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Private Client Letter - July 2013

The patient is officially on the mend!  After five years, a date for treatment to be withdrawn has been aired.

For nearly five years now the West’s economies have been on the monetary life support system known as “quantitative easing” (QE). However, in a press conference on 19th June, Dr Bernanke, Chairman of the Federal Reserve (the Fed), mooted a possible timetable for curtailing further stimulus in the United States.  It is data dependent - the unemployment rate must fall to 7% from the current 7.6% - but this is anticipated by end-2013, enabling QE to be wound up by mid-2014.

And evidence is accumulating that the US economy is gaining traction as more sectors join the growth parade. Private  Consumption  Expenditure  (PCE),  the  largest slice of the economic pie, is being lifted both by rising employment and incomes, and by the wealth effect of recovering home prices and the appreciation of the stock market.  With American household debt as a % of income down from 130% in 2007 to 105% by end-2012, consumer confidence and car sales are rising strongly. Business spending on plant and equipment is picking up.  US crude oil production rose 15% year-on-year in February, driven by shale.  Trade remains steady despite the challenging conditions around the rest of the world with the US having improved its competitiveness.

UNIT LABOUR COSTS

Unit -labour -cost

Source: Lombard Street Research

The only slice of GDP not showing any increase is publicspending, which will decline to modern lows as a % of GDP under current law, reflecting the importance that Americans attach to leaving resources in the private sector. Dr Bernanke’s press conference makes clear that he sees these economic indicators as signs of the success of his monetary largesse in bringing the economy back from its 2008 precipice. He will of course also be aware of the risks of continuing QE and not tapering – the distortions in the economy, the hit to the incomes of savers and pensioners of low interest rates, the licence being given to zombie companies to stay in business – as well as just the fact that the economic impact of stimulus is weakening.  QE has served its purpose and it makes no sense for the Fed to continue its asset purchase programme.

Equities and bonds fell sharply on Bernanke’s announcement. Historically no-one has rung a bell at the top or bottom of a market – but that is effectively what Bernanke has done: interest rates have bottomed.   The risk of Bernanke’s policy of forward guidance is that there is a disorderly stampede for the exit.  If the Fed is not buying bonds, the reasoning went, then interest rates must surely rise – and they did, up from 1.7% for the 10-year US Treasury to 2.6% in short order.

The chart below puts this rise into perspective.

US 10 YEAR TREASURY BOND YIELD

US-Treasury -Bond -Yield

Source: Bank Credit Analyst

Thus the recent rise in rates has merely taken some of the hysteria out of pricing.

However the current fundamental backdrop does not call for meaningfully higher rates.  For one, inflation is not rearing its head: the Fed’s favourite indicator of prices, the PCE Price Index, decelerated to 1.1% in the 12 months to April, the smallest gain since records began in 1960, reflecting surplus labour, excess manufacturing capacity and strong productivity.

US CORE PCE DEFLATOR

PCA-Deflator

Source: US Bureau of Economic Analysis

QE and ultra-low rates were only ever meant to create time for private and public balance sheet repair. A modest lift in rates may be welcomed as confirmation that the economy is healing, but the reaction of markets is a reminder that the road back to normality will be bumpy.

Green shoots spreading

Another economy reporting positive news is Germany. Retail sales beat estimates in May, up by 0.8%, and business confidence is rising.   A decade ago Germany had one of the worst unemployment rates in the developed world.  Today, at 5.4%, it is one of the lowest in Europe, while youth unemployment at under 8% is half that in the US!

This is no accident. After wages soared in the 1990s post unification, the German government in 2003 introduced tough labour reforms that freed up the job market. Vocational training has succeeded in getting the young and hard-to-employ into work, while giving trade unions seats on company boards has encouraged wage restraint. Reforms also extended to tax and regulation.

These structural reforms were timely, enabling Germany to ride an export boom in machine tools, chemicals and cars in the Noughties when emerging markets were booming and China went on an investment binge.

Anecdotal evidence of German competitiveness came when Siemens was recently screening 2,000 applicants in the United States for 50 vacancies as robot supervisers in one of their factories in North Carolina.  Only 10% of the Americans passed the German aptitude test…

Even in the UK there are green shoots, with the May Purchasing Managers’ Index for services, manufacturing and construction all recording expansionary readings.

However, the €urotrain remains constrained by the Club Med economies, which are still contracting under the twin burden of budget deficit and debt reduction, and hindered by the glacial pace of structural reform.

Rising sun?

Leaders in Japan face a different challenge. They too, are trying to boost growth – but, in their case, to counter years of deflation.

What is wrong with falling prices?   Falling prices mean that Mrs Watanabe can buy more with her ¥en next year than this – that’s good, isn’t it?  The trouble is that Mrs Watanabe then postpones consumption to get cheaper prices next year - to the detriment of growth. It also means that asset prices fall - but the value of debt does not, to the detriment of balance sheet strength and of investors.

Japan’s population has the oldest age profile in the world, and, with a declining birth rate and negligible immigration, the country’s population will shrink over the next 100 years from 128 million to only 43 million! Last year more adult diapers were sold than baby diapers…

The working age population will shrink by 27% over the next two decades - a major headwind for growth.

The government is not in a robust position to counter this by boosting spending. Gross public sector debt is already 2.3 times GDP. A massive 40% of tax revenues are swallowed up simply paying the interest on this debt.

SOVEREIGN DEBT AS % OF TAX REVENUE

Sovereign -Debt

Source: CFA Institute, Eurostat, U.S. Federal Reserve, and Bank of Japan

Now, with Prime Minister Abe targeting inflation of 2%, rates have bottomed and interest expense will rise with debt. The situation is less and less stable.

A third headwind for growth in Japan is that companies aren’t spending.  Companies are hoarding cash because investing in capacity without the necessary expansion in demand makes no economic sense.

Japan  is  thus  in  a  demographically  driven  deflation trap.  This is not Keynes’ cyclical shortage of demand, remediable with monetary stimulus.

The Bank of Japan’s Governor Kuroda is tackling deflation with a massive monetary bazooka and, in the short term, it is having the desired effect.   Money and loan growth have accelerated, consumer confidence has risen and the Tankan business survey has spiked. Inflation expectations have risen above 1%.

However, the demographic backdrop suggests that Governor  Kuroda  is  unlikely  to  create  demand pull inflation however much money he prints.  His other option for countering deflation is cost push inflation, achieved by depreciating the currency and so raising the cost of imports, particularly energy imports on which Japan is so dependent.  The problem with this approach is that, after a year, the % change in imported prices washes out of the indices – and fresh falls in the currency are required to push prices up further.  Monetary printing aimed at depreciating the ¥en is not a long term, sustainable solution.

What is needed in Japan, as in the Club Med countries, is  a  page  out  of  Germany’s  structural  reform  book  – reform of the labour market, of immigration laws, of corporate tax and governance, of the cross-shareholdings between companies that have woven an incestuous, non- competitive web. What is needed is a change of mind-set. That’s quite a challenge!

Prime  Minister Abe  has  promised  structural  reform  as the third arrow in his quiver after government spending and quantitative easing.  However, the mountain he has to climb is high and the jury is still out as to whether he achieves his goals.

You can’t bake a cake with just one ingredient.

As an aside, demographics are a headwind not only in Japan.  Across the industrialised world, life expectancy is rising at an unprecedented pace, challenging pension assumptions.  A 72-year old man today has roughly the same odds of dying as early hunter-gatherers would have faced at the age of 30.  The pension age would have to rise to 80 if a 20-year old starting work today were to have only the same chance of drawing a pension as a 20-year old beginning employment in 1909.

Synchronising the desynchronised

At Veritas our approach of investing in well managed, financially  sound  companies  with  the  tailwind  of  a global  growth  theme  and  bought  at  a  sensible  price is  entirely  apposite  in  the  current  investment  context of desynchronized growth.  We pay no attention to the construction of indices: our quest is to attain sustainable, real returns, ahead of inflation, on a rolling five year view. There will be years in which our returns deviate from those of the indices.  For example, this year we have not participated in the Japanese liquidity-driven rally.  It may transpire that we have been over-cautious, but we are finding attractive opportunities elsewhere.

We are encouraged by the green shoots in leading economies. However, we continue to proceed with caution, mindful of the risks inherent in markets that are buoyed by central bank stimulus.  In today’s confidence, are we sowing the seeds of the next crisis?  In the US the Fed’s consecutive QE programmes cannot be judged a success until the exit has been negotiated. The Club Med countries remain a tinderbox with further bail-outs a probability and the public’s fatigue with austerity a flashpoint.

In China the new leadership is faced with the fall-out of excess credit creation. Inter alia, more and more credit is required to generate the same level of growth.

CHINA: CREDIT INTENSITY OF GDP GROWTH

China -Credit -Intensity

Source: Haver / UBS

Beijing  is  attempting  structural  reform  and  cyclical tightening simultaneously, which is bold – but hazardous.

Given our long term horizon, our core themes remain ‘Structural Growth’ and ‘Scarcity’, and all ‘Dependable Compounders’ that we believe will deliver solid growth. Our  fourth  theme,  ‘Rising Tide  2020  Winners’,  seeks to look through the current parlous state of the world, infused with risks to which we freely admit we do not know the outcome, to those stocks that we anticipate becoming winners by 2020.

We  believe  that  medical  diagnostics  companies  such as Sonic Healthcare and Laboratory Corporation will be 2020 winners.   Sonic is quoted in Australia but global in its reach, while Labcorp is US-based.   Diagnostics is the ‘picks and shovels’ end of the healthcare sector, accounting for only 2-3% of budgets but dictating 70% of what occurs thereafter.  There is consequently huge economic pressure  for  a  patient’s  diagnosis  to  be correct.  Accuracy has been greatly enhanced by the decoding of the human genome, which has also enabled the personalization of treatment.   The ageing of the industrialized world’s population is a strong tailwind for the sector too.

Sonic and Labcorp thus enjoy a number of growth drivers to propel them forward to 2020.

Meg Woods
9th July 2013

The above review has been issued by Veritas Investment Management LLP, which is authorised and regulated by the Financial Conduct Authority.

The opinions expressed above are solely those of Veritas Investment Management LLP and do not constitute an offer or solicitation to invest.

The value of investments and the income from them may fluctuate and are not guaranteed, and investors may not get back the whole amount they have invested.