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Private Client Letter - October 2012
The sluice gates are open wide and none of the quarter’s potential accidents happened. Markets rose on a wave of liquidity and relief.
Mr Draghi at the €uropean Central Bank initiated proceedings, promising to do ‘whatever it takes’ to save the beleaguered €uro. Chairman Bernanke at the Federal Reserve followed, leading us from the foothills of quantitative easing rounds 1 and 2 to the lofty peaks of ‘QE – infinity’, committing to buy $40 billion of mortgage- backed securities per month “until labour markets improve substantially”. Finally the Bank of Japan’s Mr Shirakawa added a bottle of sake to the punchbowl and also announced further aggressive monetary easing.
To round off the good news, the German Constitutional court declared that the proposed €uro Stability Mechanism did not breach the country’s constitution – and Dutch voters returned their pro-€uro government to power.
Markets celebrated. The MSCI World Equity Index £ rose by 3.6% in the quarter, taking the rise this year to end- September to 8.8%.
What are the central banks hoping to achieve with all this ‘pump priming’? It is clearly not in their power to restore demand for the over-leveraged consumer, nor to return sovereign fiscal balances to health. No, rather their strategy is to buy time. And, just as Noah’s dove returned with an olive leaf in its mouth, so there are slivers of evidence that the central banks might be succeeding.
In the United States, housing has formed a base, banks are past the worst and Dr Bernanke has promised to keep interest rates low until 2015. Credit card debt has tumbled to its lowest level since 2002 - some 20% below the 2008 peak - and credit availability is improving. Confidence is reviving. The country is at the forefront of technology at present, including the commercialisation of hydraulic fracturing or ‘fracking’, which has opened up vast gas shale reserves and reduced utility bills. Unit production costs have fallen by 11% over the past decade where they have risen in almost every other country.
HOME PRICE INDEX (INCL DISTRESSED)
Source: BofA Merrill Lynch Global Equity Strategy. CoreLogic
In the UK, manufacturing is still shrinking but the worst of the tax hikes is past and employment has increased. New car sales grew by 8% in the third quarter, the strongest since 2001. Financial tensions in the €urozone are perceived to have eased.
May we therefore conclude, as did Noah, that the flood waters of the credit crisis have receded? Sadly, no...
Despite the slivers of light, the IMF is lowering its world GDP growth forecasts and corporate America is more pessimistic now about prospects than at any time since the start of the financial crisis. Consensus earnings per share growth forecasts for 2012 have been halved from a little over 10% as recently as June to 5% now.
PROGRESSION OF CONSENSUS 2012 - EARNINGS GROWTH ESTIMATES
Source: IBES, DataStream, UBS Global Equiry Strategy
The Dow Jones Transportation Index, viewed as a harbinger for the health of the economy, is down by -2.5% since the start of the year to end-September, in stark contrast to the S&P’s 14.6% rise.
The broader market rally has more to do with central bank action than fundamental strength in company profits.
Chasing fiscal tails
The headwinds imposed by excess sovereign debt levels in the West remain formidable. The Bank for International Settlements has calculated that the fiscal surplus as a % of GDP must swing over 10 years by 15% in the UK, 14% in Japan, 11% in the USA and 9% in France just to stabilise public debt at pre-crisis levels!
The US Congress, in an effort to be seen to be taking this challenge seriously, last year legislated extensive tax hikes and spending cuts to take effect on 1st January, 2013. If implemented, some 90% of households would be affected. The average federal tax rate would rise by 5% to 24.3%, totalling $536 billion, and the deficit in 2013 would be halved. However, it would also cause a recession.
Unsurprisingly it is widely expected that Congress will not have the stomach for this ‘fiscal cliff’ and will water it down after the Presidential election.
The real challenge with fiscal deficits is however not the palatability to the electorate of tax increases and spending cuts. It is the extent of revenues that are not reaching the coffers of tax offices due to tax havens and trust structures.
Offshore tax havens are well known. However, in a meticulously researched book called ‘Treasure I$lands’, Nicholas Shaxsin reveals that the City of London and pockets of the United States such as Delaware are equally key ingredients of this global web. Together these havens facilitate the hoovering up of trillions of dollars of revenue out of tax nets as businesses and individuals seek to side- step regulation and minimise taxation.
Governments are powerless to act because attempts to close the loopholes would simply prompt the money to move to another haven. If cattle are reared in Argentina and the beef sold in the US and EU, how should the profits be split? Through the mechanism of ‘transfer pricing’, they will be booked to the country where tax rates are lowest.
More than half of world trade passes (on paper) through tax havens. The IMF estimated in 2010 that the balance sheets of small island financial centres alone totalled $18 trillion – or one-third of the world’s GDP! The scale of it is breathtaking.
In 2006 one-third of the UK’s biggest 700 businesses paid no tax at all in the UK. Envisage the Greek problem: ship-owners merely sail their profits into the sunset. It is estimated that in 2009 some 99% of Greek and Italian money had not been declared to the tax authorities.
The Greek government announced in September as part of a cost-cutting plan that they would close 49 tax offices... Not enough work?
The fall-out of the tax havens is diverse. First, the fiscal burden has shifted onto the man in the street – witness the social unrest in €urope. US corporations paid 40% of all US income tax in the 1950s; today that has fallen to 20%. This constrains tax revenues and is damaging to consumer spending and hence growth.
Secondly, this capital escapes regulation – which was a key ingredient in the cause and depth of the 2008 credit crisis.
Thirdly, the growth rate of the countries losing these revenues is impaired. It’s rather like the impact of dividends on the total return of equities. The total return on UK equities from 1900 to 2010 was 5.3% p.a. if dividends were re-invested – but only 0.6% p.a. if dividends were withdrawn.
The structural challenges presented by these untaxed monies comes on top of other secular headwinds – the retirement of the baby boomers and the end of three decades of credit expansion on the back of falling interest rates, for example.
Shelter or surf?
Against this precarious backdrop, should investors opt for the safety of bonds – or ride the wave of central bank liquidity?
There is a clear valuation difference now between equities and bonds. With interest rates at record lows, bonds are historically expensive.
Company management is seizing the opportunity! Corporate bond issuance worldwide has reached a staggering $2.9 trillion this year, the second highest on record and 22% above the average for the last five years. In contrast, money raised on global equity markets is at a 7-year low. Siemens has issued €2.6 billion of bonds and is buying back €3 billion of shares...
The difference in valuation levels is starting to affect pension fund investment strategy. For over a decade, pension funds have increased bonds at the expense of equities in recognition of the ageing of their members.
UK PENSION SCHEMES' ASSET ALLOCATION
Source: Company Reports, DataStream, Citi Research
Now however, with yields on equities exceeding those on gilts and with pension funds’ need to generate income streams, their interest in high yielding equities has risen. A feature of this year’s rise in markets is the extent to which high yielding equity strategies have outperformed capital growth strategies.
We note other risks to bonds. Reflecting the shrinking of China’s current account surplus and foreign exchange reserves, her holdings of US Treasuries peaked at $1.31 trillion in July 2011 and have now fallen to $1.15 trillion. Japan’s public pension fund, the world’s largest and historically one of the biggest buyers of Japanese debt, is selling domestic government bonds as the number of people eligible for payments increases with the retirement of their baby boomers.
At Veritas we were early in flagging the over-valuation of bonds, but consider that recent trends support our view. We continue to believe that the most attractive asset class to achieve the real returns, ahead of inflation, to which we aspire for our clients is the equity of sound businesses with a competitive advantage and the tailwind of a growth theme, bought on a sensible valuation. However, selectivity is crucial in the current uncertain climate.
We do not benchmark to an index and this is not a strategy that outperforms the indices every year. It is a style that by its nature will lag in frothy or liquidity-driven markets, which is borne out by our track record. Share prices will fluctuate in response to short term macro pressures, but it is the long term value accretion based on underlying profits that we seek. Over rolling 5-year periods, this strategy has historically comfortably achieved its objectives and we strongly believe this will continue. We remain focused first on the protection of clients’ capital and then on its growth.
Our core themes, which act as filters in our search for stocks, remain intact - ‘Structural Growth’ and ‘Scarcity’, and all ‘Dependable Compounders’ that can be relied upon to deliver solid growth in the years ahead.
Our fourth conviction theme is evolving. ‘Rising tide, 2020 winners’ seeks to look through the €uro crisis, the US we freely admit we do not know the outcome - to those sectors that will become winners by 2020. Thus we are extending, not shortening, our time frame.
An example of our 'Rising Tide' theme is Waters Corporation, a US based analytical instruments provider. With the decoding of the human genome and the trend to more personalized medicine, the requirement to identify individual proteins and peptides that are encoded by genes is growing rapidly. Such peptides are identified by mass spectrometry, one of Waters’ two key product areas. In addition, many countries are increasing regulations covering food safety, water quality and the environment. These new regulations require the product to be tested by separating out the individual chemical components. This is done by a process called liquid chromatography, another field where Waters is the leader.
The company uses much of its prodigious cash flow to buy back shares, and, following a recent fall in the share price due to one-off events, is now attractively valued.
Veritas Report Card
The chart below, prepared independently by Asset Risk Consultants, covers the five years to 30th June 2012. The left hand axis shows both our and the aggregate private client fund manager’s average annual returns, while the bottom axis records the risk or volatility. We are pleased to reflect that the returns achieved by Veritas (the red shapes) significantly exceed the returns recorded by both the peer group (the white shapes) and by markets (the line).
The risk in our High Equity client portfolios has been so low relative to the peer group that ARC has re-classified them into their next lower ‘Steady Growth’ risk category.
5th October 2012
ARC Private Client Indices (“PCI”) are based on historical information and past performance is not indicative of future performance. PCI are computed using a complex calculation and the results are provided for information purposes only and are not necessarily an indicator of suitability for your specific investment or other requirements. ARC does not guarantee the performance of any investment or portfolio or the return of an investor’s capital or any specific rate of return. ARC accepts no liability for any investment decision made on the basis of the information contained in this report. You should always complete your own analysis and/or seek appropriate professional advice before entering into an agreement with any PCI Data Contributor. The content is the property of ARC or its licensors and is protected by copyright and other intellectual property laws. Use of the information herein is governed by strict Conditions of Use as detailed on www.assetrisk.com/pci.
The above review has been issued by Veritas Asset Management (UK) Ltd., which is authorised and regulated by the Financial Services Authority.
The opinions expressed above are solely those of Veritas Asset Management (UK) Ltd 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.