«We will continue to swim in a sea of liquidity»

Felix Zulauf, James Montier and David Iben: Three legendary investors share their views on financial markets. Everything is pricey, the European periphery is a bubble. Value investors need to venture to Russia or buy gold mining stocks.

Gregor Mast und Stefan Rehder

Felix, a bit more than a year ago, the mere announcement of tapering by the US Federal Reserve triggered a shock wave through financial markets. You called this the butterfly effect which might feed into a worldwide correction. Now we have had tapering since the beginning of the year, and all major asset classes are gently moving up on very low volatility. Is tapering really a problem?
Felix Zulauf: It was a butterfly effect for the moment because the world feared a liquidity tightening which immediately sent emerging market interest rates higher and their currencies lower while the dollar firmed as capital flowed back to the US. The Fed will be done tapering by September or October, but other central banks will take over. We have seen for many months now that the Chinese are printing more money than the US. On average, they have created Renminbi for the countervalue of 50 bn $ per month over the last six months. This is an enormous amount.  Then the European Central Bank is willing to add 1100 bn € over the next two years which equals an expansion of 50% of its balance sheet. So we will continue to swim in a sea of liquidity. The question is whether there might be other events and developments that may not be camouflaged by liquidity which could cause a change of investor expectations. Liquidity is one thing, but there are fundamentals also.

What fundamental development could that be?
Zulauf: We think it could be China. In every cycle you have a dominating excess which reinforces the cycle on the upside, but when it turns, it reinforces it on the downside. Last time, it was US and parts of European housing and in the previous cycle technology investments that created excesses and overcapacity. In the current cycle it is emerging markets, and the big gorilla is China.

Can’t Beijing control that?
Zulauf: The dimension of the Chinese cycle was enormous. In 2011 and 2012 alone, China has consumed as much cement as the US had in all of the 20th century. The credit creation in the last five or six years is mounting to the total loan outstanding by the US banking system. The excesses are mind boggling. Now anecdotal evidence tells us that the Chinese investment and construction boom has not broken yet, but it has cooled. But when it cools after a boom like we had, it’s probably the end of the cycle. However, investors still believe that the Chinese authorities can manage it because it is an autocracy. Once this assumption changes, it will have a negative effect on markets, but we do not know when exactly that will be.

After the end of QE1 and 2, equity markets corrected. Could the completion of QE3 be a trigger for the scenario you mentioned?
Zulauf: I doubt that we will see real monetary tightening by central banks. That’s the interesting thing about the current cycle. Investors are prepared for a conventional ending of the cycle with higher growth and capacity utilization resulting in higher inflation, rising interest rates and tightening liquidity that leads to a bear market. But it could be very different this time. If all of a sudden something went wrong in China, we would have another deflationary episode. If China’s currency goes down 20%, this affects pricing in traded goods and, therefore, corporate profits. All of a sudden, investors might look at the valuations of their stocks and realize that the emperor has no clothes.

Spanish, Italian and French bond yields trade on 200-year lows. Is the Euro crisis over?
Zulauf: The Euro crisis is not over. The intensity of the crisis was terminated by Mario Draghi’s famous “whatever it takes” speech in July 2012. The authorities have elevated the existence of the Euro to dominate every other issue. Of course, economics is such that you can’t have all variables fixed. If you can’t deflate to reduce the differences of the economic structures of the different economies and you can’t devalue your currency, the adjustment goes through the real economy. That’s what’s going on. Euro sceptics have taken almost one third of the seats in the recent European parliamentary elections which is a reflection of the unsatisfactory and discontent situation in the majority of the European economies. I do not see that the current set-up for the Euro and for the European economies is going to change for the better in years to come despite all the cheating and breaking of laws and contracts and treaties that is going on.

What does that mean for the EU?
Zulauf: That leads to a change in the political sphere which established parties are ignoring. Instead of taking it up and trying to change the direction of the Euro and EU from a more centrally planned  EU to a EU of subsidiarity, they are just ignoring it. If you’re ignoring the warning signs, it will get worse over time. The changes to the European situation will not come from financial markets. It must come from politics. But the established parties will not change for a long time and therefore the conflict will intensify in the political arena. So my hunch is that the European recovery is not really leading up to expectations and will continue to disappoint citizens and voters. That will be expressed at the next elections. The problems could be dampened along the road if Germany agrees to a mutualization of debt and mutually financed infrastructure programs and so on.

So you distrust the current rally in European equities and bonds?
Zulauf: For the time being, European financial markets have a honeymoon that can continue for a while longer, but this is based on the expectation that the European economy will normalize. But this expectation could eventually be disappointed.

James, we have slow growth, no inflation, low interest rates and easy monetary policy as far as the eye can see. Are we living in the best of all worlds for investors?
James Montier: How I wish that that were true. The problem with the policy of raising asset prices is that you borrow returns from the future. You can think of it as the front loading of return. So what you’re really doing is pushing down future returns. So it doesn’t really help anybody a great deal in the longer term. Of course, in the short term the effect is positive as you get some sort of balance sheet repair through rising asset prices. At least that’s what central banks hope. But when you look at today’s opportunity set, you’re left with a set of assets where nothing looks attractive from a valuation point of view.

Even if interest rates stay low for a long time?
Montier: Even if we factor in low interest rates for the next twenty years, we’re still not seeing great opportunities. We can find stuff that may be fair value in that scenario, but it’s far from obvious. This is a very difficult time – in contrast to 2007, when risk assets were expensive but cash and bonds were priced to deliver reasonable returns, which is not the case today. It’s much harder to find anywhere to hide. So far from being the best of all possible worlds, this is almost the worst of all possible worlds.

Do your clients still believe in the much-cited low return environment? The further markets move up, the more you might have a credibility issue.
Montier: No doubt. We haven’t yet reached the kind of loathing that was displayed towards us in 1999 where we were just told we were complete idiots and several clients banned us from their buildings. I think there is a broader acceptance of the power of valuation, but the longer the rally goes on, the shorter people’s memory gets. Galbraith used to talk about the extreme brevity of financial memory and I fear that’s kind of what we’re experiencing now. People are looking at last year and say look, it can go up 30%, why on earth are you saying future returns are going to be dismal.

But markets have been expensive for quite some time. How opportunistic should a value investor be?
Montier: There are two possible states of the world: either they keep rates low for a very long period of time or they don’t. Anyone who says they know which one is going to happen is either a liar or a fool or possibly a linear combination with unknown weights. The reality is, nobody knows the future, particularly when it comes to policy rates. By second guessing we’re playing some sort of ridiculous beauty contest. Therefore we should try to build portfolios which are robust and can survive different outcomes.

How do these portfolios look like?
Montier: That’s a challenge because the portfolios you want to hold in those two different worlds are almost diametrically opposed. If financial repression continues, you want to own the least bad thing out there, which is equities. In the other world, the only asset which does not hurt you when rates move to normal, is cash. So you end up with this bizarre portfolio where you own some equities where they are cheap. And you want to own some dry powder assets which protect you against inflation, provide liquidity and real return.

Does cash do the job?
Montier: Cash historically has done all three of those things very well, but in a world where rates are kept very low, cash does not do at least two of those things very well. So in addition to cash, you have to include some long-short strategies, TIPS and bonds which offer at least some yield. The really unsatisfying thing is that no matter what is going to happen in the future, you won’t hold the best portfolio. But at least, this portfolio allows you to survive.

Felix, do you come to a different conclusion?
Zulauf: I’m a believer in cycles. This cycle is very unusual in many ways. It is a long cycle because we compress interest rates while high risk aversion has kept certain asset prices low. It is also unusual because we won’t get monetary tightening in a long long time. That gives some investors comfort that there is not much risk in the market. Many of those also subscribe to the view that eventually the bull market will end with the hurrah of the retail public coming in in a big way. I have to put a little bit of cold water on that theory.

Why is that?
Zulauf: When you look at equities as a percentage of financial assets in the US, it is exactly at the extreme it was at the end of 1999 and in 2007. So the retail public is there where they always have been at the end of a cycle. They do not have the financial means anymore to create the final bubble move some are expecting. Maybe institutions could, but the retail investor won’t do it. Therefore I think this cycle will probably more likely end with a whimper than with a bang. It might continue for another year or so, maybe with a scary correction sometimes late summer or fall this year, followed by another run to the upside which firms the belief that you always have to be fully invested.

What follows thereafter?
Zulauf: We have thrown so much stimulus into the system, and all we see as an outcome is mediocre fundamental growth with real incomes eroding after fixed costs for average households in industrialized economies. The down cycle could be much bigger than anybody believes if the market realizes that all the actions taken in recent years do not work.

Dave, you like scarce assets. Are they still undervalued?
David Iben: In a world where gold is scarce and fiat currencies are anything but scarce, what do you do when stocks get expensive? Do you really run for the safety of cash when cash is no longer scarce and therefore no longer valuable? That’s a dangerous thing to do as the Fed has quintupled its balance sheet, so what is not scarce is fiat currency. Holding it for the short term maybe makes sense, but for the long term this is almost a guaranteed disaster. Therefore some of your money should be in gold.

How do you value gold?
Iben: I read all the time that if you can’t come up with a present value of discounted future cash flows, it doesn’t have value. Therefore gold or a building which is not rented out have no value. I think people have it backwards as value will create future cash flows. Mona Lisa has no cash flow, but does it have no value? I think it has, as it is scarce and can be turned into cash anytime. So instead of looking at the discounted cash flow of gold, people should ask what is cash worth relative to gold.

Do you have other examples?
Iben: Does a hydroelectric dam have value? I think it has. It is scarce. You can’t dam the same river in the same place. Once you have dammed it, you have a huge competitive advantage as you get clean electricity at almost no cost. Now regulators sometimes let you capture the value and sometimes they don’t, but the value is there. We prefer to buy it when the regulators aren’t letting you capture the value because then you can buy it – as is the case now – for 10 cents on the dollar. If the regulator only gets kind of mean in the future, you can make a lot of money.

What about farmland?
Iben: Farmland is an amazing thing. Over the last fifty years, the world’s population has more than doubled and the money supply has gone up ten times or whatever while the amount of farmland has barely grown and in, the developed world, has even gone down. That is scarce. Uranium is very scarce. At 300 $, it is not scarce at all, but at 28 $, it is incredibly scarce. Infrastructure is scarce too as there is the tendency to monopolies. Once you’re the market leader, it’s hard for somebody to replicate. You’re also going to find that energy is scarce. They are not making more oil. Natural gas is more debatable, but even there, the success of the US has not been replicated elsewhere. You can find scarce assets that are good assets that meet the needs of the population for food, communication or energy.

So what do you buy today?
Iben: We’re always looking for the thing the market hates. Two of the most disliked things I have ever seen in my life are miners of gold and Russian equities. So contrary to 2007 when everything was expensive, gold and Russian energy stocks look very cheap. Sure, Russia might be less a part of the European economy, but it might be a bigger part of the Asian economy, so when the market wants to sell us a barrel of oil equivalent for 1 $ by owning Gazprom (Gazprom 1.10 -46.60%) at 2,5 times earnings, I’m going to do it. Then there is a big dislocation between the amount of currency printed and gold. But you don’t even have to like gold at all to buy gold miners at current valuations. They are pricing in a gold price of 1000 $ or less. So you get a free option on a rising gold price which is the icing on the cake. In general, we prefer companies which have long lived reserves while the market likes reserves that can be turned into cash quickly. We like the optionality of something that’s going to be hard to find and replaced. We’re more owners of assets in this market.
Montier: I agree that there are opportunities in Russia such as Gazprom, Lukoil and Rosneft, which are all incredibly cheap. The reason for being cheap is because they are in Russia. That’s fine because they can lose half of their money or have it stolen and are still on a PE of 4. So what? The downside is reasonably muted in those kinds of stocks.
But Russia has been cheap for a long time.
Iben: We buy when the discount to intrinsic value is large enough. Value eventually plays out.

You don’t worry about China?
Iben: I agree China is a bubble. They have been overdoing everything. But when China collapses, is that worse for China or is worse for certain industries? Maybe this is bad for building materials and luxury goods everywhere, but owning China Mobile at 8 times earnings is not such a bad thing even if China messes up.

Apart from Russian energy stocks and scarcity assets: What other cheap assets do you find out there?
Montier: The other area where we have found some value is within Europe. We like some of the European value stocks. Over the last few years, each time the Eurozone crisis has erupted, we have been presented opportunities to own some pretty decently priced badly run companies – which is fine, I even buy crap if it’s priced appropriately, and it has been. Right now, that’s diminishing, but as Felix said, the Eurozone crisis is fundamentally not over. It’s a little bit like putting a band aid on a missing limb – it might look ok, but it doesn’t work for the long term as you can’t have monetary union without fiscal union. Until you get those two things together, you’re going to have periodic crisis that will be opportunities to look at Europe again.

Anything else?
Montier: Something which is just showing up on our radar screens is Japanese value. We did own Japan in the wake of the earthquake and sold out after the market decided that Prime Minister Shinzo Abe was the answer. Now it has become less obvious that Abe is the answer, and the market has gone down a lot. Then we like selected emerging markets. However, as the credit cycle is extraordinarily extended in places like Brazil, Turkey or China, one wants to be selective about the kinds of stocks you are buying.

Are high quality companies such as Nestlé still attractive after their recent runs?
Montier: As they have become more expensive, we have been exiting them since the end of last year. They are priced to deliver 2,5% real return over the next 7 years. Fundamentally low risk, but investors are paying quite a lot for that area of the market.

Do you see outright bubbles anywhere?
Montier:  From a valuation point of view, there aren’t any hugely obvious bubbles. In some ways, I find the term bubble unhelpful anyway because it’s not obvious that it helps a lot to know something is a bubble. From our perspective, the difference between something that is overvalued and something that is in a bubble is irrelevant. We’re not going to own it anyway. The places where we do see evidence of bubbles though is within the emerging market credit cycles, particularly in China.

What about high yield?
Zulauf: High yield is low yield today. The world is so yield hungry that quality spreads have gone back to the extremes we saw in the previous cycle. You can sit there for a while, but this is certainly not an attractive place.

But is it a bubble?
Zulauf: When you say bubble, it implies that it is going to burst soon. I’m not sure that’s what’s going to happen. We see a lot of bubbles, but they keep inflating. For instance, peripheral European government debt is a bubble. There is no question that they lack the fundamental economic base to finally service those debts. Spanish debt to GDP is at 95%, Italian debt is at 140% and the economy might eventually not service it. You can’t tighten the tax screw further because it means that the economy goes downhill again. Those are bubbles in the making. People keep buying Greek debt despite what happened before. Some of the emerging market currencies that are sought by yield hungry investors such as the Turkish Lira or Turkish bonds are bubble-like investments. They could inflate a bit further, but once they burst, it is going to be very painful.

To finish up, what are your three favourite investment ideas – long or short?
Montier: European value stocks, some parts of the yield curve and cash.

Zulauf: Cash to buy cheaper later, gold to sell later higher and some high-quality long duration bonds as a trade to sell later.

Iben: Long gold, long uranium and short consumer stocks.