This is the second of a two-part series on summer shenanigans in the markets. Read part one [1] first.
A fellow blogger and Monevator reader named Ermine recently noted [2] that I have been much more nervous in the past few months (although I did a bit more actual selling [3] back in August 2010).
Recently, I’ve been worried about the unintended consequences of US Treasuries losing their AAA status [4]. 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 [5] shows yields have actually tended to fall recently after downgrades from AAA ratings!
[6]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 [4] 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 [7] other people’s laziness, I am all for smart investment in infrastructure [8].
With the government able to borrow at well under 3%, that’s doubly true today.
Sean O’Grady wrote recently in The Independent [9] 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 [1], 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 [10] in 2020 than they are today. I also think equities offer better-priced inflation protection [11]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 [12], 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 [13]. 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 [14] 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 [15], 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 [16] for the future. If you’re looking to someday live off investments [17], bear markets are to be welcomed.
As ever though, the sensible thing to do is to buy a diversified portfolio [18], periodically rebalance [19], 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…)