Europe (today) to argue that a calamitous debt implosion is likely or imminent in every heavily indebted country. The Club Med countries, Spain, Greece and Portugal, for example have specific problems, such as a lack of competitiveness ( exacerbated by their membership of the eurozone), which put them in a different category to the UK and United States. Fiscal retrenchment is already underway in the UK and other countries and may yet, if combined with renewed economic growth, produce an acceptable outcome.

There are simply too many unknown variables to make a definitive forecast of how the sovereign debt crisis will play out possible. The risk of policy errors remains high. Nobodyknows whether the political will to make painful but necessary decisions will hold. In 19th century Britain, when both wealth and political power were concentrated in the hands of a small landed minority, the owners of the debt had fewer qualms about imposing rising unemployment and poverty on the majority to safeguard the value of their debt.

For investors, the important message from Chancellor's analysis is that owning bonds of indebted countries at current prices can only make sense if you are convinced that the worst outcome is where we are heading. In his words, "under only one condition – that the world follows Japan’s experience of prolonged deflation – do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don’t appeal to us".

To which I would only add: nor me. Until or unless it appears that the extreme deflationary case is coming to fruition, which is not impossible, but a low probability outcome, I would judge, the safer bet is still that inflation is coming our way. When it does happen, history suggests, it can happen very quickly. How much and how soon are the unknowns. A copy of the White Paper is attached. Recommended.
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The Book That Buffett Likes

An out of print book about hyperinflation has become a cult hit with professional investors in the United States, including Warren Buffett, reports the Sunday Times. The book is When Money Dies, an account of how hyperinflation took hold in Germany after the First World War, leading to social upheaval and, so many believe, the eventual rise of Hitler.

It was written by Adam Fergusson, a now retired civil servant who served as an adviser to the former Conservative Chancellor, the then Sir Geoffrey Howe,in the 1980s. It was first published in 1979 and was republished last week by Old Street Publishing, a small boutique publisher which, I suspect, has been somewhat taken by surprise by all the attention it is suddenly getting.

The book was first taken up by right wing bloggers in the United States last year to serve as an example of the dire consequences that can follow from an excessive build up of debt. Copies of the original hardback are reported to have been changing hands before that for hundreds of pounds - great marketing, if nothing else.

Mr Fergusson himself, to judge by the comments he is quoted as making in the Sunday Times, which challenged him to draw parallels with the task facing the new coalition government in the UK, is a more measured individual than some of those who have talked up the book on the other side of the Atlantic.

"In Britain today" says Mr Fergusson "there is this debate between neo-Keynesians who want to postpone any tightening of the economy and those who say it should be done at once. To my mind it is a non-debate, because politically now is the only time tightening can be done. In a year or so, it won't be possible, politically, any more".

"When governments are not strong or brave enough politically, finally the economy goes to pieces anyway. If you are trying to decide whether to go for quantitative easing or high unemployment, in the end you'll have both". This seems to me a very valid point, and one that serves as a useful corrective to the somewhat hysterical debate between different schools of economists over how far and how quickly to bring public spending back under control. In the UK, certainly, the new coalition government has to use the political capital the election gave it while it can.
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Heading Into The Equity Grind

Sometimes a good graph can be worth a thousand words. I am grateful to Robert Buckland of Citigroup for this helpful illustration of stock market behaviour after the largest market falls of the last 30 years. This shows in his words how equity markets typically move through a phase of strong recovery in the 12 months after a market plunge (the “equity surge”) to a period of more consolidation or gradual improvement (the “equity grind”).

Of course this time it could be different, and if you care to follow the warnings of Professor Nouriel Roubini and others, we could be in for a further gruesome period for equities as a double dip recession in developed countries starts to bite. However there is a reason why the phrase “this time it’s different” was described by Sir John Templeton as the four most dangerous words in investment. It is that believing the adage will often lead you to a dangerous conclusion. (Pedants might say it is five words, but that is another matter).

There is no doubt that the technical position of the equity market has deteriorated in recent weeks. Earnings upgrades, as noted earlier, are starting to run out of steam. There is certainly no shortage of negative news around. But that does not mean that equity markets cannot move higher over the balance of the year and that I still suspect is what they will do. In the short term equity markets look oversold, and many professionals I rate highly tell me they are finding bargains at current levels. That won’t make the pace of equity market recovery any faster, but it does provide a measure of comfort.

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The Budget: A Start Down The Road

There was nothing in George Osborne’s emergency Budget on Tuesday to contradict the idea that the transition from Labour governments to Conservative (or in this case Conservative-led) ones tends to be good for the investing classes. The fall of the Callaghan government in 1979 was followed after an initial period of uncertainty by the start of an 18-year bull market that was resilient enough to survive two nasty recessions, the 1987 crash and our undignified exit from the ERM in 1992. There were similar bull markets for shares in the mid-1930s, following the formation of a Conservative-dominated National Government, and in the Eden-Macmillan years in the 1950s.

This time round, the stock market response is again likely to be positive, once it has had time to digest unpalatable items such as the rise in capital gains tax for higher-rate income tax payers. Raising the top rate to 28% rather than 40% or higher is less of a sop to the Lib Dems than many Tories had feared. Osborne’s measures are generally a boost for the private sector. Indeed, by leaving the onus on the private sector to lead the UK out of economic recovery, he has firmly rejected neo-Keynsian solutions in favour of hitching the administration’s fortunes to those of its natural constituency.

The proposed year-by-year cut in corporation tax down to a record low of 24 per cent, and the commitment to ‘simpler rules and greater certainty’ for companies generally, are all to the good. At the macroeconomic level, his vigorous assault on the fiscal mess that Labour left behind is what markets had expected. The devil is in the detail however and the numbers will be rigorously scrutinised for fault lines. It will take time therefore before we can judge whether the results succeed in confounding the jeremiahs of the economics profession, who insist that keeping the public spending spigots open for longer is essential to avoid a second recession, as Geoffrey Howe’s famous 1981 budget was eventually able to confound the nay-sayers of the day.

Prospects for those whose investment horizons do not extend beyond home shores are certainly better than they were under Gordon Brown, but not yet as good as those whose do. UK companies which have succeeded in surviving the debt crisis have rarely been in better shape financially, and in many cases shares look reasonable value. If what Keynes called the corporate sector’s “animal spirits” can be roused, and sterling remains competitively priced, then there is room for profits and investor returns to exceed expectations.

But the fortunes of the UK will remain constrained by the burden of public debt and the painful side-effects for employment and growth of Osborne’s campaign to diminish it. At best it will be a case of two steps forward and one step back for UK plc, forced to compete in international market against less constrained rivals. The weakness of the euro is already doing wonders for German industry, for example.

Fortunately, twenty years of free-moving global capital flows have significantly increased the correlation between the performance of the main asset classes in different countries. Innovation has also greatly increased the range of markets in which private investors can readily invest. That cuts both ways: almost half BP’s dividends before the current disaster were being paid in dollars to investors outside the UK. No UK investor any longer has to place a binary bet on the success of Osborne’s strategy however.

Despite gloomy headlines about possible meltdown in the eurozone and fears that the US economy may be heading for a second recession, the global economic news has been good. The annualised rate at which global industrial production has been recovering since the darkest days of the credit crisis has been unprecedented. Giles Keating of Credit Suisse points out that car sales in the three largest economies (Germany, Japan and the US) are still well down on pre-crisis levels, yet in the eight largest emerging markets they are growing strongly. Taken together, global sales of cars in these 11 economies are already back above their pre-2008 average.

Indeed, so well are low-debt and emerging economies doing that some are already starting to confront the problems of too rapid growth, through interest rate rises and tighter monetary control. China’s attempts to control its real-estate bubble have captured most of the headlines, but the Chinese are not alone. Brazil grew at an annualised rate of 10 per cent in the first quarter and interest rates there are heading up; so too in Australia and Canada. The evidence to date has confounded the many who doubted that there might be a V-shaped economic recovery.

In the absence of serious mistakes by governments and central bankers, not something that can alas yet be discounted, the odds on further recovery are improving, but with the indebted developed world continuing to lag the developing world. It is true that many investors remain to be convinced. Risk aversion explains why, although share prices are still handsomely above the lows of early last year, yields on government bonds remain stubbornly low.

So too, with the notable exception of gold, are the prices of most commodities. That is not a pattern you would expect to see if sustainable economic recovery was now a universally accepted fact. Banks in the eurozone remain vulnerable and will need to be recapitalised, while the blundering way that the EU and ECB have handled the Greek debt crisis is not an encouraging omen.

Experience shows that a good investment strategy has several elements: an understanding of value, since buying cheaply is the only thing that guarantees good returns; diversification, to protect against mistakes and unforeseen risks; a longer-term focus, for consistency and the avoidance of pointless trading costs; and a strategy that matches the investor’s temperament and tolerance for risk. One Budget can make only so much difference. 

Looking back to 2000, no more than half a dozen good strategic calls, some running contrary to consensus opinion at the time, would have ensured a profitable decade. One was to buy and hold government bonds, which have been in a more or less continuous bull market since 1981. Another was to buy and hold commodities, which despite recent stalling, remain in one of their generation-long cyclical upswings. A third was to be out of equities when valuations rose above historic norms, as they were in 2000 and 2007, while increasing (for those with the tolerance to ride out short-term volatility) the proportion in emerging markets.

Property remained a good bet for the first half of the decade, but killed anyone with excessive leverage when the credit crisis hit. Sterling, surprisingly perhaps, ended the decade at almost the same price in dollars at which it started, and needed no long-term strategic call. Wine and art had a terrific decade.

Anyone who got those calls right could easily have trebled their wealth over the period — not bad in a decade when mainstream asset classes and allocations produced disappointing returns. The credit crisis of 2008 underlined how the diversification value of so-called alternative assets such as hedge funds and private equity proved illusory when trouble hit. Many turned out to be nothing more than debt-leveraged equity holdings that proved difficult or impossible to sell. 

Looking forward to the next decade, some of these trends, including the rise in emerging markets, are set to continue. Current prices for emerging-market equities still leave room for long-term gains. So too do prices of many large dividend-paying companies in developed markets. Equities in general are certain to enjoy a better decade than the one just finished: there has never been an example in history when a decade of flat equity returns failed to produce above-average returns in the next one.

Other trends will reverse completely. For the first time in nearly 30 years government bonds in the main issuing countries look extremely unattractive on anything but a short-term view. Bonds issued by stronger, more politically stable emerging countries look better value. However firmly the new government wrestles with the public finances, all historical experience will have been defied if higher inflation is not part of the eventual solution. Unfortunately inflation-linked bonds, one obvious hedge, are currently dear.

The factors behind the global commodity upswing remain in place. Expect higher prices over at least the next five years not just for gold and silver, which are bulwarks against the monetary debasement now being practised around the world, but also for oil, timber, industrial metals and agricultural commodities. Although the UK’s ability to devalue has given us a helpful jump-start over eurozone competitors, the longer term implication is that the dollar, sterling and the euro (if it survives) may continue to weaken over the next decade relative to the currencies of faster-growing or resource-rich developing countries. The UK’s fortunes are looking up after this week’s Buidget, but economic miracles sadly need more time to gather real momentum. It is a start, but no more

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Q and A with Jim Rogers

Jim Rogers, who co-founded the Quantum Fund, regularly speaks his mind on the outlook for global markets from his new home in Singapore. I have been talking markets with him for more than 10 years. In a Q and A session with Independent Investor, he offers his latest views on China and Korea, on the dollar and the euro, and on gold, silver and other commodities. Here is a short extract from the 20-minute conversation.

I’d like to start by asking you to explain what you think has been happening in the markets in the last month or so. They’ve been very jittery - we’ve had the Eurozone crisis, we’ve had the Israeli situation, we’ve got worries about Korea and so on. Are these worries you share, or is this just normal market action that we’re seeing here?

I hope you and everybody is worried too because, you know, we have great imbalances in the world that have to be sorted out. I mean, we’ve got gigantic debtors in the West, and gigantic creditors in the East, and we’re going to have more problems: more currency turmoil; we’re going to have more financial problems – this is not over yet.

Some people are saying that there is a serious risk of returning to a re-run of 2008 and the banking crisis – is that something you share?

Well, of course I do. There’s no question about that. It may not be the same actors, it may not be the same format, but, again, the United States essentially is bankrupt, the UK essentially is bankrupt. There are a lot of companies and countries in Europe which are getting a lot of press right now, but nobody can pay off these debts.

If you would like a transcript of the full 3000-word interview, please email me at editor@independent-investor.com. The full interview, and others in the series, will be available free of charge for subscribers to read or listen to on the new Independent Investor website. This is currently in beta format and will go live shortly.
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No More Prevarication on Public Debt

PAUL KRUGMAN, the Nobel Prize winning economist, was in top thundering form in his comments on the recent meeting of G-20 finance ministers, which – apparently prompted by the new coalition government in the UK - produced a noticeable change in political rhetoric by welcoming the plans by several countries to start tackling their hefty budget deficits.

“It’s basically incredible that this is happening with unemployment in the euro area still rising, and only slight labor market progress in the US” says Krugman.  Bowing to demands from the financial markets for fiscal austerity, in his view, is “utter folly posing as wisdom”.

“Don’t we need to worry about government debt?” he goes on. “Yes — but slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt”. The right thing would be to wait until after the economy is strong enough to allow monetary policy to offset fiscal austerity. “But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound”.

The intellectual credentials of Prof Krugman are scarcely in question. But is he right to warn that even starting to tackle the fiscal imbalances today dooms us to another recession, or even depression? Without getting into a futile doctrinal debate between followers of Keynes and the Austrian school of economists, the alternative view, much more popular in the circles which I frequent, is that tackling debt with yet more debt is a far surer way to long term ruin. Postponing the evil day, after all, was at the heart of the Federal Reserve’s failings in the later years of Alan Greenspan’s tenure and helped to land us where we are today.

Not even to begin laying the ground for reductions in public spending today, let alone to confront the huge unfunded liabilities that lie beyond budget planning horizons, makes little sense. On past form it will take years for any cuts announced today to be fully implemented, if indeed they can be achieved at all. Just as 364 economists turned out to be wrong when they denounced Sir Geoffrey Howe’s infamous 1981 UK budget, it is not axiomatic to me that Prof Krugman and co are right this time round.

In any event it is surely debatable to blame the imminence of spending cuts mainly on pressure from the financial markets. It is not, after all, as if the “bond market vigilantes” have been much in evidence recently. Long term bond yields have been falling, not rising – foolishly, history may yet judge. Pointing out the inconvenient fact that Greece and other countries have unsustainable fiscal problems is meanwhile hardly an insight confined to a few hedge fund managers.

What really seems to affront the liberal academic mind is the idea that financial markets – irrational, greedy and capricious as they indubitably can be at times – should be seen to be driving public policy in any way. Unfortunately, a good deal of the argument about fiscal consolidation is about the timing of economic recovery, the appetite for risk in the private sector and the second and third order effects of fiscal tightening. This kind of judgment, in my experience, has never been the forte of economists, whatever their school.

Unsurprisingly perhaps, I take more comfort from Paul Volcker, who as a former Chairman of the Federal Reserve has a gold-plated track record in dealing with the consequences of past financial excess (and was rightly lauded by Prof Krugman, among others, for that achievement). In an excellent recent article in the New York Review of Books, after discussing his plans for banking reform, Mr Volcker observes: “The critical policy issues we face go way beyond the technicalities of law and regulation of financial markets”.

“If we need any further illustration of the potential threats to our own economy from uncontrolled borrowing, we have only to look to the struggle to maintain the common European currency, to rebalance the European economy, and to sustain the political cohesion of Europe. Amounts approaching a trillion dollars have been marshaled from national and international resources to deal with those challenges. Financing can buy time, but not indefinite time. The underlying hard fiscal and economic adjustments are necessary”. 

That sentiment is surely unquestionable. It is only recently however that political rhetoric across the indebted developed world is starting to match up to the scale of the challenge; and even then, it has to be said, the degree of realism that is on public display is often all too closely tied to the imminence of elections. President Obama’s intemperate attack on BP for its failings in the Gulf of Mexico shows that the syndrome is as true in Washington as it is in London, Frankfurt and Athens.

“As we look to that European experience” says Volcker “let’s consider our own situation. We are not a small country highly vulnerable to speculative attack. In an uncertain world, our currency and credit are well established. But there are serious questions, most immediately about the sustainability of our commitment to growing entitlement programs. Looking only a little further ahead, there are even larger questions of critical importance for those of less advanced age than I. The need to achieve a consensus for effective action against global warming, for energy independence, and for protecting the environment is not going to go away. Are we really prepared to meet those problems, and the related fiscal implications? If not, today’s concerns may soon become tomorrow’s existential crises”.

Mr Volcker also draws on a recent visit to Ireland to justify his view that optimism is not entirely out of place in this critical environment for policymakers. “It’s a small country, with few resources and, to put it mildly, a troubled history. In the last twenty years, it took a great leap forward, escaping from its economic lethargy and its internal conflicts. Responding to the potential of free and open markets and the stable European currency, standards of living have bounded higher, close to the general European level. Instead of emigration, there has been an influx of workers from abroad”.

“But now Ireland has been caught up in its own speculative excesses and financial deficits, culminating in a sharp economic decline. There is a lot of grumbling, about banks in particular. But I came away with another impression. The people I spoke to had an understanding that the boom had gotten out of hand. There seems to me a determination to do something about the situation, reflected not just in the words of the political leaders but in support for action among the public. And there is a sense of what is at stake, that the gains they made in recent years have been placed in jeopardy. The urgent need to get back on a sustainable budgetary and economic track is well understood”.

Not so, of course, in the United States. “Restoring our fiscal position, dealing with Social Security and health care obligations in a responsible way, sorting out a reasonable approach toward limiting carbon omissions, and producing domestic energy without unacceptable environmental risks all take time. We’d better get started. That will require a greater sense of common purpose and political consensus than has been evident in Washington or the country at large”.

There is no doubt that the hand of history is sitting heavily on the shoulders of the current generation of political leaders. They have critical judgments to make, and insufficient evidence to be sure that their decisions will turn out right. Mistakes are inevitable. The markets certainly have no monopoly on wisdom either – just look at their apparent readiness to lump in Hungary, a paragon of virtue in fiscal terms, with Greece. But the time for procrastination, as Mr Volcker is right to observe, is passing.

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May Can Be The Cruellest Month Too

MAY TURNED OUT to be one of the worst months on record for world equity markets, reports Andrew Lapthorne, the head number-cruncher and quant in Soc Gen Asset Management’s award-winning strategy team. The MSCI World Index dropped almost 10% in dollar terms, making it the worst May for this index since it began in 1970, and the worst monthly performance since February 2009, which turned out to be the final death throes of the great credit crisis bear market, the darkest hour before the dawn.

The worst country casualties, unsurprisingly, included the Eurozone countries whose debt problems have been so much in the headlines; Greece down 19%, Ireland 13% and Spain 11% in local currency terms. It turns out however that the falls in Asia were much greater: China’s Shanghai B market was down 16% and the Nikkei 225 down over 11%. The best performing markets year to date, as at the start of the month, more surprisingly, are mid and small cap stocks. Both the Russell 2000 and the FTSE 250 are still ahead year to date.

What is easily overlooked, of course, as with any short term data set, is that the recent falls in equity markets followed an exceptionally long and sustained period of market gains from February to April, with the S&P 500 rising for something like ten consecutive weeks, a most unusual trend. To use the jargon of the technical analysts, markets had become highly oversold. To that extent May’s falls were no more than a necessary and overdue correction.

However it seems clear that, just as Anthony Bolton predicted six months ago, equities are likely to be pushing against headwinds for some weeks yet. News will continue to be dominated by crises of one sort or another. The earnings upgrades that have helped to drive the markets higher are petering out. Valuations appear to have priced in a lot of future recovery already, with the MSCI World index trading on a p/e of 13 and a dividend yield of 2.7%.

Nevertheless the scale and strength economic recovery around the world continues to impress seasoned market-watchers. Few fund managers have navigated the crisis of the last three years better than Jonathan Ruffer and his team at Ruffer Investment Management. To quote a recent note of theirs: “One of the by-products of the tumultuous events and the private sector bail-outs of the last two years has been a massive transfer of risk from the private to the public sectors”.

“In part it is precisely this factor which has enabled equity markets over the past year to display a raffish insouciance in the face of so many outstanding problems and risks; with risk being largely socialized and a negligible cost of money, the measures that the corporate sector has taken in terms of inventory liquidation, labour shedding and capital spending cuts means that its present rude financial health stands in stark contrast to the groaning public sector deficits on view across the globe”.

They go on: “While we never try to time markets, it does not seem outlandish to say that the next few months will see risk assets move into the departure lounge from the ‘sweet spot’. Improving economic conditions, which we fully expect, will bring into sharper relief the need for ‘exit strategies’, with a likely reduction in liquidity available for investment in financial assets”.

“Further sovereign bond crises, accompanied by default risk, may erode the valuation basis for equities. Meanwhile, even if the UK is an acute case, inflation is regularly outpacing forecasts and will prove indeed to be part of the solution. After the relative ease of the last twelve months, protecting capital and generating real returns is about to start getting more difficult again”. We shall see.

A LOT of headlines have been generated by the European School of Management’s report into hedge funds.  The main findings are that hedge fund investors chase recent past performance and merrily buy into investment styles that have been working well recently regardless of the huge differentials in risk that different styles entail. 

The researcher, assistant professor Guillermo Baquero, concludes: “These results raise serious concerns about investors’ ability to make the right allocation choices and suggest that increasing investor protection and curbing unnecessary risks and speculative activity of hedge funds should be a priority for regulators”. 

I am not so interested in the regulatory issues. It has always been my view that hedge funds are not appropriate for retail investors, and should remain what they once were, namely largely unregulated vehicles for professionals and consenting wealthy adults. There is plenty of evidence to suggest that a small minority of hedge funds, if you are lucky enough to find the ones with real talent, are proven and consistent wealth-generators.

The majority, however, charge too much for what they in practice deliver, and their risk profile is skewed far too heavily in favour of the managers to make them prudent investments for most investors. Illiquidity too can be a problem, as became all too evident during the credit crisis. It is no real surprise that there has been a lot of pushback on the level of fees since the crisis. To blame them for causing the crisis is quite wrong however.

What these new research findings do show clearly, as many of us have long suspected, is that hedge fund investors are really no different from investors in general. They may be richer, and more sophisticated in other ways, but at heart they make just the same old mistakes - too greedy for results, too short term, too hyper-active, too blind to risk.

A SURVEY by the Association of Investment Companies names the top 20 investment trusts of the last decade, as measured (a) by their absolute returns and (b) by the consistency of their performance. Top of the list on both scores, gratifyingly, comes a trust that I own, Blackrock World Mining, which has returned an impressive 811% over the past decade and outperformed the average investment trust in eight of those ten years.

It is followed in the rankings by Fidelity European Values (once run by Anthony Bolton, but for most of the period in question by his successor Tim McCarron) and HgCapital, the private equity fund that spun out of Mercury Asset Management some years ago. (This is another fund which I happen to own, having bought some shares last year). The table of supporting data is worth looking at, although purists would argue that it suffers from taking no account of risk, gearing or volatility. A table of risk-adjusted returns would show some significant differences, as indeed would a table constructed on the same basis 12 months ago.

As a long term investor in investment trusts, the main message that I take from the survey is that identifying the big long term themes in the investment world and letting them run their course through a shrewdly managed, low cost vehicle is a much easier way to make money than furiously trying to pick winners over shorter periods of time.  Blackrock World Mining is a play on the commodity cycle. A good number of the other trusts on the list are essentially beneficiaries of emerging markets in one form or another, which has been the other big story of the past decade.  In a decade when the equity markets have produced little return overall, it is also noticeable how well some smaller company funds have continued to do.

AT A ROUND TABLE discussion I chaired for Spectator Business magazine last week, to be published shortly, a key theme on which all the participants agreed was the need for the new coalition government not to make a mess of the recovery by bungling the proposed Capital Gains Tax changes. As it happens, there is a powerful blast on the subject in this week’s Spectator from Art Laffer, inventor of the notorious Laffer curve. Economists may not be able to agree whether or not the Laffer curve is valid, but the general conclusion seems compelling to me. The way that the government crafts its CGT proposals is going to be a critical test of how far the new Government is hampered by the need to make concessions on tax to its own coalition partners.

THE THOUGHTS of Canadian investment strategist and commodity bull Don Coxe on the markets (from a recent conference call with clients): “No new bear market — we are going to have a correction here, but the global economy is still growing, but not as fast as the optimists would have hoped, and I don’t believe we can have a true bear market as long as liquidity is being supplied by the central banks at virtually zero cost. So much of that liquidity was misallocated before, but gradually as the economy grows it will be able to absorb it in actually productive activity”. I hope Don is right. Marc Faber dug out this apt quote from the US founding father Thomas Jefferson for his most recent monthly market commentary: “I predict future happiness for Americans if they can prevent the government from wasting the labours of the people under the pretext of taking care of them”.

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Q and A: Richard Oldfield

Richard Oldfield, the subject of our latest Q and A, is the founder and chief executive of Oldfield Partners, a privately owned investment management firm with $2.8 billion under management, invested wholly in equities “on a concentrated, value-focused, index-ignorant basis”. He is largely unknown outside the professional world, but highly regarded within it.

Before founding Oldfield Partners in 2005 he was for nine years chief executive of a family investment office. He is chairman of the Oxford University investment committee and of Keystone Investment Trust plc, and the author of Simple But Not Easy, a “slightly autobiographical and heavily biased book about investing”, first published in June 2007, which I strongly recommend and praised in The Spectator.

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

We are torn between the extreme gloom about the problems of the public sector and enthusiasm for the new strength of the private sector, with strong cash flow and balance sheets and evidence of much improved demand, and valuations which are not too high. On balance we think it is positive for equities (which is a bias, but not an invariable bias, of ours).

Is the crisis in the eurozone over yet?

I think the outcome is resting on a knife-edge. On balance my sense is that the crisis will pass, and the euro will survive, at least for now. The stakes are too high for governments to let it go. I have always said however that the euro was unlikely to survive for more than 15 years, and I stick to that.

All that talk of the euro becoming a new reserve currency can be discounted. It isn’t going to happen. Central banks are not going to be rushing to buy more euros if they think they might be getting drachmas instead. On that basis that the euro does survive for now, however, that should mean we get a decent market rally.

What is the best approach to adopt in this kind of market?

The cushion of comfort is very important: risk is high. Investors need to be sure they have enough in low-risk assets so that they will not fret too much about the higher-risk ones. But once this cushion of comfort is determined, a different figure for every investor reflecting not only circumstances but temperament, investors shouldn’t be too shy of holding equities.

The answer I think you are begging with this question is “buy and hold is dead – do we need a trading strategy instead?” I am not too sure of that. The time to be skeptical of buy and hold was, in hindsight, in 2000 before equities gave a negative return for ten years.

Now, on the contrary, buy and hold may be a little hairy – hence the importance of the cushion of comfort – but the odds of an average to above-average return over the next ten years seem to me to have risen, particularly with quality stocks which really are for tucking away for the long term.

What opportunities do you see? Are there any striking valuation anomalies?

Not many major anomalies at the higher level – sectors or country. Japan though is cheap and maybe now the catalysts to this cheapness getting recognized have increased – a weaker yen, and a government determined to stimulate consumption. Quality equities, by which I mean major companies with low debt, strong cash flow, relatively unvolatile earnings, and high return on equity, do look good value.

There are plenty of anomalies, we think, at the stock level. Some excellent companies are becoming extremely cheap. The only question is whether the good companies in the private sector are going to get crushed by the public sector. On balance I still think that is unlikely.

Please give some examples of stocks you have been buying and why?

The most recent purchases this year have been Fiat and Hitachi, both based on the sum of their parts. Hitachi has been a dismal story, but there are signs at last of management change to sort out this amorphous conglomerate, and the stock is extraordinarily cheap.

Fiat is only the fourth car company we have bought in 30 years. Car companies are terrible – high debt, highly cyclical, usually union power – but in return for their terribleness there is occasionally huge upside and we think we have it here.

What would you avoid (or go short of) and why?

We would continue to be wary of China.

What are your thoughts on gold, bonds and property?

Gold: having been a bull for the last ten years, I am now wrongly somewhat more skeptical. The conditions still appear classically good for gold, but everyone is already there. On bonds, I am afraid, we are entirely consensus in being negative. Property – no clear view.

If you had just one moneymaking tip for this environment, what would it be?

But we don’t (and, seriously, we don’t believe in having one good idea; we think a portfolio should have a lot of decisions at play in it). Don’t stray too far from your comfort zone is the most important thing.

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