7th December 2016 | Eoin Treacy

Speaker key

Nick O’Connor – Host – (NO)

Tim Price – London Investment Alert, The Price Report (TP)

Eoin Treacy – Frontier Tech Investor, Trigger Point Trader (ET)

Charlie Morris – The Fleet Street Letter (CM)

Akhil Patel – Cycles, Trends and Forecasts (AP)

PART ONE

STAGFLATION, RISING YIELDS, VOLATILITY DEAD AHEAD AND EUROPE’S POLITICAL NIGHTMARE

In which we discuss whether bond yields and inflation will keep going up, whether we’re on the road back to the 1970s, why you need to prepare for volatility and a nightmare year ahead for Europe’s political elite

I’m already feeling slightly overwhelmed by the amount of financial firepower in the room, so let’s just get straight on with things.  This is a question for everybody.  There’s a growing consensus in the markets and the financial world in general, that next year will be defined by two things; rising inflation, and rising bond yields, or falling bond prices.

To what extent do you think that’s a reality?  Or is it, perhaps, an example of group think?  What does everybody think of that?

TP       It’s the reality now, so I think future historians are probably going to put the blame for the death of the bond bull on the election of Donald Trump.  But the reality is bond yields started backing up during the course of the summer. So if this is the turning point of the super tanker in debt, it’s, A, been a long time coming, and B, it already started to turn long before the Trump election.

The consensus probably is that you’re going to see rising yields.  That may or may not turn out to be the case.  The guy hasn’t even taken office yet.  But from a personal perspective, the bond bull is now over. 

ET       I would say that I’m fully in agreement, but I would even question whether there is a consensus.  I was just reading Jeremy Grantham last week, where they made what appeared, on the face of it, to be a compelling case that I’m sure lots of people agree with, that the discount rate would never rise. 

And I fully believe they’re 100% wrong.  That perhaps that is the greatest consensus of them all, that people have been investing for a decade on the basis of having practically a zero discount rate.  And if you’ve got a zero discount rate, everything else can go up in value.  As soon as rates start rising, then that throws that entire paradigm into question.

So I would question whether there is really a consensus at all, because if you have a bond portfolio, the worst thing you could have done is to pre-empt rising rates in the last decade, and therefore, there’s going to be a lot of people who are behind the curve on this, really a lot of people.

NO      Charlie, what do you think about that?  Because when we spoke a few weeks ago about rising inflation, rising bond yields being key themes that you were playing as part of you portfolio in the Fleet Street letter, do you see it as the end of the bond market bubble?  Are we talking about something more long-term, or a short-term trend? 

CM      A bit of both.  Let me clarify, so the first point is that this has been a major theme, really on value grounds.  Without getting into the macroeconomics, quite simply, bonds were massively overpriced, and when yields are at nothing for ten years, that really doesn’t make a lot of sense.  So at some point, investors are going to reject. 

And you’ve got to think why bond yields would go up.  And there were three main reasons.  One of the reason is inflation.  You need to be protected against future inflation, to lend money to a government.  The second is it causes economic growth, so there are exiting things to do with money, rather than park it in safe havens.

And a third is creditworthiness, whether you believe or not that the government can pay back that money in the future.  And I think that we’re not at the point of credit worthiness, as much as the internet would like you to believe that that’s the case.  I don’t think that’s the case in the western world quiet yet; it may come in the future.

So I think we’ve really got two things here.  One is the fact that inflation expectations are rising.  They’re probably not going to rise as much as people think, and I think that a lot of the expectation is already in the price. 

But the other side of it is the economy recovering.  Now, I do believe this part of the equation is real because in 2009, we had this very, very strong recovery after the crisis in financial markets, and yet the man on the street didn’t really feel it.  And here we are, seven or eight years later, the stock market hasn’t got so much to look forward to, the bond market’s really got nothing to look forward to, but the man on the street has.

So the wealth gap closes under the new populist ideas.  We don’t like that word populist, but you get the trend of Brexit, and Trump, and so on.  And I think the man on the street gets a pay rise, it’s as simple as that.  And that’s not so good for financial markets.

NO      I’d like to know what everybody thinks about that, because there’s certainly been an awful lot written in the financial press recently about Trumplation, and expectations of inflation rising.  To what extent is that an accurate perception?  Is that overblown, or do you think, perhaps, inflation could surprise by going up higher than people are anticipating at the moment?

ET       There are two important statistics.  One is China.  Chinese producer prices have been rising all year, and went to a new five year high in September.  So if prices at the factory gate are rising in China, if they can export deflation, they can most certainly export inflation.

We can anticipate that the price of consumable goods that we’re buying from China is going to rise, therefore that would contribute to inflation.  But on the other hand, we also have rising wages.  Wages broke out last year.  They did nothing in the US this year, but they broke out again just last month. 

The Fed raised rates immediately after wages broke on the upside last year.  They just broke out, they’re going to raise rates again in December.  On top of all of that, an increasing number of cities in the US are implementing $15 minimum wages.  That is considerably above where we are now.

It isn’t about the guy in McDonalds, making $15 for flipping hamburgers.  It’s about the guy who used to make $15, doing a different job, when somebody at McDonalds is making $15, what is that guy going to want to make?  Then there is this domino effect, in terms of demands for wage growth. 

And the other factor is that everything else has gone up in price, and there is no respite in higher education costs, higher insurance premiums.  So I’m not sure at all that we’re going to have massive improvement in standards of living, but I think we could certainly have higher inflation, so we might have a recipe for stagflation. 

AP       I think it’s quite easy now to attribute a lot of trends that, perhaps, were emerging in the earlier part of the year to the seismic event of the Trump election.  To my mind, I think markets shifted sentiment, probably fairly early in the year, at the point when everyone was talking about negative yields and prolonged deflation.

And I think that was at the point at which things actually started to turn around. 

I would say just from a long-term cycles point of view, which is probably where I have more to contribute, at this part of the property cycle, you certainly see this much more clearly in the US than perhaps you do in Europe, you are actually expecting inflation to be rising, and also interests rates to be falling. 

Usually, the Federal Reserve is somewhat behind the curve, and so maybe they’ll look for signs of wages going up, and commodity prices going up, and so on, and then start to raise interest rates.  They’ll certainly want to be looking to ensure that the yield curve doesn’t get too steep.  So I think that we will see, over the next couple of years, both rising inflation and rising yields.

NO      Moving on ever so slightly, there’s another idea forming at the moment, which is that one of the outcomes of the Donald Trump election, and to a lesser extent, what we saw with Brexit, was that that’s a repudiation of the status quo.  Not just politically, but also in terms of monetary policy. That it’s failed, because we’re seeing such antiestablishment votes.

So, Tim, do you think the focus now is going to shift back towards fiscal policy, government spending, rather than just central banks printing money up and pumping it into the system. 

TP       I think that’s exactly what the consensus is.  Not just in the States, but particularly in the States, it’s now broad expectation that Trump is going to splurge money on infrastructure, there’s going to be tax cuts, and potentially, all kinds of tariffs brought in.  So the net impact of that is probably too complex to parse exactly. 

But the figures that I saw before the election itself, were that if Clinton’s plans were going to add an extra several hundred billion to the US national debt, Trump’s were going to add more than five trillion.  So the impact on the debt market was quite clear, assuming that he implemented what he was talking about during the course of the campaign.

But it’s a global thing, so there’s an expectation, I think, everywhere that, A, as you say, central bank monetary policy has conspicuously failed.  So the attempt to trigger inflation through QE has uniformly been a failure.  And secondly, then, the government will have to step in with its size 12 boots, and do the job through bridges to nowhere, and all the rest. 

Eoin, I think, used what I would say is the pertinent risk work for the next year, which is stagflation.  I think there’s a big risk of stagflation now.

NO      So just explain a little bit more about what that might mean.  If someone’s never hear the term stagflation before.

TP       In a sense, it’s back to the 70s.  I’m a child of the 80s, so I’m a bit too young to have experienced the 70s meaningfully, from an economic perspective.  But stagflation is, effectively, a combination of stubbornly low economic growth, but stubbornly high inflation.  And nothing that I’ve seen to day out of what’s happening in the US, leads me to believe that that’s not a likely outcome.

Again, maybe it’s not an issue of, say, inflation.  Maybe it’s just volatility, maybe that’s the word that we use.  What we can expect out of the next year is much more volatile asset markets.  Much more volatile currency markets.  Much more volatile interest rate markets.  Much more volatile stock markets. 

Financial markets are normally pretty good at pricing in, say, economic activity.  They are conspicuously poor, and we’ve seen this twice during 2016, they are conspicuously poor at solving for politics.  So pretty much overnight, twice now we’ve had markets trying to absorb the impact of something that was never ever foreseen. 

The Brexit vote came out of a clear blue sky, as far as most people were concerned.  Happily, not for MoneyWeek, but for a lot of conventional media.  And then Trump is, in his own words, Brexit times ten.  And the markets are trying to process all of this stuff, but it’s a lot to process.  The implications are huge. 

ET       I think the biggest implication, if you think about it, before 2008, we had a period of synchronised global economic expansion.  Then we had a period of synchronised global monetary expansion. 

And with the political timetable, such as it is, in Europe, where you have the Italians voting on the 4^th December, you’ve the Austrians having their presidential election on the same day.

You’ve got the French having their presidential election, the Dutch having a presidential election.  Then there is the Hungarians having theirs.  So there is lots of fun to be had, and all they need is just one country within the Eurozone to say; all right, we’ve had enough.  And it puts the entire programme under incredible stress. 

What’s the answer to that?  Because the one thing you can depend on any bureaucrat to do is to ensure the sustainability of their own job.  So they are going to abandon their entire fiscal framework of forcing everybody to abide by their rules, and that could, then, mean that we go from a period of monetary stimulus to a synchronised global fiscal stimulus. 

And it isn’t just that we’re going to have deficit spending in the US, or the UK, or China, but everywhere.  And then that would be inflationary for asset prices, but probably not for standards of living.  So stocks could go up, property prices could go up, but then bonds would obviously not do very well.

CM      May I have a go at this question?

NO      Yes, go on.

CM      Stagflation.  What is stagflation?  I think we will see it, but then again, we’ve already seen it just without the flation.  What it means is very easy money, but what we’ve had is very easy money at low interest rates with low inflation.  We’re about to have very easy money at higher interest rates of inflation.

So the real interest rate won’t change very much, but the numbers in the curve just go up a notch.  So it feels like there’s a wealth effect going on, because actually, the economy is growing, just not in real terms; it’s growing in nominal terms.  So you can have lots and lots of economic activity, lots of copper needs to be dug out of the ground.

People have jobs.  But actually, the wealth divide just corrodes.  And the world needs this.  It’s ready for it.  And actually, if you’ve got someone in the treasury who’s good at their job, then the debt to GDP ratio for the economy can come down over this process.  It’s not easy, but it’s possible, and it certainly happened in the 1970s, which was the last example that we can see with some sort of common similarity.

But it’s a long way between here and the 1970s.  We had low interest rates in the 50s.  It was 20 or 30 year journey before we got to this.  So yes, I agree with a lot of what’s being said, but I think the timetable could be somewhat slower than the reaction we’ve had in the two weeks since Donald Trump was elected.

Now, if we take this idea and put it into Europe, it’s actually far more interesting, because it just can’t work.  Quite simply, the monetary policy, whatever it takes of 2013 from Draghi, what that did was hold the Eurozone together for a while because of compressed bond yields. 

Of course, we go back to this idea that a Portuguese or a Spanish bond isn’t quite as safe as a German bond.  And that’s because the Deutschmark is suppressed, and the peseta is overvalued, and all of this kind of stuff.  We know this argument well.  But if you take away the monetary stimulus and replace it with fiscal, then I think the bond market goes nuts.

And so I can’t see how Europe can play this game the same way that Britain or America can.  Can I have Tim’s word on that?

TP       I agree.  I think you’re right, if by nuts you mean it’s a disorderly and not positive development. 

NO     The next logical question would be; what are the chances of initially seeing a large fiscal expansion?  So for instance, today, in the Autumn Statement, the Chancellor announced a something like £23 billion infrastructure fund.  Which is, admittedly, not lots of money on a global scale.

But, say you create a vehicle like that as part of an expansionary fiscal policy.  Do you not, then, six months later, get the Bank of England stepping up and saying; we’ll put money into that, or we’ll print money and buy bonds in that, so you essentially get both happening at the same time?

TP       Isn’t it more meaningful getting the private sector to participate, though?  Because everyone’s sick and tired of the central bank printing money to do stuff.

NO      It might be more meaningful, but is it more likely? 

CM      George Osborne tried to get the private sector to do £20 billion of fiscal, I think it was £20 billion, and one billion turned up.  So it’s actually quite difficult. 

ET       If you go to the private sector and say; right, lads, we’ll give you a 15% corporate tax rate, in return for which you will invest in the fiscal…  You’re talking about new deal kind of stuff.  That’s really what you’re talking about.  You give the corporate sector a carrot, and if the carrot is sufficiently large enough, not least because particularly US corporations have got trillions of dollars parked overseas, then that is a nut to crack.  It’s not a question of if, it’s only a question of how. 

NO      The final part of that question was; is that not a road down which we get to helicopter money, to direct monetisation of fiscal policy?  So it’s helicopter money by the back door.

AP       It’s sort of a QE for the people, though, which was the idea that I think Jeremy Corbyn was hinting at when he first became leader.  The idea that the central bank can create the money that’s required to invest in physical infrastructure.

In reality, from my point of view, the way that I look at the money supply, that’s doing fiscal stimulus at zero interest, as opposed to private banks creating the same amount of money, but lending it to the government at several bases points above gilts.  In fact, I think it’s actually quite a rational way of investing in an economy. 

The reason that it’s not treated more seriously is actually because I think there’s a fundamental misunderstanding about how money is created in an economy.  It’s almost entirely created by private banks through their lending activities.
ET       There is also an argument by the technology sector that because technological innovation is happening at such an incredibly fast rate, and that it is, in fact, exponential in terms of how quickly things are going, that there is an increasing argument amongst people in Silicon Valley that there should be a universal income. 

So rather than having food stamps, but rather, to ensure that everyone has a fair income.  Because as so many jobs are literally disappearing as a result of technological innovation, and that new jobs are not being created as fast as old jobs are being destroyed.  So there is going to be an increasing argument about that, about creating some sort of universal income for people that will allow them to survive. 

And it is totally anathema to the way that the system works at present.  So we’re going to see massive evolution, both in technology, and there’s going to have to be a fiscal monetary policy response as a result.

CM      Does that mean that I don’t have to work hard and still I get paid? I’ll sign up.

ET       No.  It’s going to be more like we’re going to ensure that you can pay the lights.  You can keep the lights on, and you might be able to have one beer a week.  But if you want two, you’re then going to have to work terribly hard for it.

PART TWO

THE GRAND CYCLE: PROPERTY, STOCKS, CREDIT CREATION AND THE RHYTHM OF HISTORY

In which we discuss the property cycle, what’s next for the banks in the UK and Europe, why biotech has lead the stock market post-election and why Charlie is avoiding gold.

NO      Perhaps we’ll leave universal income to one side just for now, because I just wanted to go back to something you were talking about, Akhil.  So if you’re unfamiliar with Akhil’s work, it’s probably because it’s one of the most recent publications we’ve launched, it’s called Cycles, Trends, and Forecasts, and Akhil is at the helm of that.

So at the heart of that product is… well, it would be better if you told us about the idea that was at the centre of that, rather than me rambling on about it.  Why don’t you tell us a little bit about what that product’s about, and how that relates to things, like infrastructure spending, and house building, and things like that?

AP       Well, we deal with quite a number of themes in Cycles, Trends, and Forecasts, but the primary one is the idea that if you go back over some 200 or more years of history, you can see a very clear cycle in operation in the property market.  roughly around 18 years, but actually, with surprisingly little variation.  That’s the first idea.

And so, I suppose, many of your readers are themselves property investors, so I think it’s useful in that sense.  But the second aspect of it, and I think this is even more important, is that because of the way that our economies are structured, the economic cycle follows the property cycle.

In fact, if you go back over the same period of history, you can see that the behaviour of the bond market, interest rates, government policy, asset prices, commodities, have certain rhythms, which fit into that overall 18 year process. 

NO      Tell us where we are right now, in terms of the cycle.  Are we at the start of the cycle in property prices?  At the end?  Somewhere in the middle?  And what would you expect to be seeing in the economy that would point to that being correct?

AP      As I said, it’s an 18 year process.  I know that the idea that there are fixed cycles, and it repeats, time after time, despite very different macroeconomic conditions, and government policy, and international relations, etc.  It’s a bit of a weird thing for a lot of people to digest.

I’m purely doing it on the basis of what the historical record shows.  But essentially, during each 18 year process, you tend to have expansionary phases lasting, on average, about 14 years.  And then a major collapse, recession, depression, stock market collapse, property market downturn, etc.

The last equivalent four year period started around 2006 in the US, 2007 in the UK, and ended in around 2010, 2011.  So we’ve had a recovery in the property market since then.  I think most people would agree.  You look at the chart of the UK house prices, across the board, they’ve started rising again.  In London, more so.  The economic recovery tends to lag the stock market and the property market. 

But at this part of the cycle, banks have, to a large extent, unwound all the credit that they created in the last cycle, and are getting their balance sheets to the point where they can start lending into the economy again.  One of the reasons, and I think the primary reason why growth has been so low in western economies over the last five or six years, is because banks have not been lending into the real economy. 

Now, with a steepening yield curve, with fiscal stimulus, as Trump was saying in the United States, loosening restrictions on bank lending activity, I think you’ll start to see a reversal of a lot of those trends.  And therefore, I think growth will pick up, and will drive the cycle forward. 

NO      So you’d expect to see rising house prices and good news for the banks, which would be the distributors of any money that’s being created?

AP       Yes.  It takes time for the cycle to build.  We’ve still got, to my mind, at least another ten years to go.

NO      Ten years of rising prices?

AP       Of rising prices.  It’s not going to be straight up for ten years, of course, nothing ever is.  And there are things that come out, which knock the cycle off from time to time, but not so much to fundamentally interrupt it or actually knock it off course.  The only thing that we’ve found in about 200 years of history is the two World Wars, the only things that have really derailed the cycle. 

But as it happens, interrupted it for a time, and after the Second World War was over the reconstruction of Europe, and the baby boomers being born in the US, the cycle reasserted itself.  So rising property prices, interest rates will start rising, so will inflation, but I don’t think it will be particular high, certainly by historical standards.

If you get fiscal stimulus with a lot of construction, you’ll probably see an uptick in commodity prices, as well.  I think this will all take place over the next couple of years. 

NO      I hope you wrote all of that down, and you can keep score over the next few years.  The reason I asked you about banks is primarily because it chimes with an idea both Eoin and Charlie have been writing about recently.  Both of you, in the last couple of weeks, have been moving in to buy the banks in America and in the UK. 

I don’t think anyone’s bought a European bank yet.  Charlie, you had quite an interesting idea that you shared with me a while about why banks are a good buy when bond yields are rising and prices are falling.  How was it you put it?  A bank is the opposite of a bond.  Is that why you’re moving on banks at the moment?  Is that the motivating factor, that yields have turned around?

CM      Yes.  You’ve got to consider the regime, which works for financials, above and beyond most other regimes.  And certainly, they’re not necessarily great fans of inflation.  Ask the Zimbabwean banks when there was inflation there.  But they’re certainly a fan of a steeper yield curve and rising interest rates, because they can pass the cost on, it increases their lending margins, and it’s a very simple argument. 

Also, if you take the view that a rising bond yield or a steeper yield curve is a sign of economic recovery, which I believe it is, then that’s also good for banks, because that’s actually what they need.  They don’t want a recession.  Why is there an economic recovery?  It’s been mentioned a few times. 

It’s tax cuts.  If you want more growth, the quickest and easiest way to instantly deliver growth is to cut taxes.  There’s no better technique.  Fiscal spending, QE, all of it, clever tricks, there’s no better policy than cutting taxes for people to go out and spend money.  So I do think that you’re going to see that in America, and that’s got people very excited.

It’s probably one of the reasons why the stock market in the last couple of weeks has been so strong in the States, because they’ve got that pledge of tax cuts, which we haven’t got over here quite yet, or ever, possibly. 

AP       And a lot of that upside in the US was driven by bank stocks, which I think are starting to potentially price in future earnings. 

CM      Banks, industrials, and biotechnology.  Everything that got saved from Hilary. 

ET       There are two very salient dollar points that are very much in favour of banks, one is they’re cheap.  They are a sector that was absolutely decimated during the financial crisis.  Only a very small number have done well since then.  And by and large, the sector has been under a cloud for a decade. 

Then why was it that so many people owned banks before the crisis?  It’s because they pay good dividends.  And they’ve been totally constrained from increasing their dividends because of having to pay back governments, trying to rebuild their balance sheets, complying with regulations. 

So they haven’t been able to pay dividends, but interest rates are rising, that’s good for margins.  Then there is a prospect of deregulation, which improves margins, and if margins improve, and business is better, and people are spending money, then banks will increase their dividends.  So they’re cheap, and they have the prospect of increasing dividends. 

Therefore, they are something that is like a unicorn in the current market, that they are both a growth and a yield play. 

NO      Actually, I think it was a couple of days after the election in the US, Eoin, that you published to readers of Trigger Point Trader something you called the Trump portfolio, which was, essentially, made up of banks and biotech stocks.  You’ve explained the bank side of that.  What was it that motivated you to get into biotech? 

ET       Biotech, I liked to begin with, and I’ve been a big fan of biotech for upwards of five years.  But it was a dangerous place to be in when there was a high prospect of Hilary Clinton getting in, because one of the things that both she and Bernie Sanders were doing were taking pot shots at these small companies.

If you’re a biotech company, you’ve come up with a new innovative product that has got a revolutionary impact on your client base.  Your sales aren’t very large to begin with, therefore, the price is high.  And that is quite different from a pharmaceutical company buying an old patent, and then checking up the price of a legacy drug. 

But that distinction is not convenient for politicians.  So they were taking pot shots at these really small companies with fantastic growth stories.  And because the Democrats did not win, and because Trump is in, and because he very clearly said that he doesn’t have a problem with high priced drugs, well that is just a green light for the growth story to get a new lease of life.

So I think that biotech, and not least because it is all about technological innovation, and targeting one of the most inefficient sectors in the world, which is healthcare.  And if we are going to solve the world’s problems, if we are going to get to a point where we’re going to reduce the cost of living for al to of people, then tackling the cost of healthcare is a massive question.

And it is in the biotech sector, that the real cutting edge of that kind of research is going on.  So it is something that we definitely have to keep an eye on.
NO      Just moving on again, we’ve talked about the banks, Eoin, you’ve been looking at the banks in the USA, Charlie, you’re backing the banks here in the UK, the elephant in the room is European banks, and the European banking system as a whole.  So, Tim, you’ve recently been warning our readers about the threats posed by the European banking system, particularly regarding Italy. 

Could you tell us a little bit more about that, and also what exactly it is you’re looking out for next year for signs of it deteriorating? 

TP       I’m a huge fan of Italy as a tourist destination, so every year, my partner and I go off to Italy on holiday.  I’m a fan of Italy as a holiday destination, but not as an economy, an not as a financial system.  There are, apparently, more bank branches than pizzerias in Italy, I’m led to believe, which suggests that it’s one over banked market.

And they all have a problem with their non-performing loans.  None of the banks appear to be marking their book to market.

NO      Explain exactly what that means. 

TP       Effectively, as I see it, and I have no dog in the fight, so it’s not like I’m betting against them, but after Lehman failed in 08, and we had the stimulus and all the rest, the US largely recapitalised its banking system.  The UK partly recapitalised its banking system, and the Eurozone did precisely nothing.

And those chickens are starting to come home to roost now.  So I think these figures are broadly correct.  The Italian economy hasn’t grown in a decade, it’s just flat lined.  So it’s not exactly the most robust part of the European Union.  But bankers made a lot of bad decisions, and a lot of loans were extended that never should have been.

And if they want to try and offload those now, their real value is way below what they’re currently pricing them within their portfolios.  So this has been this game of extend and pretend, or mark to make believe, or mark to myth, used to be the language in the market back in the crisis. 

There’s only so long you can keep kicking this can down the road, and Eoin mentioned earlier, the elections.  We’ve got Renzi, who’s putting his country to a referendum on economic policy in a month’s time.

ET       The 4^th December.

TP       He may lose that.  That may be just one of the first shoes to drop.  If it’s not that, I think, as Eoin as implied, it’s going to be something else.  So the Eurozone is a gigantic mess, that’s made no real attempt to put its house in order for nearly a decade.  That is a shocking state of affairs from any perspective.

ET       And I think, in Italy’s case, it’s even more fun than that, because when I was going to visit Italian banks a decade ago, the best selling product that they were selling to retail investors were reverse convertibles, and they were selling them into retail products. 

NO      What is a reverse convertible? 

ET       A reverse convertible is very simple.  It is a bond with an implied put off.  So if the bond is going badly, then the bank can choose to convert the bond into equity, and that equity could be worth close to nothing.  So generally speaking, by buying something like that, you’re given a very high yield, but the yield couldn’t possibly be large enough to compensate you for the risk you’re taking on from the kind of issuer that would issue that kind of bond.

But the problem, of course, is that they were hot sellers in a falling interest rate environment, and there are substantial quantities of these kinds of very, very leveraged products in the retail sector.  Now, here’s the big question.  What happens when the EU created a rule on the 1^st January this year?

They said; right, we think what we did in Cyprus was a great idea, that we should bail in the deposit holders, and then, and only then, even consider bailing out the banks.  And you can do that with a small country.  You can bully Cyprus.  Italy is not a small country.  Italy is one of the founding members of the EU. 

Now, the Italian banks, as Tim said, are in serious trouble, and now here is the question; what does the EU do when an Italian bank fails.  Do they stick the rule that they created on the 1^st January this year, and say; no bail outs?  You must bail in all those little old ladies who bought the reverse convertibles.

Or do they break their rule for a big country, that they imposed on a small country, and therefore, give ample evidence to everybody who suspects that it is nothing more than just a giant despotism, rather than any kind of democracy or equality, and just cave?  So this is going to be a huge crisis of consciousness for the entire Eurozone. 

Because if it is really just one Eurozone for the big countries, and quite another for the small ones, then why should Portugal stay in?  Why should Ireland stay in?  Why should Slovenia stay in?  Why should Hungary, or any of the Baltic states stay in?  Because they’re going to get short shrift in any kind of crisis.  That’s the big question.
CM      Eoin’s just given us a very good example of an EU regulation, and that is why I voted Brexit.

NO      Amongst all the things we’ve been talking about, there’s a difference emerging between the way you’re talking about Britain and America, and what’s going on there, and then the situation in Europe.  It feels like they’re worlds that are going in separate directions. 

So if you’re looking at a grand cycle, is that a worldwide thing?  Is that just a UK market, just an American market thing?  And if it is worldwide, how do you reconcile the idea with the fact that we seem to be getting these very different responses?

AP       I think there’s probably not enough historical evidence in many countries to say definitely that it’s a worldwide thing.  But any economy that is structured in a similar way to western economies, in other words, what I describe in the newsletter as the private capture of economic rent, and allowing that to capitalise into a price, and then to be traded, in the most obvious case, in the land market.

You get real estate cycles.  I think what we’re starting to see is that there are, maybe, two main groups of countries following their own timing.  One is the US led group of western economies, predominantly.  And when they went down in 2006, 2007, 2008, it was a massive financial crisis, which affected the whole globe, but eastern economies, for example, recovered much more quickly from that, because they were, to my mind, in a very different place in the cycle. 

East Asian economies had an equivalent major, major financial crisis in the late 90s, and what’s not so well understood, I don’t think, about that was actually, there was rampant property speculation in the years running up to that.  It was a genuine real estate led depression. 

The impact in the 90s wasn’t quite as great on the rest of the global economy, though it did cause financial markets to sell off rather dramatically, in 97 and 98.  There’s not enough historical evidence to say whether that repeats at the same 18 year period as yet.  Many of these economies, particularly after the colonial era, are relatively new, and they’ve got an enormous amount of development still to go.

And you tend to find when there’s so much latent capacity within an economy, it’s very fast rising incomes, a lot of people joining the middle class, that you sometimes can get through these blips rather quickly.  A good example of that from the Second World War onwards is actually Japan.

So you didn’t really see the emergence of a major real estate led crash in Japan until 1990, but they had several periods up to that point, where there was a recession, and then they recovered quite quickly.

NO      Charlie, you told me a few weeks ago that no good portfolio has just one theme.  It doesn’t take just one theme in the economy, there are two, or three, or four, and you make sure you call it theme diversified.  Assuming you still think that’s the case, what themes are you particularly positioning Fleet Street Letter portfolio in, and your own money in, and other things, to take advantage of next year?

CM      Diversification is the rule of the game in this business, because we can’t be certain what’s around the corner.  So we try and be ready for a range of scenarios.  I’m trying to avoid the scenario that seems likely to go against that.  That’s the most important point there.  And it does strike me that one of the bad places to be at the moment, and why we cut our position is gold.

And the very simple reason for that is because of rising interest rates, and rising inflation expectations, which is very, very strong for commodities.  It is not so strong for gold, because what you need for that is falling real interest rates, which, with that same sort of scenario, is often quite good for growth stocks, and for developed markets, in general. 

So you’re looking at the interest rate cycle, have we got high inflation, high rates?  Possibly there’s a bit of that, we’ve seen the copper price go up.  We’ve seen one or two emerging markets do quite well this year.  But it hasn’t been that broad, actually.  Then we’ve seen tech stocks do really well, we’ve seen financials do well. 

And then we’ve seen many of the defensive things start to go wrong.  And all that evidence leads me to believe that we’ve got to be prepared for, first and foremost, a world that’s got higher rates.  Anything rate sensitive is the thing to avoid, and that’s very, very important. 

So what likes higher rates?  Insurance companies like that, because they’ve got a big float of cash, and they just put that in the bank and receive interest.  A stockbroker would be the same, they’re sitting on other people’s money.  Banks are the same.  This sort of industrial recovery favours many of the areas of the commodity market.

Oil’s been touch and go.  Yes, it was 27 at the low, and it’s slightly below 50, but it’s still a hell of a run this year.  And it could well be a longer term bullish theme.  I’m not quite so sure at the moment, but I’m certainly holding my oil stocks on value grounds.  And then other themes.

Microthemes that pop up, here and there.  For example, in The Fleet Street Letter recent report, you have to buy it to hear this name, but a very large treasure of a resaler up and down the country that sells Percy Pigs.  For example, that’s a retail portfolio of lots and lots of shops.  This is an asset play.

You’re getting a retail portfolio that trades at 2003 prices, generally speaking, so that any property boom that’s happened outside of the retail sector, because the internet’s done all the hard work there.  And if the man on the street gets a pay rise, they’re going to go and spend more money on the high street. 

These are not people who would naturally go and charge off to Silicon Valley and buy microchips.  They’re going to go and buy something from Marks & Spencer, and companies like that.  So I’ve got a number of themes about the consumer, about the financial, about insurance, about commodities.  I actually secretly like Russia. There’s a possibility that it will end up in The Fleet Street Letter, at some point. 

PART THREE

OPPORTUNITIES: RUSSIA, US BANKS, VIETNAM, BITCOIN, COPPER

In which we discuss the opportunities the world is presenting to investors in 2017, from the “enemy of the West” to the “world’s most undervalued tech stock”

NO      What makes you like Russia?  Is it pure value grounds?

CM      Yes.  The Russian stock market has done well this year, but it’s down a lot from its peak in 2007.  What you’ve got in Russia is the enemy of the Clinton, EU administration.  And that’s now changing, and you wonder; why are we at odds with Russia? 

And it does strike me that the relationship with Trump is going to be very constructive.  And it does strike me that World War Three is less likely now than had Clinton won.  The Liberals will tell you that the Democrats are the peacekeepers, but actually, I don’t think Trump is actually a Republican per se, he’s certainly not a neo con.  He’s a libertarian. 

NO      He’s an old school isolationist. 

CM      He wants to cut taxes, and reduce bureaucracy, and reduce the role of government.  And I think that he quite likes and respects the Russian superpower, and I think one of the problems in recent yeas is that we haven’t respected Russia as a superpower, and that has led to problems.  So I digress, but that’s another microtheme that I’m quite interested in for next year. 

NO      I’m interested to know what other people think of that.  So, Tim, you’re a deep value investor.  I think recently, you were moving into Vietnamese stocks.

TP       Yes.  We got a real focus on Asia, it was part of that deep value proposition.  I’m very sympathetic to the Russian story.  We own it for some of our clients, but it’s a step too far for Mr and Mrs Miggins, at the moment, because the corporate governance just isn’t there, and you’ve still got this big, long shadow of geopolitical risk.

But from a valuation perspective, you can barely get a cheaper market than the Russian stock market. So I’m certainly sympathetic.  And you can pick up decent, dare I say banking franchises.  So I have a lot of sympathy for that view.

NO      Charlie, just going back to what Tim just said, how do you approach that kind of situation, where you like the market, but you’re worried that there are risks, which are just too rich. 

CM      Very simple, position size.  In the case of The Fleet Street Letter, and I haven’t recommended Russia yet.  Readers know that I’m thinking about it, I’ve told them several times, but it’s an interesting market, and we’ll see if this thing’s credible.  Certainly, I like the macro position, not just the relationship with America, I also like the way the currency’s behaving, and the bond market’s behaving, and the real yield that it offers.

And it would probably be for an investment trust, most likely, or a fund.  There aren’t many investment trusts that you can buy for Russia in Britain.  So a fund could be an option there.  Unlikely to be an ETF. 

ET       You should buy Magnet, which is the largest Russian retailer, and by far, the closest thing to Walmart there is in Russia.  It’s transcontinental, and it’s listed in the UK. 

What I would actually look at is Japan, because I honestly believe that the Bank of Japan fully understands that negative rates was an enormous mistake.  They’re trying their very best to peddle their way backwards out of it, and the yen is weakening fast.  My subscribers will definitely know that I’m looking at Japan, and I’m really personally just waiting for an excuse to pull the trigger. 

Because I think that they have just gone back to trying to devalue the currency.  They’re definitely getting ready for a massive additional fiscal stimulus, and then that is going to have an inflationary impact on nominal share prices, which is good for us.

TP       Two other things, just on the topic of Japan, because I’m also huge Japan bull, and we’ve got a huge position in Japan we’re going to fund.  Corporate governance.  The change in corporate culture is real in Japan.  It’s not a figment of anyone’s imagination.  And the buy back activity is really starting to ramp up now. 

So it’s a tale of two economies, if you like, because in the States, you’ve got companies that are borrowing money to buy back their stock at obscene multiples.  Whereas in Japan, companies are quietly getting on with the action.  And the amount of buy backs as part of the overall value of the market is tiny in Japan, compared to what it is in the States and the UK.

So you’ve also got huge players that have been encouraged to increase their exposure to Japanese equities, including the GPIF, which is the largest government pension fund in the world.  But you’ve also got retail investors finally coming back in through things like NISAs.  This is a market.  What’s not to like in Japan?  It’s got great valuation, too.

NO      There you go.  Before we move on to a few questions, which readers have kindly sent in, one final question for everybody.  It’s just a little bit of fun, more than anything, because I think it’s interesting.  If I was to give you an envelope with £5,000 in it today, and say; you’ve got one year, I want you to go and punt it somewhere on the stock market, but I want you to get the highest return you can possibly manage. 

Where would you be looking right now?  And keep in mind, that isn’t the sensible thing to do with your money, so this is just a bit of fun.  More of a thought exercise than anything.  Why don’t we go Eoin and down, and that way, Tim gets to assess how good everyone else’s ideas are.

CM      I think they’re just asking for our top tip for the year, is that what you’re asking for? 

NO      In a slightly more creative fashion than that. 

ET       I think we are in the latter stages of a bull market, and the thing that does best in the latter stages of a bull market are things that are leveraged to economic growth.  So anything that you pick for something that’s going to do the best next year will have to be leveraged to economic growth.

And I will certainly be tipping something like that in the first part of the year, but off the top of my head, I would have to go for a copper miner, and I’d go for Freeport–McMoRan. 

CM      I think that I’m going to go for… can I go for bitcoin, or is that cheating? 

NO      You’re allowed to go for bitcoin, but I want to know why. 

CM      Because I think it’s the ultimate devalued tech stock, and it’s a fast growing network, and we know how valuable networks are in lot of the world, Facebook, and Whatsapp, and so on.  And it appeals to people for different reasons.  It appeals to technology people as being something new in computing. 

It appeals to the libertarians, who see it as a way to escape what they’ve just done in India recently, confiscating money and the war on cash.  It appeals to the speculators, because they see something that has the potential to rise a very great deal.  And then at the moment, it’s got a real use that’s perhaps not something we should talk about too much, because it’s slightly underground. 

But there are overground reasons to use bitcoin, as well, and all sorts of applications that are being developed.  So I think it’s devalued because I’ve got a valuation attempt to value the network, which is considerably above the current price.  That network is growing.  There’s a macro reason.  And I think it’s a very exciting theme, and the world’s crying out to have a go at money.  The internet’s taken over everything, let it do money. 

NO      That’s a pretty compelling case.  Akhil. 

AP       Seemingly easy question, but quite difficult to answer.  If I was to choose one thing, so I would probably go out and buy US banks stocks.  I can’t give you, off the top of my head, which one.  For two reasons.  One is if you look at the reaction of such stocks during the year, both before and after the election, clearly, I think they are pricing in future increased earnings.  There’s good dividend yield, and I think the US dollar is also breaking out, and will appreciate against most currencies.  So I think it would be a good play from a number of perspectives. 

TP       For me, a slightly riskier animal than I’d normally advocate.  It’s a market in Asia, it’s Vietnam.  Frontier market, so it comes with all the attendant risks and caveats there.  94 million population.  It’s quite a big country, it’s also a very young country, and I think at least half the population is under the age of 30. 

94% literacy rate, so they’re better educated than we are, at least the UK is.  And they’ve got wage rates that are a third the rate of China, so they are the foreign direct investment destination across all of Asia at the moment.  And the fact that the TTIP isn’t necessarily going to happen, I don’t think it’s necessarily bad news. 

It’s young.  It’s got great demographics.  It’s got comparatively healthy banks.  It’s growing like a train.  It is likely to join MSCI emerging world at some point in the future, so it’s likely to be promoted from frontier to emerging market status, which will cause a wall of money to tumble in from big firms. 

It’s a long-term investment, so it wouldn’t be appropriate just for 12 months, but it’s probably our favourite market, other than Japan, at the moment.

NO      There you go, four very distinctive ideas.  And, I think, broadly speaking, it summed up a lot of the things we’ve been talking about.  So I’ve just got a few questions to finish today off.  These have come in directly from you at home, so thank you, if you wrote in.  I’ll just do a couple, because I don’t want to keep you any longer than we need to.  I don’t have the names of the people who wrote in, my apologies.

 

NO      And I think on that note, we will wrap up for today.  So, Tim, Akhil, Charlie, Eoin, thank you for joining us.  Thank you, everybody at home, for tuning in and listening.  I hope that what we talked about was interesting and valuable, and made you want to read our next issues of respective newsletters, as they come out in the coming weeks and months.  So on that note, I think we’ll say goodbye.