Alice in Squanderland
Posted on: 04 Sep 2012 by James Farmer

You think the big picture in Europe is bad? You’re not wrong, says Dick Turpin, Managing Director of Artemis Fund Managers. But shares are still good value:

Ah, the comforts to be gained by studying history. Why, just think …

In 1923, it took 4.2 trillion Deutschemarks to buy one US dollar. Yet the Reich recovered. In 1952, when our second Queen Elizabeth ascended, an average acre of English farmland cost £56. That figure is now £6,156, a rise (give or take) of 10,000%. Yes, in the long run we’re all dead. But regression, and then recovery, endure.

And so, as the intractable meets the interminable and Europe’s crisis continues, we consider the predictive powers of the past.

• Latin American Debt Crisis (early 1980s). In the ‘60s and ‘70s, Brazil, Argentina and Mexico borrowed huge amounts for industrialisation and infrastructure. Then in the early 1980s oil went up and growth came down. Enter the IMF and austerity. Most of Latin America has prospered greatly since.

 

• International Banking Crisis (late 1980s). After Lat Am’s defaults, contagion. Enter Brady Bonds, allowing commercial banks to change their claims on developing countries into tradable instruments. Thus began the market for emerging debt.

 

• US S&L Crisis (early 1990s). The “thrift” industry (essentially, mutually owned mortgage banks) was deregulated in 1980. Disaster. Enter the Resolution Trust Corporation, which “resolved” 747 thrifts with $394 billion in assets.

 

• Swedish Banking Crisis (early 1990s). A bank-financed real estate bubble burst. Sounds familiar? But this time, in 1992, the government forced the banks to write down their losses and issue warrants to the government. Distressed assets were sold through a new agency. Unemployment rose from 2% at the start of 1990 to 12.6% in June 1993 – and down again.

 

• Asian Debt Crisis (1997-1998). The Thai baht in virulent batter. Enter the IMF (again), this time with a “structural adjustment package” (SAP), aka extreme austerity. The results speak for themselves. For example, from its high of 16,673 on 8 August 1997, the Hang Seng Index fell by over 60% to 6,660 – and then climbed by over 375% (to 31,638) in the next decade.

 

Euro-Paralysis

We could go on, but we won’t. Our point is that, by contrast, Europe’s emollient leaders seem to be following, if any, the indecisive Japanese model. Perhaps they have no choice. This time there is little or not enough vigour elsewhere in the world to make up for real austerity in Europe; and the banking system epitomises the dangers of that hideous neologism, “interconnectedness”.

 

So? It’s either a major melt-down or – and happily, we think this much more likely – more muddle-through. We agree with former US Treasury Secretary Lawrence Summers: “Not all problems can be solved. It is not certain that the full repayment of all currently contracted sovereign debts, sustainable growth for all and the eurozone retaining all its current members will be feasible.”

 

There will be, no doubt, more “solutions” of increasingly brief longevity. The IMF can call all it likes for “a banking union and more fiscal integration.” But the Euromess is all but as complex as computing’s non-polynomial problems. Resolution is far from impossible. That said, it will take years.

 

Crippling Debt Burdens

Meanwhile, the biggest risk we can see out there is, simply, debt: the developed world’s net income and gross habits. The amount of eurozone sovereign bonds that need to be issued to service public debt and fund spending is expected to reach €794 billion this year. As Ronald Reagan said, “A billion here, a billion there, and pretty soon you’re talking real money.”

 

At the end of last year, US treasury debt was a record $15.2 trillion. The labour force was 153.9 million. So each American worker (employed and unemployed) holds a record $98,925 of this debt, while employed workers hold a record $108,125. We learned recently that there is, apparently, $53 trillion in global dollar-denominated debt out there – but a total money supply of only $2.7 trillion in circulation. Would you buy a $20 dollar bill for $392?

Italians evaded €120 billion in taxes in 2010 – almost four times the savings that Mr Monti’s ‘austerity package’ is meant to achieve. Act. Cut. Do. Such imperatives, even optimists must admit, are not inherently Italian.

Another 120 billion, this time in sterling, is what the UK government will have to borrow this year to make up the difference between its income and expenditure. Meanwhile the hapless taxpayer picks up the £6 billion “overspend” at the MoD on projects running, in aggregate, 26 years late.

Thus (too) many still draw deeply on the teats of the state. The result is that our total national indebtedness exceeds £1 trillion. And although it already owns around a third of all UK gilts, the Bank of England has produced another £50 billion of financial alchemy. Does it really sound better as quantitative easing?

 

The European Central Bank’s name for the same thing, of course, is Long Term Refinancing Operation (LTRO, aka “Love the Risk On”.) When you add its €529.5 billion in March to the €489 billion doled out in December last year, European banks have taken over €1 trillion from LTRO at (or around) a handy 1%. To put this into context, €1 trillion would be enough to buy every major bank and finance house in Europe, and still have about €300 billion left to buy most of the big American banks.

 

Light at the End of the Tunnel

It is, in short, a lot of money; Alice in Squanderland; beyond the interstices of intelligence. And its contribution to a “solution” to the Euromess? Perished as though it had never been.

 

Well, it’s a funny old world, which never ceases to surprise. The red-brick cornershop on Grantham’s Broad Street, where one Margaret Thatcher grew up, is now a chiropractic centre and “holistic retreat”. The sole Japanese passenger on board the Titanic, a civil servant called Masabumi Hosono, survived – only to be sacked when he got home for the dishonour of being alive.

 

But it’s certainly one in which there are stocks – and certain bonds – to buy and hold. In an uncertain world, we are sure of at least one thing: we would rather own a sound equity paying a sustainable dividend than most supposedly ‘risk-free’ government bonds. The question isn’t whether these stocks and shares will reward patient investors, but when.

We own, at any one time, around 1,000 stocks and 140 (mostly corporate) bonds. What strikes us, on the whole, is how healthy they are. That doesn’t mean that the market prices them correctly. It does mean that it might, or even will, in time. We note that the cash balances of FTSE 350 companies, ex-financials, stood in aggregate at a total of £160 billion in cash at the end of each quarter last year. Companies in general have learned the lessons of 2008. Their exemplary management of their balance sheets is not yet, we reckon, ‘in the price’.

Cash-rich companies do what? Apple’s recent and inaugural dividend is at one end of the scale.  Option 2, of course, is M&A. In short, corporate Darwinism is alive and well. Come bull or bear some companies will not only survive, but thrive. We have been (re-)considering the lessons from such fine works as The Triumph of the Optimists or Anatomy of the Bear. Forecasting the economic cycle may be fascinating; but it is unlikely to make you money. Good equity market returns are primarily the result of low starting valuations.

 

For those, and although of course it could fall, the price/earnings (p/e) ratio on the UK market is down to around 10. Since 1965, that ratio has reached over 20 (in 1968/69 and 1999/2000). Other than the low of 1974, when it fell to 3.2, the p/e has rarely traded below 8 and has averaged over 14. So, on most definitions, the equity market is currently cheap and gilts are expensive. It was probably time for a decent rally. And after a torrid few years, investors could be forgiven for thinking that we all deserve a further rally – or even more.

 

 

 

 

 

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