The Height of Folly by Tony Yarrow

Written by Admin, 02 December 2011

The Height of Folly

Blog - December 2nd 2011
Why QE hasn’t worked; Risk assets and risky assets; Discount on discount; The height of folly; Brief update on funds

Take heart! This blog is less than half as long as the last one.

Why QE hasn’t worked

I had never heard the words Quantitative Easing before 2009, when they were (I believe) coined to describe the process whereby a country’s central bank prints money which it then uses to buy that country’s government bonds. In this country, the Bank of England bought gilts, causing the prices of gilts to rise, and their yields to fall. The idea was to create two beneficial results. The first was to lower the government’s cost of borrowing. The second was to make other income-paying investments look cheap by comparison with gilts, inducing investors to buy them, raising their prices and causing a wealth effect to spread through the economy. And for the first six months or so, ending in September 2009, that’s exactly what happened-investors bought shares and corporate bonds, and their values rose. Since then gilt prices have risen further, while other asset prices have fallen back.

So, where are we today? A third round of QE was recently announced, adding a further £ 75bn of gilt purchases to the £200bn already completed. With the gilt market worth roughly £ 900bn, or £15,000 for each man, woman and child in the country, the Bank of England will soon own around 30% of the entire stock of UK government debt. They have made a handsome profit on the purchases made with the first and second tranches of QE, but it will be interesting to see how easy this volume of stock will be to sell when the time comes, and what might happen to prices.

The first objective has been achieved. The UK government’s cost of debt is very low-around 2.5%, similar to what the German government pays. But we are nowhere near attaining the other objective. Gilts are at record high valuations relative to shares, commercial property and most corporate bonds. There is plenty of value to be found in those sectors in my view, but in such a highly manipulated market, valuing assets by looking at the ratio between their yields and gilt yields is less meaningful than in other ‘more normal’ times.

Risk assets and risky assets

Observers of the world’s financial markets talk about ‘risk on’ days and ‘risk off’ days. On a ‘risk off’ day, the stock market will go down, particularly the banking, insurance and mining sectors, together with higher-yielding corporate bonds, most industrial commodities, the euro and the pound. Meanwhile, the yen, the dollar, gilts, gold, and the shares of certain companies with perceived defensive qualities will go up. On a ‘risk-on’ day, exactly the opposite will happen. In the last few months, there has been a lot more ‘risk off’ than ‘risk on’. In the longer run, it is unusual for such diverse assets to be as closely correlated as in today’s markets. It has become normal to describe the assets that go down on a ‘risk-off’ day as ‘risky assets’. As we watch the value of our assets shrinking, it is worth remembering that the world’s most valuable and productive assets are to be found in the ‘risky assets’ basket. For my clients, I aim to acquire as many of these valuable and income-producing assets as possible. I recently heard that the total amount of dividends paid by the world’s quoted companies is around one trillion dollars ($ 1,000,000,000,000), which is equal to £92 for each of the seven billion men, women and children on Earth. At times when other investors don’t seem to want these assets, which they haven’t done of late, then we are in a good position to obtain more of these dividends for ourselves-and it’s perfectly legal!

Last Friday, the stock market’s longest losing streak since March 2003 came to an end. I well remember the situation back then. We were about to go to war in Iraq, in the full knowledge that Saddam Hussein had weapons of mass destruction, and was probably prepared to use them. We were told that Saddam could bomb Jerusalem from inside Iraq. A hideous bloodbath seemed inevitable. The stock market felt cheap, but went on falling, day after day. There will be no rally until this war is over, the experts said. In fact, the rally began a week before the start of the war, and it was an explosive rally, with a gain of 8% in the first two days. By the time the rally ended, four-and-a-half years later, the stock market index had doubled.

Of course, this time it’s different, but there are some common features. There is the intractable and worsening situation in Europe, with no solution in sight. We have the prospect of many years of austerity, and morale is at a low ebb. We don’t know what’s going to happen, but we own some of the world’s most productive assets, and we can be reasonably confident that they will come through this difficult time, as has happened in the past.

What of the risk-off assets? It’s a stretch to call gilts safe. In buying a gilt*, I gain access to an asset that gives me an income of 3.2% after paying basic-rate tax, which is less than the rate of inflation, and will give me my capital back in thirteen years’ time, less a guaranteed deduction of 21%. I will get no tax relief against the capital loss I’m going to make, and I am offered no protection against inflation. One day investors are going to wake up and realise how unappealing this opportunity is. Index-linked gilts are similarly pricey. Gold may turn out to be a good investment, but it will never pay an income, and will go up in value only if demand continues to outstrip supply, which can’t be guaranteed.

Discount on discount

This thought occurred to me last week, on reading that the Asian investments held in British Empire Securities (currently TB Wise Investment’s largest holding) which are held through local Asian investment-trust-type structures, are at an average 44% discount to their values on the open market.

British Empire itself was at a 6.5% discount last week, and if you held it through Caledonia Trust, which TB Wise Investment also owns, you benefit from the 22% discount that the market applies to Caledonia’s assets. And Hong Kong’s Hang Seng index has fallen 42% from the peak it reached in late 2007.

So, let’s imagine you’d had a shareholding worth £ 100 in Hong Kong in late 2007. Today, through Caledonia Trust, British Empire Securities and the local funds which own the assets, the share is 42% lower, less a 44% discount, a six-and-a-half percent discount, and a 22% discount. Putting all those things together, you can own the same Hong Kong asset for less than 24% of its open-market value just four years ago. The nature of discounts is to grow in tough markets, and unwind as things recover.

The height of folly

Mark Twain once remarked that one should never make predictions, particularly when they are about the future. It would clearly be the height of folly to make any predictions as things stand at the moment, so that’s what I thought I’d do.

I see this crisis as an anxious journey along an upland river, where stretches of relatively calm water alternate with periods when we shoot through the rapids, with rocks hurtling by on either side of the boat. The first of these periods of heightened anxiety came in the second half of 2007, when the extent of the sub-prime crisis had come to light and it was clear that there was something badly wrong. The second, much more traumatic time was the six-month period following the bankruptcy of Lehman Bros. in September 2008. The third one, focussing on the survival of the euro, began in July this year.

Financial authorities have learned that printing money always buys them time.

The euro can be saved for the moment because the will to defend the single currency exists, so the money will probably be found. However, the strains and contradictions of the Euro will still be there after the re-financing. The crisis is likely to erupt again periodically, until a sustainable structure emerges.

Then there’s China, where inflation has started to fall, and the government is beginning to stimulate growth again. However, the time of useless infrastructure projects financed by cheap loans is probably nearly over. Eventually, maybe in one-to-two years, there will be a banking crisis in China, accompanied probably by much lower commodity prices. The Office for Budget Responsibility (OBR) said this week that the lower growth the UK is experiencing has been caused mainly by higher commodity prices, so lower commodity prices should act as a stimulus to the economies of the West, at the same time as lowering inflation.

However, once that phase is over, the vast amount of money which has been created around the world will finally start to cause inflation, which, once it has taken hold, may rise quickly. Up to this point, interest rates will remain low, because the West’s central banks are no longer concerned about inflation, whatever they may say. They worry about growth, and will keep interest rates at rock bottom until they can see unmistakeable signs of growth coming through. But if inflation starts to rise strongly, then central banks will have no option but to raise interest rates, causing a second wave of falls in the prices of houses.

At this point, public sector workers will be in no mood to accept sub-inflation pay rises. Their bargaining power will be stronger then than now. The main public-sector job cuts will be over long before inflation picks up, and the remaining workers will have far greater job security than their colleagues do now. We may see a return to the conditions of the 1970s, where there is a genuine reason to buy before prices rise. Inflation creates winners and losers, the main losers being anyone whose income is fixed.

The coming credit-crunch in China could lead to increased tensions between China and the US. China’s economy rests on three foundations, construction, export and domestic consumption. When construction dips, the exporting economy will be even more crucial than it is now. China will want a weak renminbi to keep its exports competitive. The last thing the US wants is an artificially weak renminbi, which exacerbates the trade deficit and destroys jobs in America.

It’s clear that the US needs strong government. They don’t have it at the moment. Some people say that President Obama is nowhere near as good at governing as he is at oratory. Another factor is that the two sides are equally matched but have diametrically opposed policies on the great question of the day- deficit reduction- and the result will be stalemate until after the election. For the issue to be resolved, one side needs to win decisively. Maybe it will be the democrats-perhaps the Tea Party will render the Republicans unelectable. A clear win for the Democrats would be my personal favourite outcome-it seems pretty clear that rich Americans are taxed extremely lightly, and a combination of tax rises and spending cuts, proposed by the Democrats would probably work a lot better than just the spending cuts envisaged by the Republicans.

Height of folly-suggested calendar of events


• The ECB, the Bundesbank and the IMF, acting in concert, agree to act as ‘lender of last resort’ to the governments of countries in the euro.

• UK inflation falls to 2.75%

• UK unemployment rises to 2.75 million

• Greece leaves the euro zone

• US election. Narrow victory for Barack Obama over Mitt Romney


• Inflation in China falls to 3.0%

• Eight Chinese regional banks declared insolvent.

• World price of copper falls to $ 5,000 per ton

• UK unemployment peaks at three million. UK inflation finally-briefly- hits 2.0% target

• The new US government announces comprehensive deficit reduction plans

• Portugal leaves the Euro


• The US announces import tariffs on a wide range of Chinese goods

• Chinese invasion of Taiwan.

• US announces that it is 80% self-sufficient in energy

And that’s quite enough folly to be going on with.

Funds-brief update

During the recent sell-off, TB Wise Investment and TB Wise Income both performed better than the overall market. Naturally, they have lagged behind the recent surge, partly because the rises haven’t filtered through yet.

Each new rally has a different shape to the others. The classic shape is for the largest companies to rise first, followed by the more risky medium and smaller ones. Sometimes, all shares rise in unison, and very occasionally the small ones rise first. This one is the classic type, with the largest companies strongly outperforming. The medium and smaller ones, which had become rather fully valued in the summer, when we took some profits, have fallen harder in the last four months than the overall market, and are lagging far behind in the rally. That pattern suits us well, as it has allowed us to top up holdings selectively before they’d really started to move. I expect to see a catch-up over the course of the next few weeks.

We have a fair amount of performing to do to get back to this summer’s highs. On a total return basis, TB Wise Investment needs to go up by nearly 17%, and TB Wise Income by nearly 13%, to regain those levels. For both funds, roughly speaking, anyone who invested in 2007, or at any time since the beginning of October 2010, is losing money on their investment so far. We are naturally very keen to improve the position.

I think the stock market has past its low point for 2011. The violence of the recent rally can partly be explained by hedge funds rushing to cover short positions, but this looks like something more than a ‘short-covering rally’; there is value on offer,there is a lot of cash on the sidelines, and good company results keep coming.

Pleasingly, the funds’ low points this year are significantly above their 2010 low points, which isn’t true for many of the shares and funds we monitor.

This will probably be my last blog of 2011, so it’s time to offer you my warmest seasonal wishes. If you have any questions or comments, I am as always delighted to hear them.

With best wishes,



*Treasury 5.0% ‘25