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Private Client Letter - January 2013

Hiking is one of Angela Merkel’s favourite pastimes. Reportedly she is not a fast hiker, actually quite slow, but dogged, step-by-step, no matter how tough the terrain. She doesn’t give up.

‘Step-by-step’ aptly summarises the course of the global economy in 2012. Progress has been made on each of the three issues that had been worrying investors at the start of the year - the €uro, the United States and China.

In the €urozone, the ECB’s declaration in the summer that it would do ‘whatever it takes to save the €uro’ was followed in December by Finance Ministers’ agreeing on establishing  a  single  banking supervisor  for  the  larger

100-150 banks. Reforms, while glacial, are being passed, and unit labour costs have fallen from their peak by 17% in Ireland and by 7% in each of Spain, Portugal and Greece. Ireland is back in current account surplus, and surpluses are forecast for the other three in 2013. Greek government bond yields tumbled from over 29% in June to 11.7% by year-end!

Only France still does not get the message, opting for corporate tax breaks to improve competitiveness rather than tackling labour costs.

The US economy that earned President Obama a second term looks nothing like the mess he inherited four years ago.   Unemployment is falling, the housing market is rebounding, consumers are paying off their debts and the big banks are again healthy. Energy prices have dropped on the back of the shale gas ‘fracking’ revolution, and manufacturing is returning from abroad back to American shores. Apple is bringing the production of Mac computers back the US.


Gas Spot Prices

Source: Natural Gas Intelligence

The third area of concern for investors had been China, but her economy has met our expectations and ended the year with manufacturing expanding as domestic demand compensates for export weakness.

Step by step. Kilimanjaro was climbed... one step at a time, my grandmother would remind me.  The world is edging forward from the mire of excess debt, and the MSCI World Index rose by 10.7% in 2012 by way of approval.

Not the hare...

The US Congress is however determined that their steps should be as small as possible.   The midnight oil, end- of-year, band-aid tax hikes to avoid the fabled ‘fiscal cliff’ of tax increases and spending cuts equal to 4% of GDP merely kicked the can down the road to the next milestone, namely, the ‘debt ceiling’ when the government in February reaches the limits of its borrowing authority.

We are obliged to an unknown contributor to Twitter for the following lessons on the fiscal cliff.

Lesson #1:

  • US Tax revenue: $2,170,000,000,000
  • Federal budget: $3,820,000,000,000
  • New debt: $1,650,000,000,000
  • National debt: $14,271,000,000,000
  • Recent budget cuts: $38,500,000,000

Let’s now remove eight zeroes and pretend it’s a household budget:

  • Annual family income: $21,700
  • Money the family spent: $38,200
  • New debt on the credit card: $16,500
  • Outstanding balance on the credit card: $142,710
  • Total budget cuts so far: $385

Got it??  Ok, now... Lesson #2:

Here’s another way to look at the debt ceiling...

Let’s say you come home from work and find there has been a sewer back-up in your neighbourhood... your home has sewage all the way up to your ceilings...

What do you think you should do?

Raise the ceilings?... or remove the sh*t?

We apologise for the concluding language... but it does capture the situation graphically!

Costs of democracy

Western   governments’   penchant   for   spending   more than revenues is being indulged by their central bankers who persist with accommodative monetary policies and repressing interest rates. They turn a blind eye to the long term fall-out of their policies. For example, low interest rates produce a misallocation of capital: one in ten British businesses is only being kept alive by low rates!

Repressed interest rates also cause pension liabilities to balloon. In the UK they are estimated by Hymans Robertson to have risen by an astonishing 40-50% since 2009.   More than 80 Dutch pension funds face cutting payments to pensioners for the first time ever from April 2013!

Thus the politicisation of the major central banks continues, step  by  step.     Dr  Bernanke  at  the Federal  Reserve now promises to continue quantitative easing until the unemployment rate falls to 6.5%. Clever... Those who worry about the inflationary fall-out of all this printing of money should reflect on the Chairman’s in-built stabiliser: as soon as growth starts heating up (measured by the fall in unemployment to 6.5%), the punch bowl will be eased off the table.

Indeed, it is interesting to note in the minutes of the December 2012 Federal Open Market Committee meeting that some members mooted slowing or even stopping bond purchases by the end of 2013. This would clearly be prudent given the huge inventory of bonds now on the Fed’s balance sheet... but might it also reflect a quiet confidence in the US recovery?

Congress’ seeming inability to tackle the deficit in any meaningful way, forcing the hand of the Federal Reserve, does cast a spotlight on the Achilles Heel of democracy. As Gillian Tett observes in the Financial Times, “modern American political rhetoric is peculiarly addicted to the presumption of permanent growth”.  She quotes Peter Thiel, founder of the company PayPal, “Democracy works where voters think that things are getting better”. It presumes that the economic pie can be made to expand.

In Japan, a country that has effectively been ex-growth for over two decades, they have just elected their seventh Prime Minister in six years.  The economy is moribund with total debt at 235% of GDP. This in strong contrast to China, where the problem of over-heating was successfully tackled head on by the Politburo of 9 people, and they are now in a position to again loosen the reins.

Faced with a choice of investing in a company with a board of over 500 directors – or a board of 9 directors – which would you choose?

And the expansion of the Western world’s economic pie will not revert to the growth rates seen in the 1980s and 1990s any time soon as de-leveraging takes its course and as the Baby Boomers retire. This does not augur well for political leadership in the major democracies.

The ageing p/e ratio

The economic consequences of the Baby Boomer retirement have drawn the attention of Zhen Liu and Mark Spiegel at the Federal Reserve Board of San Francisco.  They have studied the relationship between the age distribution of the US population and stock market performance.  Their results are shown in the graph below. The red line, scaled to left hand axis, is the price/earnings ratio of the S&P 500

Index; the green line, scaled to the right hand axis, is the ratio of the middle age group (aged 40-49) to the old age group (aged 60-69), dubbed the ‘M/O ratio’.


Baby -Boomers

Sources: Bloomberg (PE) and Haver Analytics (MO)

The two are highly correlated.  Between 1981 and 2000, as the post-War Baby Boomers expanded the labour force and reached their peak working and savings ages, the M/O ratio rose from 0.18 to 0.74.  The price/earnings ratio tripled from 8 to 24.  In the 2000s, as the Baby Boomers approached retirement and ‘de-risked’, switching out of equities and into bonds, the M/O ratio declined – and so did the price/earnings ratio.

Messrs Liu and Spiegel go on to project the S&P500’s price/earnings ratio based on Census Bureau population forecasts. The result is shown below.


Projected -PE-Ratio

Source: Bloomberg and Census

Their study suggests that demographics may cause the US price/earnings ratio to fall to high single digits from mid- teens at present.

Rising tide 2020

Is the best behind us?   Where is growth going to come from?

The last 250 years saw three great waves of innovation based on, first, the invention of the steam engine, second, electricity and third, computers.  The last 25 years have been buoyed by the successful integration of the world’s most populous country, China, into the global economy.

Prior to that however, between the years 1000 and 1820, global GDP grew by only 0.04% p.a. according to Capital Economics. With the albatross of excess debt and ageing populations, will the world now revert to its earlier mean?

We do not believe so.  We see two major positives for the world as we look through its current troubles to 2020 and beyond.

First, technological innovation is still revolutionising many industries. The internet is extending education to the Third World. Driverless cars (pioneered by Google, in which we are invested) have the potential to turn car journeys into productive time.  3D printing is set to transform areas of manufacturing.   Hydraulic fracturing has sent gas prices tumbling in the US.  The decoding of the human genome is opening areas of research for a pharmaceutical industry that was struggling to find new products.

The second major positive is that, despite the ageing population in the West and in China, the working age population in the rest of the world is expected to continue to grow strongly.  Following on from the BRICs (Brazil, Russia, India and China) are the MINTs (Mexico, Indonesia, Nigeria and Turkey), aided by the spread of education over the internet.  Integration may not be as effective as China; it will nonetheless be huge.

The expansion of the global middle class means that emerging markets’ consumption could make up an astonishing two-thirds of global consumption by 2050, according to Karen Ward and Frederic Neumann at HSBC.

Furthermore,  the  savings  surpluses  of  the  emerging world that have financed the current account and budget deficits of the West look set to continue.  Barclays 2012 Equity Gilt Study estimates that in 2002 the gap between international foreign exchange reserves and ‘safe haven’ bond issuance (bonds issued by solvent governments) was a chunky 35% of global GDP (the gap being funded by the private sector).  The gap has now fallen to only 12%, and is projected to remain broadly at that level through to 2021, even allowing for sizeable Western world government issuance.

A gap of this order should be readily funded by the private sector. Those looking for an early return of interest rates to normality may be disappointed…

At Veritas this approach of looking through the current malaise  to what  the  world  will  look  like  in 2020  and beyond is the fabric of our current investment strategy. Rising Tide, 2020 Winners is our core conviction theme at present. We are constructive that the €urozone, the US Risk relative to World Equities and China will, step by step, work their way through their issues, but we are not going to speculate on timing nor on the inevitable attendant volatility in markets.

Rather our strategy is to ferret out those sound businesses with a competitive edge and global perspective that we believe will become winners by 2020, and in which we can invest on a sensible valuation.  Despite the challenging backdrop, there are opportunities.

Given that we pay no attention to indices in constructing our portfolios, this may well mean that our performance deviates from markets in individual years; it is the long term value  accretion  based  on  underlying  cash  flows that we seek.  However, our approach has historically, over rolling five year periods, delivered the real returns that are our objective for our clients, and we have every confidence will continue to do so.

Veritas Report Card

The chart below, prepared independently by Asset Risk Consultants, covers the five years to 30th September, 2012.   The left hand axis shows both our and the aggregate private client fund manager’s average annual returns, while the bottom axis records the risk or volatility. We are pleased to reflect that the returns achieved by Veritas (the red shapes) significantly exceed the returns recorded by both the peer group (the white shapes) and by markets (the line).

Veritas -Report -Card

Source: Asset Risk Consultants

The risk in our High Equity client portfolios has been so low relative to the peer group that ARC has re-classified them into their next lower ‘Steady Growth’ risk category.

Meg Woods
8th January 2013

ARC Private Client Indices (“PCI”) are based on historical information and past performance is not indicative of future performance. PCI are computed using a complex calculation and the results are provided for information purposes only and are not necessarily an indicator of suitability for your specific investment or other requirements. ARC does not guarantee the performance of any investment or portfolio or the return of an investor’s capital or any specific rate of return. ARC accepts no liability for any investment decision made on the basis of the information contained in this report. you should always complete your own analysis and/or seek appropriate professional advice before entering into an agreement with any PCI Data Contributor. The content is the property of ARC or its licensors and is protected by copyright and other intellectual property laws. Use of the information herein is governed by strict Conditions of Use as detailed on

The above review has been issued by Veritas Asset Management (UK) Ltd., which is authorised and regulated by the Financial Services Authority.

The opinions expressed above are solely those of Veritas Asset Management (UK) Ltd 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.