Here's a pretty gutsy investment review from Jonathan Ruffer of Ruffer LLP (who look after my investments - so far very well). Basically predicting the demise of the credt bubble. This sort of prediction is very unusual from a firm always trying to attract new money.
The 2006 vintage of Chateau Ruffer was not one to relish. The stock markets put in another barnstormer, but we were more barn owl than barnstorm. We had a good showing in both 2004 and 2005 (each of them recovery years in the stock market) but we were not able to repeat it in 2006. Why was this?
This last year has seen the second mania in ten years (the last was the dot-com boom). This is a most unusual phenomenon, since the disgust which follows the puncturing of a bubble usually lasts a generation and sometimes rather more. The reason, of course, is that the whole of the last ten years has been a period of an irrational exuberance of appreciating asset values, with various classes taking it in turns to bathe in the sun of investor euphoria. In early 2000 the top hundred NASDAQ stocks made, in aggregate, no profit and were valued at $6 trillion, the equivalent of the gross domestic product of the United States for eight months. (The last time that such madness had been seen in the investment community was in 1989 when Hirohito’s tennis court (and accompanying palace) was worth more than California: astonishing when one considers that Hirohito wasn’t even very good at tennis.)
The present manifestation is every bit as extreme as the technology boom of 1999/2000, and is considerably more pernicious since it is not so easily identified for what it is. In that earlier period even the bulls of Colt Telecommunications and Yahoo could see that these companies were not without risk, however attractive their long-term outlook. As a result they were largely acquired with saved money, or with minimal debt – all the risks were in the investment vehicle. Today we see the reciprocal of this – all the risk is in the funding of the investment, which means that the investments themselves have, in abundance, all the qualities of safety. The investment opportunity comes about from the availability of massive borrowing at reasonable rates. A recent example has been the purchase of Thames Water for £8 billion, funded with £7.75 billion of debt, and only £250 million of equity. On this sort of financial structure, a fall of 3% in the value of the asset sees all your own money evaporate; from then on it eats away at someone else’s – the lender’s. The key is therefore to draw attention away from asset values, and onto cashflow considerations. If a target investment has a gross yield of , say, 6% and borrowings can be obtained at 5.5%, there is a 0.5% differential which, geared up thirty-fold, gives a return of 15%. Use it to pay down the debt, and the excess gearing recedes. After a few years, the debt has become manageable, so the key is to hope that the string bridge of positive cashflow holds steady over the initial period when the chasm of capital gearing makes the debt/asset value impossibly risky. Thus, the targets of this mania are built around stability and duration of the cashflow, not the capital value. The major beneficiaries of this phenomenon have been top quality property (Manhattan real estate selling on a yield of 3.5%, and in Piccadilly at 3.75%), utilities, infrastructure projects, good brand names of staple products (think Marmite) and long duration bonds of less than exceptional quality, whether corporate emerging market debt, or synthetic.
Synthetic? Once a mania is underway, naughty children find new forms of misbehaviour. The ‘synthetic’ bonds (assets backed by an index representing underlying bonds often with a total value only a fraction of the synthetic itself) have value only on the assumption that the underlying asset movements continue to behave in an orderly and predictable fashion. This cannot be assumed. It is a repeat of the velveteen scam of the zero coupon preference share debacle coming back in a different garb: me no lycra.
Another enormity is to borrow money in a foreign currency with a lower interest rate than the currency of the host investment. The benefit is a lower cost of debt, widening the differential on the net return in the investor’s favour, but with a substitution of currency risk. Jim Grant of Grant’s Interest Rate Observer cites how rampant and widespread this phenomenon now is: 92% of home equity loans in Hungary are Swiss Franc denominated, and 70% of housing related debt in Poland has such currency risk. Moreover, it transpires that the naughty child is not naughty at all, but a genius: the foreign currency risk has turned to be a currency reward as more and more ‘investors’ jump onto the bandwagon and drive these currencies downwards (see chart, overleaf).
This chart is a thermometer of the heat of this mania. The relationship between the Swiss Franc and the Euro is a stable one, since they have so much in common. One thing alone differentiates the Swissie – its reputation as a safe haven and for this ‘insurance policy’ its holders pay a premium in the form of a lower interest rate and less liquidity. Its movement is, in broad terms, a gauge of markets’ fear and complacency; this most eloquent chart shows a decisive victory for complacency over fear.
It is a single example of a most worrying characteristic. Investments in absolute safety are all weakening, and the more absolute the safety (such as index-linked stocks, short dated government bonds and bolthole currencies) the more they tell the same picture of a retreat in value. It is normally the preserve of risk assets to fluctuate in value, since the sort of safety which comes about through risklessness rarely loses value comprehensively. This phenomenon is not, however, unprecedented. It was the striking feature of 1999, when the rush into telecom madness sucked money out of safety to feed the frenzy. It is the dynamic of the tsunami, the first evidence of which is the retreat of the tide in the opposite direction from which the danger itself comes. Those who understood, knew that it was time to head for the hills. We believe that a similar move is warranted now.
We have long predicted a financial tsunami, but we always make it clear that its timing is uncertain, and that there was little point, and some mischief, in trying to pick the moment of its arrival. The prediction of a financial dislocation is a big enough investment call, without adding an overlay as to its likely timing. But, for the first time, we are calling the top. To us it is simply incredible that the big majority of forecasters do not even consider this relentless rise in leverage as worthy of consideration. In our view, we take our cue from the Michelin rosette: stock markets are currently worth a detour.