More Bread and Circuses

Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.

“Lower borrowing and a smaller deficit mean less debt.”
– George Osborne, British Chancellor, in his 2014 Budget Speech.

“Bingo ! Cutting the bingo tax and beer duty – To help hardworking people do more of the things they enjoy.”
– Asinine Conservative post-budget advertisement.

“Bingo ! I say, you there ! How is your whippet ? Jolly good, jolly good. Carry on.”
– Inevitable twitter response via #torybingo.

“..beer, and above all gambling, filled up the horizon of their minds. To keep them in control was not difficult.”
– George Orwell, ‘1984’.

“Mad piece of theatre over the petty cash”
– Headline to Matthew Engel’s budget review in the Financial Times.

First, pedantry corner: lower government borrowing and a smaller deficit do not mean less debt, they merely imply that the rate at which the government’s vast debt pile grows is slowing. It is still growing. But in a triumph of Orwellian doublespeak, the UK coalition government has managed to handily conflate ‘debt’ (the overall mountain of government borrowing) and ‘deficit’ (the shortfall between government revenues and expenditure in a given year), in much the same way that it has contrived to conflate tax ‘avoidance’ (which is entirely legal) with tax ‘evasion’ (which isn’t). The financial media tend toward tacit support of this deliberate confusion. At first glance, George Osborne’s budget did contain some eye-catching announcements on savings and pensions – until the BBC’s Paul Lewis pointed out that only 1 in 8 UK adults has more than £50,000 in savings and 1 in 5 have no savings at all, with those in between having, on average, around £10,000 in their savings or pensions ‘pot’. A nation of savers we are not.

But then with deposit rates hovering at around zero, is it any surprise ? The Chancellor did manage to drive a further wedge between the pensioner and younger generations by introducing ‘Pensioner bonds’ paying 4% for three year paper (versus the 1% available on three year Gilts). If this is a lousy time to be a saver, it’s an even lousier one to be a young saver. Speaking of inter- generational tensions: as we’ve said before, a heavily indebted government’s fiscal policy can be reduced to just four words: the unborn cannot vote. “Welcome to the world kids,” tweeted Oliver Ralph (Deputy Head of the FT’s Lex column), “after paying off your student loan and saving for a house deposit you can now subsidize your parents’ retirement.”

On a more positive note, the broadening of the ISA subscription limit to £15,000 makes these relatively simple, flexible and transparent vehicles quite an attractive alternative to pensions for many private investors (given Paul Lewis’ observation above), provided that cash-strapped future governments aren’t tempted to raid them. But given trends in longevity, healthcare and government indebtedness, one is obliged to ask quite how the State will manage to support a growing population of elderly poor.. We’ll pass over that for the time being.

So you have your expanded ISA – what are you going to put in it ?

Cash has to be low down the list of priorities. In a fiat currency world in which politicians can print unlimited amounts of ex nihilo money as they see fit, one has to ask whether there is any point to cash savings at all, except to provide the optionality of investible dry powder as and when markets “correct” – assuming that they ever will, given those unlimited amounts of ex nihilo money cascading into the markets.

With interest rates still stuck at 300-year lows, most bonds look distinctly unpromising as anything except material for gallows humour. Our own bond exposure is limited to sovereign and quasi- sovereign paper offering a positive real yield – and to floating rate exposure in the same names targeting USD Libor + 7%.

By a process of elimination, equity markets seem set to be the primary beneficiaries of all those yawning ISA pots. But which ones ? The most important characteristic of any investment one makes is its starting valuation. That would tend to argue against most North American stocks, given a) the close-to-all-time-highness of the major indices and b) the absolute all-time-highness of US corporate profits as a share of GDP. Assuming the latter mean reverts, US equities are destined to disappoint almost everybody over the medium term. European markets are more fairly priced, but then they should be since the euro zone remains stuck in an existential crisis of bad banks, low growth and insoluble indebtedness. Since we’re not constrained by index or benchmark, we can pursue value for value’s sake, and the answer remains: Asia, albeit selectively (and ex-China). Our favourite (by definition bottom-up, deep value) Asian equity fund has the following characteristics:

Average price / earnings ratio: 9x.
Price / book: 0.9.
Historic return on equity: 14%.
Average yield: 3.8%.

Relative to any other market or sector, there is simply no comparison.

Other than geopolitics, the major fly in the ointment for equities as an asset class remains confusion over the extent and duration of Fed (and other central bank) interference across financial markets. We think the Fed, after five years of increasingly ludicrous monetary stimulus, has painted itself into a corner from which it cannot escape, and it has created a false and grossly inflated market from which both equity and bond investors are now reluctant to withdraw. And so the investment world effectively now falls into just two camps: momentum investors (hot money), and investors only interested in valuation. We are happy to occupy the latter camp. There are presumably also some somewhat lonely investors occupying the sidelines and waiting to take advantage of lower prices, but their wait may be long, and you won’t likely hear much about them because the fund management industry and its attendant financial media abhor the vacuum of market non-participation (aka “cash”). As in 2007, there are too many investment managers apparently hearing the music and feeling compelled to dance.

In summary, we are trying to have our cake and eat it. In a financial environment where no prices can really be trusted because relentless QE and monetary stimulus distort everything, we strive to be fully invested – but across multiple asset classes, selectively incorporating high quality debt, deep value equity, uncorrelated funds and precious metals. By not capitulating entirely to the equity market gods we plan to avoid the risk of appreciable loss from overmuch equity market commitment. As the noted value manager Seth Klarman points out,

“The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times. Many institutions interpret their task as stock-picking, not market timing; they believe that their clients have made the market timing decision and pay them to fully invest all funds under their management.”

Given the thick fog that surrounds any consideration of the future, being fully invested (in stocks, specifically) seems as dangerous as the concept of indexing itself. Seth Klarman again:

“To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that “in any sort of a contest—financial, mental or physical—it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.” I believe that over time value investors will outperform the market and that choosing to match it is both lazy and short-sighted.”