BLOG MAY 7^th 2010

SOME GOOD NEWS AND SOME BAD

After my last blog, called ‘The canary in the mine’ I’d like to thank those of you who contacted me to point out that when the toxic gas escapes in the mine, the canary doesn’t sing, it-as you might say-croaks. The canary was intended as a metaphor for early-warning signs of trouble in financial markets. This blog was intended as a follow-up, and was going to be a list and analysis of various early-warning signs and ratios that we have found useful over the years, updated in the light of recent experience.

However, events have overtaken this plan, as we find ourselves in the middle of a full-blown crisis. So, this blog will give a view of the Greek debt crisis and some of the other factors challenging markets at the moment, with, as usual an update on TB Wise Investment and TB Wise Income.

I need hardly say that the extent and speed of the collapse in the stock markets has taken me by surprise. The good news is that our funds have held up very well in the turbulence so far. So far, in the last month, from the close on April 6^th to the close yesterday, our benchmark index the FTSE-100 has fallen by 8.5%. During the same period, TB Wise Investment is down 0.9%. TB Wise Income is down 2.2%. Let’s have a quick look at the reasons.

TB Wise Investment has been helped by several factors. First, a period in which small companies performed better than the overall market. Second, our overseas holdings have been cushioned by the falling pound. Third, we haven’t been in those areas of the market that have fallen most. The Greek crisis, together with news of a slowdown in Chinese industrial production, have caused a general rise in risk aversion, with a sharp sell-off in commodities, mining shares, and banks, none of which we hold.

However, it often happens that a sell-off affects the more liquid, larger companies first, and the smaller ones later. It seems inevitable that our smaller companies will be dragged down with the market, so we have reduced our holdings in this area. Also, we have sold some more defensive funds in areas such as biotechnology and Japan.

These have done their job of being defensive, and once this storm has blown itself out, it feels better to be holding cash to pick up bargains-we may even see opportunities to dip a toe into the emerging markets, for the first time in several years. As a result of the sales we’ve made, TB Wise Investment now has around 14% in cash.

Around 22% of TB Wise Income is in fixed interest and property, which have hardly moved over the last couple of weeks. Not holding banks or miners has been a big plus for the fund, and though there isn’t much invested overseas (around 10%) the weak pound will have helped in this area. The part of the fund that has been weakest has been the insurance company shares-particularly Legal & General, Aviva, and Standard Life. We have had trading statements from all of these companies in the last couple of weeks, and all are trading well, and rapidly increasing their already healthy cash piles. The prices of all these companies discount a great deal of bad news, but they have dropped with, or in the case of Aviva, more than the market on worries about the extent of their exposure to problematic European sovereign debt.

Increasingly, I think of Wise Income as an annuity. The value of the assets in it is the value and durability of the income streams they produce. All the things that have happened over the last couple of weeks have not altered the value of those income streams, except to the extent that in future it may be harder for the payers of those income streams to maintain or increase them. Any fall in the asset prices simply increases the yield, and Wise Income’s yield is nudging 6.0% again. The fund is still fully invested. I continue to believe that so long as we can maintain the quality of Wise Income’s earnings, the price will take care of itself in the end.

If you’re going to panic, you have to panic early, and it is no time now to be raising more cash in the funds. We are already getting to the point where the markets’ reaction is starting to look overdone, and it wouldn’t  surprise us if there is a substantial bounce as soon as next week.

THE GREEK DEBT CRISIS-HOW BAD IS IT?

It’s all part of the wider debt problem. If you had just come back after twenty years’ solitary confinement, or somewhere equally remote, I’d explain it to you like this. Over a period of at least three decades, the Western world gradually borrowed more and more money. Inflation stayed low, because we were able to buy ever more goods from China ever cheaper. So interest rates stayed low, and money was easy to borrow. As a result, there was a property boom-you might say bubble-almost everywhere. Eventually, the boom in Northern Europe spilled over into the holiday-homes market in Southern Europe, fuelled by cheap loans.

The West bought manufactured goods from China. The goods travelled West, and the money travelled East. To close the circle, the Chinese invested in Western government stock, mainly that of America. Things started to unravel with the ending of the housing boom in the US in the summer of 2006, and by the middle of 2008 things had got so bad that around half of the Western world’s banks were insolvent. Governments were faced with a nasty choice-either let the ruined banks fail, which could lead to small savers’ deposits being wiped out and a complete loss of confidence in the financial system-or rescue the banks, and somehow come up with a plan which would prevent them from getting into the same mess again. 2008 was about banks-what we are seeing now could be the start of the next phase of this prolonged crisis-sovereign government debt.

The Greek problem is a uniquely difficult one. I felt at the time (1999) that the Euro project was rushed into. The strong northern European countries were synchronised and a currency union between them worked well. But they rushed to sign up others without waiting to absorb each new entrant. We are now seeing the weakness of the others, but it is now virtually impossible for them to leave the Euro. Before joining the Euro, the Greek government had a low credit rating and it was difficult and expensive for it to borrow. Once in  the euro, money was plentiful and cheap. Now it turns out that a good deal of the borrowed money has disappeared, and the accounts haven’t been reliable, either. The property boom is over. The economy is uncompetitive and is in recession, but they can’t devalue their currency.

The Greek people are angry at the harsh austerity package which goes with the loan package that will stop their government from defaulting on its debt. The Germans are angry too. 30% of Greek government spending goes on benefits-their state retirement age is 57. Why should the Germans, whose state retirement age is 67, subsidise the profligate Greeks? But, if they don’t, the euro project could be over. For politicians brought up on the absolute necessity of making sure that the 1939-45 war could never happen again, such an outcome is unthinkable.

For the last decade I have had a preference for investing in North and West Europe, and an aversion to the South and East. This has turned out to be a correct hunch, but unfortunately, this is no longer just a Greek problem, or even a southern European one. It affects the Germans and others who will have to bail the Greeks out. The problems could also spread to the other weaker economies-particularly Italy, Portugal and Spain. Any bank or insurance company who has lent to these governments will be lucky to escape without losses-which will weaken their businesses, making it harder for them to lend to others.

We are now in the middle of the panic phase of this crisis. The bail-out has been accepted, the austerity measures agreed, the sticking plaster applied, and probably the euro will survive-for now. But the strains within the Euro-possibly terminal-will be with us for a long time.

THE ELECTION

This was the tightest possible result. Labour plus Libdems come within a seat or two of Tories plus Democratic Unionists. Either of these two combinations would appear unable to govern for more than a very short time. Labour have far more need than the Tories to do a deal with the Libdems, as without an alliance they will be in opposition. It looks as if the only combination that could produce a working government would be Tories plus Libdems. The problem is that the Tories are opposed to voting reform, and the more right wing members of the party don’t want an alliance. If these difficulties can be overcome, the market would probably be fairly relaxed about a Tory-Libdem alliance.

A second election very soon, to produce a decisive mandate, is also an appealing possibility. Anything else looks unworkable, and could only prolong the horrible state of policy vacuum in which we have lived for over a year.

This blog represents the personal views of Tony Yarrow as at May 7^th 2010, and does not constitute financial advice.