With worries prevalent about a resurgence of inflation, Veritas Asset Management is focusing on holding companies that can ride out any storms, as well as firms which play to spending themes such as healthcare and infrastructure.

There have been contrasting economic developments on the economic front recently. The rate of decline of US house prices has slowed, and there are rumours of London house buyers being suddenly outbid by rivals, a practice known locally as gazumping. Average credit default swap prices have fallen back to long term averages. World equity markets have bounced by 18 per cent from their March lows to end-June, and consensus earnings estimates are improving around the world.

On the other side of the coin, the US unemployment rate has doubled from 4.8 per cent to 9.5 per cent in just 16 months. Repayments on loans known as Option ARMs (adjustable rate mortgages) will re-set from $1 billion per month to $8 billion per month by late-2011. Some $400 billion of commercial loans are due to be re-paid or re-financed this year; if they are not, the underlying properties may have to be sold. Western fiscal deficits are astronomic and the prospect of tax increases is hanging over Western consumers’ heads.

Some markets are in free-fall: Manhattan apartment prices dropped by 18.5 per cent in the second quarter (year-on-year), the first drop since 2002.

Nothing common

What we are experiencing now is not a common or garden variety recession. Rather it would appear to be a part of a longer term, secular plate shift. The Russian economist Nikolai Kondratieff in 1925 published his hypothesis of long wave cycles, of the order of 50-55 years, based on his study of a range of economic statistics for the previous 150 years (commencing in the 1780s).
 
We are not Kondratieff disciples, but it is fascinating to observe how closely the key tenets of his theory are playing out again today. 

For instance, he said that in a rising wave, capital accumulates at a higher rate than investment; now Asian savings produced a global savings glut. Eventually the long wave goes full cycle, cost cutting gets underway, new inventions emerge – and the rising wave starts again

Are we in the Kondratieff "long wave down cycle"? We have only to consider that total US debt stood at a breathtaking 375 per cent of gross domestic product in the first quarter of 2009 to see that it is possible. Credit-based growth cannot continue indefinitely. Even in 1933, in the Great Depression, the ratio only reached 299 per cent.

Ben will fix it
With these debt levels, consumers’ net worth having plummeted by $14 trillion in two years and unemployment rising sharply, it is little wonder that the US personal savings rate is climbing back up to more sensible levels.

Inter alia, ‘baby boomers’ are adjusting to the prospect of a more subdued retirement than they had anticipated. The labour participation rate is edging up as people postpone their retirement.

Democracy however requires that politicians and central bankers make every effort to put off the evil day of sanctioning the economic pause / recession / depression required to return debt to sustainable levels. Financial institutions at risk of going bankrupt? Not to worry, the government will bail them out. In the UK, the government has rescued Northern Rock, Royal Bank of Scotland and Lloyds. GM in the US now stands for "Government Motors".

Politicians are focused only on re-election: if the drug addict is experiencing withdrawal pains, keep him happy by giving him another shot. Exactly as Karl Marx predicted, democracy is leading to socialism. It is ironic that the West is moving towards socialism just as China’s communist regime is enthusiastically embracing capitalism.

For more than 10 years, the US Federal Reserve, under the chairmanship of Alan Greenspan and now Ben Bernanke, has been interfering with the market’s natural cycles, ratcheting up the money supply to combat various economic problems – the 1994/5 Mexican "Tequila crisis", the 1998 Russian financial crisis and associated Long-Term Capital Management hedge fund crisis, and the feared Year 2000 (Y2K) computer disruptions (which never materialised).

Inflation risk
The risk is that this massive stimulus leads to inflation. On one hand, inflation worriers believe that inflation is a monetary phenomenon and consider it inevitable that the vast amounts of stimulus will feed through to prices in time. Indeed, they opine, governments will keep stimulating until there is inflation; de-basing the currency is the only weapon at their disposal to resolve the issue of excessive debt.

The deflationists compare the total amount of credit destruction so far, estimated at $14 trillion in the US alone, with the US Treasury and Fed’s stimulus of $2 trillion – and conclude that the Federal Reserve is pushing on a string, that inflation is still a long way off.

They look at the size of fiscal deficits, already out of control, and believe the markets will rein governments in before the onset of inflation, which is the cruelest tax of all. Inflation needs shortages to take hold, and the deflationists also cite the G7 output gap, which shows that actual output / production is significantly below capacity.

The jury is out as to which camp is going to be proven correct. At Veritas, we are alert to the risks of inflation with our emphasis on companies with pricing power that would be able to pass cost increases on.

Nearly two years after the onset of the credit crisis, the outlook remains opaque.

Lumpy returns
The 2009 edition of Prof Dimson, Marsh and Staunton’s “Global Investment Returns Yearbook” focuses on the fact that economic history does not go in a straight line and equities do not get to their destination smoothly.

In the 109 years from 1900 to 2008, equities returned in real terms an average of 6.0 per annum. However, the average in 1900–49 was only 3.5 per cent p.a. - but from 1950 to 1999 it was 9 per cent p.a. We were spoiled by the high returns of the 1980s and 1990s – years in which the Berlin Wall fell, the Cold War ended, productivity and efficiency accelerated, technology progressed and trade expanded with globalisation.

Even so, for the long term investor, the superior track record of equities relative to bonds and bills remains firmly intact. As  a 109-year graph shows, an investment in equities (with dividends re-invested) would have grown in purchasing power by 582 times, that in bonds by 9.9 times and in bills by 2.9 times.

In the two decades of the 1980s and 90s, equities seemed a sure route to getting rich quickly. However, the confluence of events listed above was exceptional and not repeatable. Today, as we look ahead, the enrichment process will be slower. The Professors advise investors “not to harbour fantasies of an immediate return to previous higher rates of return.”

At Veritas, our faith in equities as the long term driver of real returns, ahead of inflation, remains undimmed. Will it be a V-shaped recovery? W-shape? L-shape? We’re opting for a ‘V-L’ shape – Vera Lynn’s “don’t know when, don’t know where”. We do know though, that dividend yields on many blue chips are tantalisingly in excess of 5 and 6 per cent p.a., which must be attractive on a 5-10 year view relative to, say, the 10 year gilt, yielding a fixed 3.8 per cent p.a.

The contrarian would salivate at the mountain of cash that is parked on the side-lines at present.

With our global thematic hat on, our clients’ money is at work in companies where we see growth in free cash flow over time, a key building block in achieving our objective of real returns.

One of the ways we find this growth is through our core conviction theme of secular growth. Here, Asia, especially China, still tops our list, for all the well known reasons. China is of the few countries with a fiscal surplus, comfortably able to afford last November’s $585 billion stimulus package. No pension or healthcare drain on profits. It has a large population with minimal debt and high savings, discovering fresh horizons in terms of lifestyle.

The focus in our Asian strategy has for some time been on the domestic side, with exporters under pressure. Countries like China need to re-orient their economies so that domestic demand takes the baton from exports as the main driver of growth.

US household consumption runs at 67 per cent of GDP, Japan’s at 55 per cent - China’s at 33 per cent. One of the reasons is the thin social safety net. As Paul Krugman, the Nobel Prize-winning economist, explains it: “Because people have to stop at the bank on their way to the hospital, they build up precautionary savings at the expense of consumption”.

Turned tables
China had re-invested $1.7 trillion of her export surpluses into US Treasury and other bonds by the end of 2008, equal to 40 per cent of her GDP. It is said that if you owe your bank £1,000 and can’t pay, you have a problem; if you owe £100 million and can’t pay, it is the bank that has the problem. Beijing is increasingly airing her concern over the US government’s fiscal profligacy.

When Timothy Geithner, the US Treasury Secretary, went to visit Beijing in June, he went with the humility of retaining one of his biggest customers and financiers: currency manipulation and human rights abuses had quietly slipped off the agenda. A Treasury official told reporters that “we are attuned to the interests of our investors and plan to listen closely to what they have to say”.

The Governor of China’s central bank published a paper on 24th March calling for “creative reform of the international monetary system towards an international reserve currency with a stable value, rule-based issuance and manageable supply.” That rules out the dollar. The paper is however unequivocal that this should be “a gradual process that yields win-win results for all”.

Beijing won’t shoot itself in the foot and do anything to damage its largest investment, but the dollar’s card would appear to be marked on a 10-20 year horizon.

China has now approved the use of the renminbi to settle trades with ASEAN region countries to help domestic companies avoid exchange rate risk. Russia may be included. China will allow Hong Kong companies to start issuing renminbi debt, putting Hong Kong banks at the forefront of internationalising the renminbi. The Head of China’s Construction Bank has called on the US to issue renminbi-denominated bonds.

Other investment themes

Other Veritas structural growth themes include outsourcing, regulation and targeted healthcare. Where appropriate to clients’ mandates, we own Alcon, an eyecare company that produces intraocular lenses for cataracts and drugs for glaucoma. Demand for these products is impervious to economic cycles.

Another core conviction theme is ‘Big Government’, reflecting the elevated levels of fiscal stimulus at present, especially on infrastructure. Examples are toll roads, power companies, water companies.

Given the opacity of the outlook, our third core conviction theme remains ‘strong survivors’ – established companies with a dominant market position, durable competitive advantage and strong free cash flow that will emerge from the present still-fragile environment in robust shape.