This is the second of a two-part series on summer shenanigans in the markets. Read part one first.
A fellow blogger and Monevator reader named Ermine recently noted that I have been much more nervous in the past few months (although I did a bit more actual selling back in August 2010).
Recently, I’ve been worried about the unintended consequences of US Treasuries losing their AAA status. I still am worried, and will be until it happens without consequence, although the very low yields on these bonds shows I’m in a minority. Most investors couldn’t give two hoots about a ratings downgrade.
As an aside, the following graph from Business Insider shows yields have actually tended to fall recently after downgrades from AAA ratings!
S&P downgrades: A very contrarian indicator, recently.
This doesn’t say S&P is wrong to downgrade – only that the market anticipates the rating change by selling off, and then buys once the deed is done. But the wider point is that downgrades haven’t been doomsday by any means. (Mind you, things might be different when it is the world’s reserve currency that gets downgraded).
Another reason UK and US government debt has done so well is sovereign default fears in Europe. In other words, it’s a beauty pageant among ugly sisters. Forget doomed Greek bonds and the like, I’d even rather buy our debt than German bunds. I think the Eurozone crisis will be resolved, but it will be at the expense of higher German interest rates as the pain is spread around a more closely-integrated Europe.
German bonds would surely be vulnerable in such a scenario.
Right problem, wrong time
The real irony is that the UK and US governments are so committed to debt reduction in the near-term, even as they can finance spending more cheaply than ever before.
I first wrote in November 2008 that while I’m no fan of paying taxes to pay for other people’s laziness, I am all for smart investment in infrastructure.
With the government able to borrow at well under 3%, that’s doubly true today.
Sean O’Grady wrote recently in The Independent that:
Right now, British business is sitting on a £60bn cash pile, some 4.5 per cent of GDP, too frightened to spend it on new kit because they don’t know what’s round the corner.
What’s more, business investment is in long-term decline, on a quarter-century view, and that is not promising. In the past decade or so it has been hidden by some substantial government investment, but that is now set to shrink sharply. According to the CBI’s latest forecast private sector investment is due to grow by an annual rate of about 9 per cent over the next year or two – if companies can summon up the gumption to do so, and on a low base.
But the really startling trend is in government fixed investment. While certain high-profile projects such as the fast link to Birmingham will be protected, many others, not least the Building Schools for the Future programme, have been cancelled. So government fixed investment is due to shrink by an annual rate of 10 per cent plus in the coming months.
It’s a similar situation in the US. But sadly, in both countries government spending on useful infrastructure has been pretty weak compared to spending on what the Americans call ‘entitlements’, which aren’t half so good for boosting productivity, and on tax cuts, which are probably neutral.
With GDP faltering, the resultant public backlash against government debt couldn’t have come at a worse time for making the case for governments spending more, even though in both the US and the UK it’s easy to think of massive job-creating projects that could boost our nations for years to come, from railways to windfarms to nuclear reactors.
It’s not hard to get a decent return on capital when you are borrowing at less than 3%!
Betting on a mid-cycle slowdown
The final twist therefore to the present situation is that even as the US moves towards reaching a resolution about its debt ceiling – and so potentially staves off a meltdown – equities are selling off because of a fear that the consequent reduction in US government spending will choke off global growth.
There are already jitters that more companies have started to miss earnings estimates, although personally I think that’s more due to a mid-cycle slowdown exacerbated by Japan’s earthquake. But as we saw in part one, US earnings are close to their previous peak. They are undeniably vulnerable to a setback.
I’ve even found myself researching strange indicators such as the share price of auction house Sotherby’s! The theory is it peaks before a recession, due to all the excess cash sloshing about. That particular rune has indeed looked a bit toppy, although I wouldn’t say it’s brought the hammer down yet.
But on balance, I’d still prefer to be overweight shares than anything else. I don’t think UK shares are fundamentally dear, and I think that stock markets will be a lot higher in 2020 than they are today. I also think equities offer better-priced inflation protection than most alternatives (though I prefer to keep cash in NS&I index-linked certificates).
According to Bloomberg, the FTSE 100 is on a current year P/E of just under 10, falling to less than 9 on next year’s estimated earnings. The famed single digit P/E ratings beloved of bears! Even the S&P 500 is on a reasonable looking 12.5, falling to 11 on next year’s estimates.
True, the US housing market and unemployment remain mired in the doldrums and the UK and much of Europe is struggling, but equally I’d say that makes today’s earnings more credible than say 2007, coming off such an unpromising backdrop.
Finally, I think that most trading in equities is currently done by hedge funds and the like at the margins. Private investors never truly came back to shares, and nor have institutions like pension funds. As such, any choppiness in share prices could turn on a dime: I don’t take these summer gyrations as profound indications of a change in sentiment.
One caveat: like hedge funds, I’ve been actively trading more than ever. My passive allocation has been at an all-time low point since early this year, as I’ve tried to position myself more defensively through globally-focused dividend paying shares like Diageo and Unilever, and seemingly mispriced securities like the Caledonia Trust. I’ve also realised about 4% from selling vulnerable or illiquid holdings, mainly to give myself a little war chest to cheer myself up if things turn really bleak!
It has all helped recently, but it obviously won’t protect my net worth in a rout. If we see one, it’ll be time to dust off the bear market survival guide again. As a 30-something I’d much rather take my chances with equities for the long-term than government bonds at 300-year old lows. If you’re 60 you might take a different view, although you should be thinking about rebalancing as you age, not as the market wobbles.
Just as I believe the UK government should be investing for the long-term given it can borrow so cheaply, I still believe these past years will eventually prove to have been a great time for us to build up an income for the future. If you’re looking to someday live off investments, bear markets are to be welcomed.
As ever though, the sensible thing to do is to buy a diversified portfolio, periodically rebalance, and not try to be too clever!
Readers, what do you think of the recent market wobbles? Let us know what you’re doing below (saying “nothing different” is entirely acceptable…)
Comments on this entry are closed.
A thoughtful article, as ever.
However, after a career helping the public sector to ‘invest’ I am not so sure that it gives value for money. For example, there is an inbuilt bias towards ‘new’ rather than ‘refurbished’ in public sector accounting. Thus, perfectly good school buildings are knocked down and new ones built – because the accounting system insists on capital rather than current spending.
Moreover, projects like HSR2 (high-speed rail) are much less beneficial for the country than they at first seem. Grants to purchase electrical cars are manifestly silly in terms of national economic activity (and GHG!).
Despite the headlines, govt expenditure in the UK (and US) is not significantly less, for fear of triggering a recession. My take, is that the govt needs to squeeze much more on the wasteful public expenditure and to explore ways of ‘mending and making-do’ rather than ‘investment’.
Great set of posts.
Perhaps I am too much of a bottom fisher, but for the first time since last July values I feel tempted by corners of the equity market again, and discounts on ITs are beginning to widen. I share your view that this will be temporary pullback rather than a rout, but it would be welcome to see the pullback continue a little longer yet (though doubt the market will fall below the levels of last June).
What’s your feeling about Lloyds – now cheaper than at any time since March 2009?
Totally agree, Mr Monevator.
@ moneyman – I agree with you too and I think the idea of ‘value for money’ seems to have got lost somewhere in public sector organisation.
Playing devil’s advocate, I would hazard a guess that this is partly because the public sector is so large it has had to become increasingly bureaucratic in order to ‘keep order’. This means that only companies with access to large resources in terms of tendering, marketing etc can compete. The resultant side effect seems to have been to strip out the opportunities for smaller, leaner companies. Hence, once a company gets in with the public sector, price seems to be a secondary consideration. I suppose this is understandable as no-one wants to be accused of shonky business dealings further down the line.
I can only liken it to when you pick a wedding venue and are then forced to pick between, say, 3 outrageously priced caterers.
@ Faustus – I’m not sure what to make of Lloyds. I bought some last year and sold out after watching the price drop.
I am intrigued to note that Philip Gibbs of Jupiter International Financial fund has almost 60% of his fund in cash. Make what you will of that!
GMO
@Moneyman — Well, I definitely tried to allude to a distinction between wasteful spending and investment for the future. Low-level nonsense like we saw towards the end of the Labour years is definitely not what I have in mind. But vast quantities of the infrastructure the country relies on was built by the public purse, from power stations to the roads to most hospitals to the London Underground.
Investing in upgrading such infrastructure gives the double whammy of keeping people in proper, skilled jobs, and making the country more productive in the future. Study after study has shown this (together with education, but that’s a seemingly intractable issue!) is a real Achilles Heel in the UK economy.
I’d baulk at issuing bonds to pay for it at say 5-6% and in a boom time where it could crowd out private money, but if people are willing to take less than 3% on gilts then on their head be it. Much of the construction and support sector is still going through the wringer, so it’s not like government would be sucking investment away from the Invisible Hand of the market’s machinations.
And we could call the ‘Rebuild Britain Bonds’ or similar! 🙂
@Faustus – Thanks…We went below 10% off the peak today, and the US markets are down 10%, too, so it’s now an official correction. Still not what I’d call a rout! 😉
For small cap stock pickers I reckon there are all sorts of anomalous bargains around if you can sort the wheat from the chaff, due I think to private investor panic and margin calls from spread betters and the like. Some of the big cap mining moves seem overdone too, and with the price of gold also bizarrely down, I wonder if we’re seeing margin calls among the hedge funds, also.
As for Lloyds, I have pretty much reached the conclusion I should have reached years ago that it is a complicated beast with no easy read. I have traded in and out of them for three years, and the same with the preference shares (LLPC). I’ve also traded Natwest prefs (NWBD). I bought both the latter for long-term income, and sold despite that. I am only human, after all.
Basically the whole thing is roughly a wash for me. For a while I was well up on my Lloyds stake (hard to believe they were approaching 80p now!) and I sold about half, but I’m underwater by roughly the same amount on my remaining holding, that I have out of stubbornness.
I read the results today, and they didn’t look great. Impairments were up, net margin down, they’ve gone quiet on cost-cutting, and the improvement to T1 Capital seems to have stalled. They’re doing the right thing selling off non-core stuff (it should improve many of these metrics in time) but for now you get the impression of a sinking ship throwing fancy furniture overboard as it steams on and down.
I don’t believe it will sink — in fact, I still believe it will likely someday be a supertanker — but timing that seems to be impossible. The best hope is the new man from Santander seems a stand-up sort, and I wouldn’t be surprised if he’s tried to kitchen sink as much as he could, especially as the government was insanely looking for ways to split up Lloyds and cost us all money — that after forcing the HBOS deal on shareholders, of whom I’d been one for years for its safety and dividend. In such circumstances, I’d be tempted too to not shout about any improvements until the climate eases up.
The £3billion PPI hit is an enormous blow, but it’s a one-off. A victory for the little guy, unless the little guy is a Lloyds shareholder!
@GMO — I do wonder about the public sector’s future. You have people claiming to be vocational and demanding certain perks on the back of that and yet being paid in many cases now more than private sector workers, especially given their pensions.
Yet equally, why shouldn’t they if the public sector is in turn becoming more commercial, and they have to pay the same insanely inflated house prices as the rest of us? It’s a bit convenient for a banker or lawyer or newspaper editor to say “well, she shouldn’t care less if she earns less, she’s a nurse, she’s not in it for the money”, which you increasingly hear.
And then you have consumers demanding cutting-edge consumer experiences from services like the NHS, such as that appalling article by that Liz Jones woman that did the rounds the other day where she demanded priority treatment for her woe-cation in a war zone.
No easy solution. My Recession Bonds wouldn’t touch the service side of the public sector with a bargepole. We want to build big amazing things that leave a legacy, and deliver more than 2.7% on our investment. (Not hard when inflation is nearly 5%!)
I wonder whether the figures Sean O’Grady quotes for 10% cuts to “government fixed investment” include the off-balance sheet PFI spending; that counts as private-sector capital spending, as far as I’m aware, since the private sector gets to own the capital. Brown and Darling queued a bunch of those projects up, and they have not all been cancelled.
Capital investment is the type of government spending with the highest estimate of “Keynesian multiplier” so it does seem dumb to cut that back. But it is probably politically the easiest thing to cut: it is the cuts to recurring entitlement spending which provoke the strong media/voter reaction, not the bridge that didn’t get built.
I am not too worried about needing more fiscal stimulus. Politicians tend to go for the big vanity projects like HS2, which make for great press conferences but will come in at twice the planned budget and half the planned value. They’d be better off building a nuclear power plant or two for that money, IMO! And then allowing that extra runway at Heathrow…
Monetary stimulus is what is important, and the Bank of England seem much more dovish than either the ECB or Fed, even in the face of higher inflation than in the EU or US, so I remain optimistic about the UK. Also the worries about recent GDP figures are mostly interpreting the data wrong, per http://stocktickle.com/2011/08/04/uk-gdp-forecast-revised-up-for-2011/ 🙂
The UK service sector PMIs from July came in way stronger than the EU and US equivalents. Good news gets lost in the noise, these days…
Also I went 10% overweight on gilts thanks to today’s crash, so I’m selling some and buying some FTSE tomorrow. Merv, fire up the QE, please.