Last week, on Wednesday 20^th,world stock markets started falling, and by the close yesterday our FTSE-100 index ended 5.5% lower than where it was six trading days earlier. Investors are nervous in a general way. The stock market has risen a long way since last March, and the rally must stop sometime. Is now the time? If so, we weren’t expecting it - a rally with such enormous momentum behind it should take a fair amount of time to run out of steam, rather than just ending suddenly. However, we were nervous about China, emerging markets and mining shares, and these are the areas that have fallen hardest.

 

WHAT ARE PEOPLE WORRYING ABOUT?

There are four separate areas of concern.

1)   The end of quantitative easing. (QE) QE in the UK is the process which has been going on for almost a year, whereby the Bank of England buys government stock (gilts), to support the market.  The artificial demand keeps prices up, and the yields stay low. Most other assets are priced with reference to government stock, so when yields on gilts are low, yields on shares and property are likely to be low too, which happens when their prices rise.  Over the last year the Bank has bought about £200billion of gilts, which is roughly the same amount as the Government has issued.  But now the QE must stop, and investors must come forward to buy the new issuance of gilts - and the government will continue issuing gilts at the same unprecedentedly high levels as last year. If not, prices will fall, yields will rise, and all other assets will start to look expensive by comparison, and their prices will fall too, and their yields will go up.  Other countries, mainly the US, have used QE too, and the world bond markets will need to absorb their debt as well as ours.It seems that the markets are giving the UK government the benefit of the doubt - the gilt market has fallen a bit recently, but not much - till after the election, when a credible plan for debt-reduction will have to be implemented.

2)   Overheating in China

Since I wrote my blog on China three weeks ago there has been a lot of news. Google has decided to pull out of China because of the government’s censorship of the Internet. There is growing evidence that the house-price bubble in Chinese cities is getting out of control, and the authorities have ordered the banks to curb lending. We don’t quarrel with the long-term China story, but we worry about the valuations at this moment, and now, it seems, others do as well.

3)   Bank Regulation

Last week President Obama announced plans for new bank regulations, aimed at preventing a recurrence of the crisis. The cornerstone of the new proposals is the idea that banks’ riskier operations, the ones that led to the melt-down, should be separated from their retail operations (taking deposits from person A and lending it to person B). This idea has been well aired over the last year, but banks and their investors must have assumed that it wouldn’t happen, judging by the market reaction - a sharp fall in the shares of all banks. A similar proposal is being considered by the UK government at the moment.

The idea seems reasonable to us. Banks can speculate in complex financial instruments and lose huge sums of money if they so wish. The proposals address the fact that regulators are unable to assess the riskiness of each new generation of financial instruments, and should not be expected to do so. Meanwhile, taxpayers cannot be expected to bail out the banks each time their risky trading gets them into trouble.

4)   Sovereign debt default and the possible collapse of the Euro

Greece’s government finances are in a parlous condition, which leads experts to conclude that default - the inability to pay the interest on all loans - is a real possibility. Iceland, Dubai and Latvia are in deep trouble, too, and it seems likely that there will be sovereign defaults somewhere before this crisis is over.

Beyond that, some analysts believe that the euro will come under irresistible pressure due to the varying strengths of its component regions - one possible outcome might be the evolution of a ‘hard’ euro and a ‘soft’ euro. The ‘hard’ zone would be Germany, France and the Benelux countries. The ‘soft’ zone could include Greece, Spain, Portugal and Ireland.

HOW WE ARE POSITIONED

Given the concerns listed above, it isn’t surprising that the main fallers in the last week have been banks, miners and emerging markets. We don’t invest in any of those, and we don’t hold any government stock, either in the UK or elsewhere. However, the main lesson of the last couple of years has been the interconnectedness of all things financial, and just because you aren’t in the epicentre, doesn’t mean you won’t be affected. We are watching things very carefully. There are two possible outcomes. One is that investors continue to rotate from the overvalued areas (mining, etc) to other sectors which have been getting steadily cheaper, in which case our portfolios and funds will do very well, or there will be another general panic and rush for the exits, which would affect all non-cash assets. At the moment, and despite what’s happened in the last week, we continue to think that the former outcome is the more likely one over the next few months at least, but the second one is a possibility, and if we see the odds shortening, we will do all we can to protect our clients from it.

SMALL PIECES OF GOOD NEWS

There is always plenty in the macro-economic picture to make your head swim, but closer to home there is some good news. We have had the year-end net asset values from the property companies we hold in Wise Income, and they are all well ahead of their end-September figures. One of the funds, Standard Life Property Income trust, has just been paid £19.2m for a property in Uxbridge, bought last February for £10.98m, a profit of 75% in less than a year. They had bought it for the long-term, but the offer was such a good one that the cash can be better used to buy cheaper, higher yielding assets. It’s certain that this fund will raise its dividend this year, but we don’t yet know by how much.

In the last few days we have heard from two of the private equity funds that Wise Investment holds, that they have raised their cash holdings and reduced their commitments. Private equity is like a conveyor belt - you buy into companies, turn them round, and then sell them on, and at any time you have companies in your stable at all stages of the process. You commit to future investments, and you pay for them through sales of companies, known as ‘realisations’. Of course, the crisis has played havoc with the process, and with the private equity companies’ share prices, by bringing the realisations to a grinding halt. Suddenly you are looking at a pipeline of commitments, no realisations to pay for them, and no possible help from the banks. One of our investee companies, Graphite Enterprise, has continually said to us that the market has been far more worried about their cash-flow than was necessary, because if things stay bad, there will be few realisations, but hardly any new investments either. Anyway, at the end of September, Graphite had £100m of cash and £270m of commitments, due over the next few years. By the end of December they had £114m cash and £243m of commitments. Meanwhile, the banks are becoming more willing to lend, in a modest way. This is important, because in the next year or two there will be a rich harvest of companies looking for private equity help, and far less private equity companies looking to invest in them, so those who are in a position to invest will prosper.

Apple’s profits were announced a couple of days ago - 50% up on the previous year. Apple is the biggest holding in Polar Capital Technology trust, a sizeable holding in TB Wise Investment.

DEBT

Debt, personal, company and government debt, has been growing steadily over the last four decades. July 2007 marked an extreme level, at which debt threatened to ruin the entire financial system, and nearly did so. The actions of governments have moved debt around, rather than decreased its overall level. This is a bit like noticing a large air pocket under the carpet you’ve just laid. You step on the bubble to flatten it, and it just pops up somewhere else. To return the financial system to better health, overall debt levels need to fall worldwide, and lending practices in the future need to be more responsible. This will not happen quickly.

We all know this, and while it’s true that ‘we’re all in this together’ it’s equally true that some are a lot better able to cope than others. We are interested in companies which can thrive in these more difficult times. This is something we bear in mind in every investment decision we make.

THE FUNDS

Since January 19^th, FTSE-100 has fallen 5.5%, and the mining share Rio Tinto 13.5%. TB Wise Investment is down 2.98%, and TB Wise Income 1.99%. Our investment trusts are in many cases on unusually wide discounts, which gives us an extra comfort factor.

The following quotation from Dean Witter in 1932 is good enough to be worth repeating.  “Some people say that they wish to await a clearer view of the future. When the future is again clear, the present bargains will no longer be available.”

With best wishes,

Tony

This blog represents Tony Yarrow’s views as at 28^th January, and does not constitute financial advice.

 

Tony manages TB Wise Investment and TB Wise Income.