"China ain't waiting!"

“China ain’t waiting!” – that’s my verdict after a recent visit organised by Ashburton. Whilst, I only had a very small taste of this vast country one thing was abundantly clear, China has set its sights on becoming mainstream by 2020. My trip from the tradition of the capital City, Beijing, to the mind-blowing development in Chongqing, and then finally to the glitz and glamour of Shanghai seemed to confirm that they are well on track. Now I am not saying that this ambition will be easily achieved, far from it, China has many well known social, economic and environmental challenges.

Chinese tourists flock to the Summer Palace, Beijing.

Beijing is a good entry point for the first time visitor to China, the 4.5 million vehicles on the road that guarantee a slow crawl from the airport to City centre but provide an excellent sightseeing opportunity. My taxi ride took me past the symbolic portrait of Chairman Mao overlooking Tiananmen Square, but this was to be the only obvious sign of communism that I saw in a week. The major tourist attractions are the many temples and palaces which preserve the memory of Chinese imperialism. The majority of visitors are Chinese, a sign that the tourism industry is growing fast supported by the massive investment infrastructure spend on highways, high speed rail and airports.

A model of the future in Chongqing.

But it was when I landed in Chongqing, one of the “mega” cities in Western China, that I began to appreciate the sheer scale of modernisation taking place. The Government realised many years ago that it had to address the imbalance between the wealthy Eastern coastal region and the rural areas of the West if social stability was to be maintained. Chongqing, located at the confluence of the rivers Yangtze and Jailing is one of five cities given Special Status by Beijing and the only one in the West. To improve the living standards of the City’s 6 million population and the further 25 million that live in the surrounding provinces, will require very deep pockets. High rise residential buildings, industrial parks and the supporting transport infrastructure are being constructed at a frightening pace across this rugged terrain. It is quite a staggering sight, if you can see through the thick brick dust lingering in the air. The surrounding rural areas are also receiving funding in an effort to stem the migration from the fields to the cities. This is not only essential in sustaining the country’s need for food but also creates jobs, I visited one farm growing a variety of fruits for the export market.

Shanghai skyline, the finished article.

If Chongqing is a work in progress, my final stop, Shanghai was the finished article, a glimpse of the future of China. A thriving City with luxury apartments, iconic buildings and plenty of retail therapy that rivals many of the cities of the Western World and the Middle East. The Global Crisis may have stunted the ambitions of growth in the US, Japan and Europe but not so in China, where economic growth is visible for all to see. For any sceptics, if you don’t believe me, go and see for yourselves.

John Husselbee
4th October 2010

Back to School

September, end of the summer holidays and back to school for many. Parents are sorting out uniforms and children are sharpening their pencils. Whilst our children may have new subjects to study, students of the financial markets continue to study the same old topic they have studied all year – Deflation or Inflation? In our School students are divided by their views, and the bond and equity teachers seem to be telling us different stories.

Bond markets see growth in the global economy stalling, deflation and the possibility of a “double dip” recession. As a result ten year government bond yields in the US, UK and Germany have fallen sharply from their peaks earlier this year. At the beginning of April this year, ten year US treasuries were yielding nearly 4%, more recently the yield has been below 2.5%. Despite the falling yield, recent US data shows that for the second year in a row, investors have been putting record amounts of cash into bond rather than equity funds. It would seem at these record low yields that investors are more concerned about return ‘of’ their capital rather than return ‘on’ their capital.

The UK Gilt story is much the same, the yield on ten year paper was standing at 4.23% on 22nd February this year, today it is nearer to 2.8%. In their recent Inflation Report, the Bank of England reported that UK inflation stood at 3.2% in June, well above their 2% target. The Report explained the higher level of inflation was due to rising oil prices, the restoration of standard rate VAT back to 17.5% and sterling depreciation. They also stated that they felt inflation would stay higher than expected in the medium term, particularly with VAT rising to 20% in 2011. So whilst gilts have outperformed UK equities year to date, there seems to be little attraction in investing at these levels. Yes, you will get your money back in ten years and an annual income of 2.8% but it is more than likely that inflation will erode your original investment.

So the lesson here for bond students: Trees don’t grow to the skies!

In the equity class, you will find the students in a more optimistic mood. Equities are now much cheaper compared to bonds following the second quarter sovereign debt crisis in Europe. Companies remain in fairly good shape with stronger balance sheets, improved profitability and a more confident outlook. These students are well aware of the different shapes of economic recovery that we are witnessing around the World. Countries such as China, Brazil, India and other parts of Asia are booming to the extent that most of these countries are beginning to tighten monetary policy in order to fight inflation. At the other end of the spectrum most of the Western economies have experienced a fairly lacklustre economic rebound since hitting lows in 2009, despite record levels of monetary and fiscal stimulus. For these economies a further round of Quantitative Easing is now expected. When money printing was introduced last time, in March 2009, equities rallied sharply on a wave of optimism.

So the theory followed by equity students: Fight fire with fire!

So where do I sit in class? I suppose the answer is to sit close to Ben Bernanke, the Chairman of the US Federal Reserve and one of the leading scholars of financial crises, especially the Great Depression. The committee he chairs has the mandate to maximise employment and control inflation. This is the committee that at the height of the financial crisis last year cut interest rates to zero and urged the US Congress to act quickly by injecting masses of capital into financial markets after one of the worse recessions since the Great Depression of 1930’s. Despite this massive stimulus, there has been no real improvement in US unemployment nor in the US housing market. Many students point to aging population and the structural issues which weigh upon economic growth. However Bernanke has an unwavering belief that deflation is reversible and recently testified in front of a Congress committee that the Fed is prepared to intervene once more. He stated “We are ready and we will act if the economy does not continue to improve, if we do not see the kind of improvements in the labor market that we are hoping for and expecting.” I suspect that they will act again soon and we should see a significant market rally. The size and extent of that stimulus and the strength of the subsequent rally will be determined to a great extent by the unemployment data, as US inflation is not a concern at this time.

For now I continue to see deflation short term, inflation long term. This is a view shared by William Littlewood, manager of Artemis Strategic Assets Fund, in his recent Fund commentary. He sees the threat of inflation from developing markets being offset initially by developed markets such as Japan. However he also believes that the effects of the first round of Quantitative Easing and further rounds will tilt the balance towards inflation. His response to this is to be long equities and short government bonds stating, “these are levels (ten year government bond yields) which will only make a proper return for investors if inflation is eradicated for the next ten years, a scenario I view as extremely unlikely. They are also yields which show scant regard to the history of fiat money and governments’ abilities to generate inflation.”

My own view at the beginning of the year was that this would a “tricky” market but that it was still possible to make money. It has indeed been tricky and the “risk on, risk off” market has continued throughout the year unsurprisingly given the environment of continual political, economic and market volatility that we have experienced. When risk is removed the US dollar rises whilst equities and commodities fall, and vice versa. At North we have balanced our client portfolios between risk and defensive assets, although we have been light on bonds preferring gold and absolute return funds as an alternative. We also invest in UK Equity Income funds as I find it difficult to believe that low yielding gilts can continue to deliver better returns than high quality UK companies offering a competitive yield and with a track record of dividend growth. This, for me, is a very good story but one where patience may be required for things to play out so don’t expect overnight success.

John Husselbee
31st August 2010

"Small savings add up"

Travelling home after work on the train last night, this advert (see below) caught my eye. With the General Election being called last week, it seems Essex County Council are keen to show the voting public that they are doing their best efforts to reduce the Nation’s growing debt burden. They boast that by moving to second class postage for non-urgent mail they have saved £100,000. The money will be spent in filling a thousand potholes after a long and extraordinary cold winter. Something to shout about I would agree, but you have to ask how many more potholes could have been filled by saving the cost of these adverts too?

John Husselbee

14th April 2010

Every penny counts, it's a competitive world!

The expected upward revision to UK’s fourth quarter economic growth was announced last week by the Office for National Statistics (ONS). Preliminary data, released in late January, suggested that UK’s economy grew by 0.1% in the final three months of last year; this figure has now been revised to 0.3%. This followed the news earlier in the month that inflation in January measured by the Consumer Prices Index (CPI) rose by 3.5% and by the Retail Prices Index (RPI) 3.7%. According to the ONS, the return of VAT to 17.5% and rising fuel prices were the major contributing factors. The Bank of England uses the CPI to set interest rates whereas RPI is often referred to in wage negotiations. A letter of explanation from Mervyn King, the Governor of Bank of England, to the Chancellor is required if the CPI is more than 1% above or below the Government’s 2% target. In his recent letter to the Chancellor, Mervyn King expressed his belief that the recent rise we have seen in inflation is only temporary and he predicted that it will fall below the 2% target later in the year. As a result interest rates were left unchanged at 0.5% at February’s MPC meeting but it was decided to put Quantitative Easing on hold.

The rather lacklustre 0.3% economic growth that we have just received doesn’t seem a lot to show for what has been an unprecedented amount of stimulus and a significant devaluation of the Pound. What it does indicate is that the recovery is a fragile one and may still be reliant upon this stimulus. Any exit strategy, after the abundant liquidity in 2009, will need to be carefully planned and co-ordinated in order to sustain the recovery and avoid the double dip recession that the UK Economy is still susceptible to. It is also important to be realistic, whilst the UK economy is now officially out of recession; we are still lagging far behind other developed world economies that saw a return to economic growth much earlier in 2009. This is a concern particularly as the UK is competing, in the absence of a high domestic savings rate, to attract international investors to buy gilts to fund its increasing debt burden.

Furthermore, after the debt issues facing Dubai late last year and the Greek sovereign debt issues that we have more recently seen, international bond investors are clearly scrutinising each country’s fiscal position far more closely. Abu Dhabi stepped in with a bailout that helped with the debt position in the Middle East and it is expected that similar assistance will be advanced to Greece by Europe. Unfortunately the UK does not have the luxury of such deep pocketed friends.

So the forthcoming General Election, still expected to be held in early May, may turn out to be a very significant event. A hung parliament is a real possibility as the current government gains ground in the polls on the Tories despite the growing split between the Prime Minister and his Chancellor. The future health of the UK economy requires a trustworthy government with a majority and, most importantly, strong leadership. The monetary and fiscal medicine that has been administered so far is not a long term cure. What is required is a credible fiscal budget to reduce the UK’s deficit.

In an environment where the economy is growing, albeit at a lacklustre pace, inflation is above target, Quantitative Easing is on hold and uncertainty about the forthcoming General Election, the longer term outlook is one of rising gilt yields. With spare capacity in the economy the deflationary threat is still real and this may well temporarily provide support to gilt prices. However, this will also provide bond investors with further opportunities to reduce duration and rotate to a more defensive stance as gilt yields begin to rise. At North, we have constructed our own structured product to reflect our bearish stance on gilts within our portfolios. Whilst, it is difficult to directly sell short government bonds, the 10 year swap rate does provide a suitable alternative. Essentially we are looking to make a return of 12% per annum should 10 year gilt yields rise from their current level of 4% to 6% over the next five years, a return, for our investors, of £1.60 for every pound invested.

We may be negative on gilts, but the credit markets, in our opinion, still offer further value despite the increased levels of issuance and the equity like returns that we saw from this asset class last year. With the banks reluctant to lend, many companies have turned to the credit markets to raise liquidity. The high yield market has been seen as a popular source of funding for many corporations. With fundamentals improving, spreads have tightened as default risk declines. We do, however, believe that we are nearer to the end than the beginning of this story and we are starting to shift our emphasis towards total return bond funds that can hedge out duration and interest rate risk.

Outside of the UK, the theme of tightening liquidity is being played out at varying speeds. The World’s largest economy, the US, is preparing to withdraw Quantitative Easing as their recovery gains momentum. Whereas, in contrast, countries like China and Australia are now pursuing a policy of monetary tightening as their economies have quickly returned to previous growth rates and inflation is now rising. The importance of the economies of the Asia Pacific region and Emerging Markets to overall global economic growth continues to grow in importance as the West staggers along, weighed down by growing deficits. Today, the main threats to global markets are the premature removal of stimulus in the West and/ or an overly aggressive policy of monetary tightening in the developing economies.

Investors are closely monitoring events and this year we have certainly seen a marked increase in volatility. This is what we describe as, a “risk on, risk off” market. The “risk on” market is characterised by a weak dollar and rising equity and commodity prices. Conversely, the “risk off” market is one where the dollar is strong and equity and commodity prices are declining. More recently, though, as attention has been turned to the Greek’s fiscal position and fears around potential sovereign default have increased, this relationship has broken down. The Euro has come under great pressure due to bailout of Greece and the prospect of having to potentially provide assistance to other member states. The US dollar has been the main beneficiary of these events. Yet despite everything equity markets have rallied back towards the levels when they started this year.

We said at the beginning of the year we wouldn’t be surprised to see the wider market move sideways in 2010. If the key word used to describe the events of last year was “unprecedented,” then the key word for 2010 would have to be “tricky!” That is not to say that you cannot make money in “tricky” markets, you certainly can, however, you need to look at this as “a market of stocks”, rather than a stock market. In this environment it is the stock pickers who will succeed as the distance between winners and losers begins to widen. There will also be good opportunity for those investors backing quality, stable companies with a track record of dividend growth. The current environment continues to support equity and commodity prices, however, be wary of becoming complacent. Look for opportunities to take out cheap insurances for portfolios to hedge against risks in the equity market, rising government bond yields, volatility and, of course, currencies movements.

John Husselbee

3rd March 2010