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Private Client Letter - October 2013

This was the quarter in which Ben Bernanke, Chairman of the US Federal Reserve, blinked.

Having mooted in May that the US economic recovery was sufficiently entrenched that he anticipated being able to ‘taper’ quantitative easing, probably in September, Bernanke announced after the Fed’s September meeting that bond purchases would remain unchanged at the rate of $85 billion per month.


Simply put, inflation is well below the Fed’s target, unemployment remains too high, the recovery is faltering on the back of the rise in interest rates since Bernanke’s May announcement, and Congress is playing games with the fiscal budget, thereby risking default on US government debt.

Bernanke had linked the Fed’s policy decision to a specific unemployment rate: he pledged in June that the Fed would complete its bond buying when the jobless rate fell to 7%. With a decline to 7.3% in August, it seemed conclusive that tapering would indeed begin in September.  However, the fall to 7.3% was for the wrong reason: many unemployed Americans are giving up on finding work and are no longer registering as unemployed.  The labour force participation rate is falling.


Participation -Rate

Source: Bank Credit Analyst, Bureau of Labour

Picking the unemployment rate as their key yardstick has thus turned out to be a huge mistake on the part of the Fed, and Bernanke is now downplaying it. “The grand old Duke of the Fed marched investors up the hill, and marched them down again” (with apologies to the nursery rhyme on the front cover…).

Bernanke’s real concern though, as a doctoral student of the 1930s Great Depression, is deflation.  Debt in the US is still excessive, totalling a massive 2.4 times GDP. Should prices actually start falling, the repayment burden of debt, measured in spending power terms, actually rises, creating the risk of a damaging negative spiral that ends in depression.

With all the monetary printing that governments around the world have undertaken since the credit crisis, surely deflation cannot be possible?  Well…  There are three strong deflationary forces in the world at present.

The first is the ageing of the population as the ‘bulge’ of the post-World War II ‘baby boomer’ generation approaches retirement.   The Boomers are now past their peak earnings and debt accumulation years, and their spending is declining.   This is exacerbated by the predicament of the Gen-Xers (born 1965-1980) as the most debt-ridden generation of the past century and hardest hit by the credit crisis.  And the Millenials (born 1981-2000) are burdened by  high  levels  of  student  loans  and  struggling  to  find jobs.  There is a structural dampening down of consumer demand in the Western world.

The second, newly unleashed deflationary force comes from Japan, whose recently elected Prime Minister, Mr Abe, is determined to reverse the culture of falling prices that has plagued their economy for some two decades. Under the guise of monetary stimulus - currently very acceptable globally - he is depreciating the ¥en.   This is inflationary within Japan - but deflationary to the rest of the world as prices of Japanese exports fall.

The third deflationary force comes from across the East China Sea. Beijing’s new government is also embarking on a fundamental transformation of China’s economic model, although their problem is the opposite of Japan’s, namely, over-heating and excess credit creation. Wages are rising at double digits, ramping up costs and marginalising the growth potential from labour.  An explosion in investment has led to widespread excess capacity and falling returns. The baton for growth needs to pass to the consumer.


China -Investment -Consumptio

Source: UBS 'Economic Insights', George Magnus

The list of reforms to achieve this swing is long. It includes freeing up labour markets by revamping the ‘hukou’ system of household registration that restricts the mobility of labour. The uncompetitive state sector needs to shrink.  Interest rates must be deregulated and non-performing loans written off.  Etc, etc.  All prudent, sound policy changes, but will result in slower growth. Again, deflationary for the rest of the world.

With these three potent headwinds, Bernanke’s fight against deflation is rather like a salmon fighting its way upstream.

His tenure as Chairman of the Fed will soon be drawing to a close.   He retires next January and one of the key questions for markets at present is who succeeds him. The front runner at present is another member of the Federal Open Market Committee, Janet Yellen.   Might Hilary Clinton succeed Obama as US President?  Then we’d have Janet… and Hilary… and Angel Merkel as German Chancellor… and Christine Lagarde as Head of the International Monetary Fund.  Arguably the four most powerful people in the world all women!  Gentlemen, are you ready for this?!

Still recovering

Bernanke’s hesitation on tapering should not be construed too bearishly.  The US recovery is tenuous, but it is intact, driven by pent-up consumer demand for housing and cars, as well as the replacement of capital equipment. GM and Chrysler are struggling with the unfamiliar but happy problem of production not being able to keep pace with demand!

Europe, like America, is on the mend.  The tortuous fiscal and  structural  repair  work  undertaken  since  the  crisis is paying off, laying the foundations for growth.  Public deficits in Europe have halved in three years, unit labour costs and competitiveness are rapidly adjusting, bank balance sheets are on the mend and current account deficits are disappearing.  In the second quarter this year the €urozone emerged from seven quarters of recession and reported positive growth.  Real wages are increasing and consumer confidence is at a two-year high.


Economic -Indicator

Source: Bank Credit Analyst

The repair process is not complete.  Take Greece as an example. Greek GDP was about $120 billion in 2001 when it joined the €uro.  This had tripled to an astonishing $360 billion eight years later. If however one projected the 2001 figure at a more sustainable 3% p.a., GDP would only have reached $152 billion by 2009.   Even today Greek GDP is at $250 billion.   In other words, Greece either needs bail-outs of $98 billion p.a. to sustain its economy at the current size – or further austerity is called for. Mrs Merkel, a nuclear physicist, will have done similar sums, and the outcome is likely to be a combination of (smaller) bail-outs plus further shrinkage.

Investor conundrum

What are investors to make of this multi-faceted backdrop?

Low inflation and continuing aggressive monetary policy provide a benign backdrop for equities.  The recovery in the US and Europe is tenuous – but this points to inflation remaining low, underpinned by significant excess capacity. However, tapering is postponed, it has not disappeared. Interest rates will rise, but in the early stages that reflects improving confidence, an important positive. The increase only acts as a brake once inflation becomes an issue.

Companies’ cash balances are robust: in the UK, the net cash position of FTSE100 companies has risen from £12 billion in 2008 to £74 billion this year, prompting special dividends and buybacks. A similar situation prevails in the United States where share buybacks are a more popular avenue for excess cash, but even there the dividend payout ratio has risen from 29% in 2011 to over 36% this year.

Should investors worry that equity markets are expensive after their strong rises since the credit crisis lows?

The bear camp often refers to the Cyclically Adjusted Price/Earnings (CAPE) ratio, developed by Robert Shiller of Yale University.  This computes the p/e ratio on the average of the past ten years’ earnings in order to smooth out fluctuations caused by the business cycle.  The CAPE ratio successfully predicted the high returns of the 1980s and the poor returns of the Noughties.  At present the CAPE ratio suggests that the S&P 500 Index is expensive.

However, Jeremy Siegel, Professor of Finance at Wharton University, points out that the current CAPE ratio ignores a crucial point.  It does not pick up on structural changes. Accounting standards changed in the 1990s, introducing write-downs when corporate assets fall in value – but increases in value are only recorded when the asset is sold.  During the credit crisis, some S&P companies had huge write-offs that have artificially depressed the ten years’ earnings figure.  If the National Income & Product Accounts figures are used - which are not subject to this rule and so more stable - the CAPE ratio does not indicate over-valuation.

On a traditional price / earnings measure, the S&P 500 Index is selling for between 15 and 16 times 2013 estimated earnings, close to historical averages.  Moreover, in real terms it is just approaching pre-credit crisis highs, and is still some way off the ‘tech bubble’ peak.


US-Equity -Market

Source: Lombard Street Research

Seat belts fastened!

Of course there will be turbulence. Tapering will be a tight rope when it comes. In the United States the Republicans are playing ‘chicken’ over the federal budget and debt ceiling, making a mockery of the democratic process that passed Obama’s Affordable Care Act into law.

However, at Veritas we do not time markets.  Rather we invest in sound, financially strong companies with proven management, a moat around the business and the tailwind of a global growth theme, bought on a sensible valuation. We  have  conviction  that,  on  a  rolling  five  year  view, these companies will weather any storms and achieve the real returns, ahead of inflation, that are our objective. Because we pay no attention to the construction of an index in building our portfolios, performance in individual years may diverge.

Our core conviction themes are unchanged - ‘Structural Growth’, ‘Scarcity’, and all ‘Dependable Compounders’ that we believe will deliver solid growth over our five year horizon.  Our fourth theme, ‘Rising Tide 2020 Winners’, seeks to look through the current uncertainties to those stocks that will become winners by 2020.

Intriguingly, an overlap is developing between our Structural Growth sub-themes.  Google, best known for its eponymous search engine, has recently added to its list of innovative projects for the future an investment in healthcare, another of our core sub-themes.   The company is called Calico, it is chaired by the Chairman of Genentech (owned by Roche, another of our stalwart stocks), and addresses the challenge of ageing and related diseases.

There is huge scope for the interaction of technology and ageing, with the retirement of the Baby Boomer generation providing the scale needed to justify such research.  For example, a group of former Microsoft employees (another of our stocks) has unveiled a system of tiny sensors that help the elderly retain their independence but flag any cause for alarm.  For example, a sensor on the daily pillbox will relay to a relative or carer that it has not been opened by, say, 11am.

Robots are being developed that can wash an elderly person, wipe, shave and brush teeth. However, so far a robot can only lift 10% of its own weight, which is a significant restriction as it precludes picking up a person who has fallen.

We shall watch Google’s foray into ageing with great interest, and commend management for their culture of innovation and long term thinking.

Two or three years’ ago we were finding new investment opportunities  in  the  United  States,  but  we  are  now finding more European companies creeping onto our screens.  One such example is Safran, quoted in Paris and a manufacturer of engines for narrow-bodied aircraft. Their key profit driver is after-sales service, which makes for a transparent and dependable earnings stream as airlines are subject to stringent regulatory maintenance requirements. Based on the pick-up in engines sold since the credit crisis, together with fleets previously in the air, it is clear that Safran will report steady growth in profits and cash flow over the next few years.  The share in addition offers an attractive dividend yield of circa 3.5%.

We find Safran’s transparent earnings stream attractive in the current challenged economic backdrop.

Meg Woods
3rd October 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.