20th November 2011

Euro zone crisis

Let’s assume the euro will fail (note the Panel did not necessarily think this was the case but the scenario is worthwhile considering). Should one hold any assets in the euro area? The answer is yes, especially if they’re priced attractively. There is a good chance of a flight by investors to quality, so robust assets which generate cash and pay out dividends should be attractive (one should stick to northern Europe, such as Germany and the Netherlands). Simple business models which don’t involve cross-border transactions could be attractive as they avoid currency matching problems in times of uncertainty.

China slowing

There is evidence that China is slowing. There are signs of capital flight (individuals buying assets elsewhere in the world), and that the Chinese current account is heading towards deficit. One example discussed was the New Zealand pulp factory that has not received an order from a Chinese buyer for three months – this hasn’t happened in the last decade.

If the Chinese current account turns to deficit, they may become sellers of US government bonds instead of buyers. The impact of this could be significant for US bond yields, and if US government bonds start to look attractive again, there could also be an impact on equity yields (via falling prices) as money starts to flow towards bonds again.

The panel looked at the headwinds that have been plaguing Chinese exporters: increasing labour costs, a strengthening domestic currency, increasing raw material prices and weakening western consumer demand. Of the four, the only one that the panel did not see easing was weakening western demand. However, as advantages to Chinese exporters have diminished, their consumption of imports has increased. As such, an interesting asset class is western consumer products manufacturers with brands strong enough to tempt Chinese away from cheaper domestic alternatives.

US residential property

US residential property is one of the few properly undervalued assets in the world, and prices are down 20-30% but in certain markets it would be closer to 40-50%. US property is now cheap compared to rents again, with pockets of excellent value. There are several reasons for this – the US has a growing population; the houses are often not built to last; anywhere in the south half of the country a house will be uninhabitable if neglected for long due to damp, rot, termites, etc; the US went into this trouble before anyone else, so could be further along the recovery path.

If US property prices have bottomed (and that’s a big “if” – just because an asset is cheap, doesn’t mean it can’t get cheaper), then this could be a positive surprise for US banks. The US banks lead the way into the troubles (subprime, for example) and there is a general feeling that they have been addressing the problems, at least partially due to the fact that the Fed has been flushing the system full of money so they can afford to take the write downs. Anecdotally, the panel believes that the European economy has a long way to go before its banks have really addressed the problems they face. In the UK, banks may look a little bit further along, but the housing market hasn’t had a correction on the same scale as the US. But which US banks look attractive? You could always do worse than following Warren Buffett.

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

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