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Private Client Letter - January 2014

It took the pundits by surprise.

The previous three efforts of Dr Bernanke, Chairman of the US Federal Reserve (the Fed), to exit quantitative easing (in 2010, 2011 and 2012) had caused markets to fall sharply and he was forced to re-start the printing presses.  In May last year, even the mention of tapering caused markets to shudder.  However, Dr Ben massaged investors, delayed acting in September, and then in December finally announced the tiniest of tapers, from $85bn a month to $75bn from January, although with the prospect of more to follow.

This time markets rose on the announcement.

What caused Bernanke finally to pull the trigger?

The key enabling event was Congress’ fiscal budget agreement a fortnight previously.  Having twice in the preceding year shut the government down due to a failure to agree a budget, Washington discovered the key to success – Republicans and Democrats meeting behind closed doors, out of the spotlight of the media, and determined to succeed. The passage of a two year budget deal  signalled  that  the  longstanding  political  gridlock on fiscal issues in the US capital had eased, at least temporarily.  The risk of default has been avoided… well, at least for two years…

The Fed would also have been motivated to act by the economy’s  continuing  progress.    GDP growth of 4.1% in the third quarter was the fastest for two years, and healthily almost all due to stronger consumption. This was underpinned by an increase in business inventories.

Across the Atlantic, the €urozone is showing signs of recovery too, with factory activity rising at its fastest pace since 2011.  Unemployment in Spain fell by 107,000 in December, the biggest fall since the series began 16 years ago, and Italy’s manufacturing index bounced from 51.4 to 53.3, the highest since mid-2011.  Only France is lagging, now the sick man of €urope.

The third driver for Bernanke to pull the trigger was that he knew that quantitative easing (QE) was overdone. The Fed’s balance sheet has ballooned from $900bn in 2006 to $4 trillion now. Growth at this rate is clearly unsustainable and, at the margin, had become ineffectual. Tapering was long overdue.

Four expensive words

So…    is  this  time  different?    Market  lore  would  have these as the four most expensive words in the investment industry.   Will the Fed this time be successful in exiting QE? Reading the roons, there are positive signs.

Having achieved the initial stabilisation of the credit markets post the 2008 crisis, it appears that QE was thereafter actually shooting the recovery in the foot and tapering might therefore be helpful.

American banks are required to hold reserves with the Fed against checking accounts.  In the past, the Fed had no authority to pay interest on these reserves, but, in 2008, in the middle of the credit crisis, legislation was introduced to change this. The current rate paid is 0.25% p.a., a miserly figure - but nonetheless higher than other money market rates. This effectively incentivised banks to increase the reserves they hold at the Fed to levels well in excess of minimum requirements, as evident in the graph below.

REQUIRED AND EXCESS FEDERAL RESERVES

Federal -Services

Sources: Federal Reserve Bank of St Louis, Financial Analysts Journal Nov/Dec 2013

Reserves deposited at the Fed are monies not lent out to companies and consumers – but it is credit that oils an economy’s engine.  Add to this the step-up in capital requirements to de-risk banks post the credit crisis, and it is easy to understand that bank lending has been weak.

However, as stimulus is withdrawn and market interest rates rise, the profit margins on loans will increase, banks will be encouraged to lend and this will fuel up the economy. Five years of pent-up demand will start to work through the economy. Tapering might thus actually encourage growth.

QE has essentially only filled the credit void left by banks, which is why it has not been inflationary. QE was necessary but has achieved its purpose.

Exacerbating  the  anaemic  supply  of  bank  credit  has been the fall in the velocity of money to the lowest level in six decades.  Velocity is the rate at which money in the economy is lent out, deposited, lent out again, and its decline reflects weak demand for money as the consumer de-geared post the credit crisis.

VELOCITY OF MONEY 1900 - 2013

Velocity -of -Money

Sources: Federal Reserve Board, Hoisington Investment Management

However, the consumer is again venturing forth as evidenced in the third quarter growth figures mentioned above.

Driven by shale

The Fed has other structural tailwinds assisting its efforts to resuscitate the economy.

A big positive for America is the shale gas boom, borne out of advances in extraction technology.  Gas prices fell by 66% in the US between 2005 and 2012, ushering in improved competitiveness and an industrial renaissance. In contrast in Europe gas prices rose by 35% over the same period, while Japan is currently paying five times more for its natural gas than the US!

America’s domestic energy revolution has driven the trade deficit to its lowest level in four years, with oil output forecast to rise by 2015 to its 1970 record high. The petrochemicals deficit of $25bn is forecast to become a substantial surplus in the years ahead.

This will be augmented by breakthrough technologies in ‘big data’, transforming efficiencies in retail and manufacturing to produce meaningful productivity gains. Computer- aided design is helping minimise raw material use.

There are however also headwinds to the Fed’s efforts to revive growth.

One such headwind has been labour’s declining share of GDP.  In 1958 this was 50%; by 2013 it had fallen to 42% on the back of globalisation and technology, both of which have reduced the power of labour to bargain.  Labour has further had to contend with the burden of pension and health contributions being shifted from corporations to households, serving as a de facto tax increase.   These various trends have served to restrain consumer spending – which makes the third quarter growth in consumption so encouraging.

For investors, the flip side of lower wages has been higher profits. After tax profits have also benefited from a material fall in the tax rate, while earnings per share were further boosted in 2013 by buybacks totalling $750bn, equivalent to almost 6% of the S&P’s market capitalisation.

US TAX RATE ON DOMESTIC PROFITS

Domestic -Profits

Sources: BEA, NBER, Minack Advisors

The  overall  recovery  in  profits  since  the  credit  crisis has thus been strong, although markets initially lagged this recovery  with unbelieving investors  demanding  an elevated equity risk premium for a protracted period after the trauma of 2008.

THE BULL MARKET IN U.S. STOCKS

Bull -Market

Source: BCA Research

Taking these diverse factors into account, what conclusion should be drawn about the Fed’s prospects for successfully exiting QE?

The truth is that the Fed is sailing in uncharted waters and no-one knows, not even the Fed itself. Economics is founded on human behaviour; it is not a science.  Unlike scientists, economists cannot hold other things constant as they adjust one variable.  Unlike mathematicians, they cannot end their policy statement with QED (quod erat demonstrandum or “which was to be demonstrated”). However, reducing the disincentive to bank lending, five years of pent-up consumer demand, and the impact of shale gas and other new technologies on competitiveness are all tailwinds that will assist Janet Yellen as she takes the helm of the Fed over from Bernanke.

Caution the watchword

At Veritas, with our approach of focusing on both the protection of capital as well as its growth, caution has been the watchword in our strategy given the elevated level of markets and ahead of the Fed embarking on its fourth attempt at exiting QE.

In the US, total debt last year reached a lofty 3.44 times total GDP. With this level of indebtedness, a rise in interest rates as a result of tapering may snuff out the still-fragile recovery.

There are other risks. Some of the practices that preceded the credit crisis have re-emerged.  Low interest rates have caused many investors in their search for yield to clamour for higher risk products. Sales of junk bonds last year surpassed the pre-crisis peak. Synthetic collateralised debt obligations have returned.  ‘Covenant-lite loans’ that come with fewer protections for lenders accounted for almost 60% of loans sold in 2013, compared with a 25% share in 2007.

Private sector institutions hoovered up the high yielding bonds of emerging economies, displacing banks as the main provider of liquidity in these countries.  However, these tourist dollars skittishly withdrew back home to the US at the Fed’s first hint of tightening last May, causing emerging markets to hit an air-pocket.

We are reminded of the delightful story about a young Paddy who bought a donkey from a farmer for £100. The farmer agreed to deliver the donkey the next day. The next day the farmer drove up and said ‘Sorry son, but I have some bad news.  The donkey’s died.’  Paddy replied ‘Well then, just give me my money back.’  The farmer said ‘I can’t do that. I’ve already spent it.’  Paddy said ‘Ok then, just bring me the dead donkey.’ The farmer asked ‘What are you going to do with him?’ Paddy said ‘I’m going to raffle him off.’  The farmer said ‘You can’t raffle a dead donkey!’ Paddy said ‘Sure I can. I just won’t tell anybody he’s dead.’  A month later, the farmer met up with Paddy and asked ‘What happened with that dead donkey?’  Paddy said ‘I raffled him off.  I sold 500 tickets at £2 each and made a profit of £898’.  The farmer said ‘Didn’t anyone complain?’  Paddy said ‘Just the guy who won. So I gave him his £2 back. Then I sold the donkey to Findus.’ Paddy now works for a well-known bank.

Bypassing murky waters

Mindful of the risks and the sharp rise in markets, we continue to pick our way gingerly across the investment landscape in our quest for ‘real returns’, ahead of inflation, on a rolling five year view. Successful investing, like life, is a marathon, not a sprint.   Armed with our global thematic approach, we seek to invest for the long term in established, financially strong businesses with a competitive advantage and at a sensible price.   Bonds are expensive and equity valuations full.  Finding new attractive opportunities has become challenging.

We have two core themes at present.

Our ‘Rising Tide 2020’ theme sees us looking through the current murky waters to stocks that we believe will be winners as far ahead as 2020. This encompasses secular growth sub-themes such as technology (mobile, data, ‘the cloud’), healthcare (lifestyle diseases, personalised medicine) and financials infrastructure (payment networks).

Our other theme is ‘Scarcity and Supply Constraint’, such as scarce assets or networks that cannot be replicated economically.  An example is Vinci, quoted in Paris, a concession and construction company that operates French toll roads and has recently bought Portuguese airports. Concession assets, circa 60% of operating income, are contractually inflation-linked, creating a supportive framework for real dividend growth over time. The toll roads and airports will benefit from a pick-up in European economic activity.  The legacy contracting businesses are less attractive but management is growing higher-end engineering and services and focusing on margins and cash rather than market share.  The share price on entry was at an attractive discount to our intrinsic value and offered a dividend yield over 3.5%.

Meg Woods
9th January 2014

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.